SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

                      ------------------------------------

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF
1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003.

                                       OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE TRANSITION PERIOD FROM ______ TO ______.


Commission File Number: 0-23336
                        -------

                               AROTECH CORPORATION
 -----------------------------------------------------------------------------
             (Exact name of registrant as specified in its charter)


                Delaware                              95-4302784
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     (State or other jurisdiction of        (I.R.S. Employer Identification No.)
      incorporation or organization)


           632 Broadway, New York, New York                10012
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      (Address of principal executive offices)           (Zip Code)

                                 (646) 654-2107
--------------------------------------------------------------------------------
              (Registrant's telephone number, including area code)

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

  Title of each class           Name of each exchange on which registered
-----------------------         -----------------------------------------
         None                               Not applicable

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01
                                                            par value

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the  preceding 12 months (or for such  shorter  period that the  registrant  was
required  to file  such  reports),  and  (2) has  been  subject  to such  filing
requirements for the past 90 days: Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation  S-K (ss.  229.405 of this chapter) is not contained  herein,  and
will not be  contained,  to the best of  registrant's  knowledge,  in definitive
proxy or information  statements  incorporated  by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [ ]

Indicate  by check mark  whether  the  registrant  is an  accelerated  filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]

The  aggregate   market  value  of  the   registrant's   voting  stock  held  by
non-affiliates  of  the  registrant  as  of  June  30,  2003  was  approximately
$31,017,725 (based on the last sale price of such stock on such date as reported
by The Nasdaq National Market).

(Applicable  only to  corporate  registrants)  Indicate  the  number  of  shares
outstanding  of each of the  registrant's  classes  of common  stock,  as of the
latest practicable date: 62,312,796 as of 3/23/04

Documents incorporated by reference:                                       None



<PAGE>

                                PRELIMINARY NOTE

         This annual report contains historical  information and forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995  with  respect  to  our  business,   financial  condition  and  results  of
operations.  The words  "estimate,"  "project,"  "intend,"  "expect" and similar
expressions  are  intended  to  identify   forward-looking   statements.   These
forward-looking  statements  are subject to risks and  uncertainties  that could
cause  actual  results  to differ  materially  from those  contemplated  in such
forward-looking  statements.  Further,  we operate in an industry  sector  where
securities  values may be volatile and may be  influenced  by economic and other
factors beyond our control.  In the context of the  forward-looking  information
provided  in this  annual  report  and in  other  reports,  please  refer to the
discussions  of risk  factors  detailed  in,  as well as the  other  information
contained in, our other filings with the Securities and Exchange Commission.

         Electric  Fuel(R)  is  a  registered  trademark  and  Arotech(TM)  is a
trademark of Arotech  Corporation,  formerly known as Electric Fuel Corporation.
All  company  and  product  names  mentioned  may be  trademarks  or  registered
trademarks of their respective holders. Unless otherwise indicated,  "we," "us,"
"our" and similar terms refer to Arotech and its subsidiaries.


<PAGE>

                                     PART I

ITEM 1.           BUSINESS

General

         We are a defense and security products and services company, engaged in
three business areas:  interactive  simulation for military, law enforcement and
commercial  markets;  batteries  and  charging  systems  for the  military;  and
high-level armoring for military,  paramilitary and commercial  vehicles.  Until
September  17,  2003,  we were known as Electric  Fuel  Corporation.  We operate
primarily  as a holding  company,  through our various  subsidiaries,  which are
organized into three divisions. Our divisions and subsidiaries are as follows:

         >>       We develop, manufacture and market advanced hi-tech multimedia
                  and interactive digital solutions for use-of-force and driving
                  training of military,  law enforcement and security personnel,
                  as well as offering  security  consulting  and other  services
                  (our Simulation, Training and Consulting Division), consisting
                  of:

                  o        IES Interactive Training, Inc., located in Littleton,
                           Colorado,  which provides  specialized "use of force"
                           training  for  police,  security  personnel  and  the
                           military ("IES");

                  o        FAAC  Incorporated,  located in Ann Arbor,  Michigan,
                           which provides  simulators,  systems  engineering and
                           software  products  to the  United  States  military,
                           government and private industry ("FAAC"); and

                  o        Arocon Security Corporation, located in New York, New
                           York,  which provides  security  consulting and other
                           services,  focusing on  protecting  life,  assets and
                           operations with minimum hindrance to personal freedom
                           and daily activities ("Arocon").

         >>       We  manufacture  and sell  Zinc-Air and lithium  batteries for
                  defense and security products and other military  applications
                  and  we  pioneer   advancements  in  Zinc-Air  technology  for
                  electric  vehicles (our Battery and Power  Systems  Division),
                  consisting of:

                  o        Electric Fuel Battery Corporation, located in Auburn,
                           Alabama,  which  manufactures and sells Zinc-Air fuel
                           cells,  batteries  and  chargers  for  the  military,
                           focusing on applications  that demand high energy and
                           light weight ("EFB");

                  o        Epsilor  Electronic  Industries,   Ltd.,  located  in
                           Dimona, Israel (in Israel's Negev desert area), which
                           develops and sells  rechargeable  and primary lithium
                           batteries  and smart  chargers to the military and to
                           private industry in the Middle East,  Europe and Asia
                           ("Epsilor"); and

                  o        Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh,
                           Israel,  which  produces  water-activated  lifejacket
                           lights   for    commercial    aviation   and   marine
                           applications, and which conducts our Electric Vehicle
                           effort,   focusing  on  obtaining  and   implementing
                           demonstration projects in the U.S. and Europe, and on
                           building broad industry partnerships that can lead to
                           eventual  commercialization  of our  Zinc-Air  energy
                           system for electric vehicles ("EFL").


<PAGE>

         >>       We utilize  sophisticated  lightweight  materials and advanced
                  engineering  processes to armor vehicles (our Armored  Vehicle
                  Division), consisting of:

                  o        MDT  Protective  Industries,  Ltd.,  located  in Lod,
                           Israel,  which  specialize in using  state-of-the-art
                           lightweight  ceramic  materials,   special  ballistic
                           glass and  advanced  engineering  processes  to fully
                           armor vans and cars, and is a leading supplier to the
                           Israeli military,  Israeli special forces and special
                           services ("MDT"), of which we own 75.5%; and

                  o        MDT Armor  Corporation,  located in Auburn,  Alabama,
                           which conducts MDT's United States  activities  ("MDT
                           Armor"), of which we own 88%.

         We acquired FAAC and Epsilor in early 2004. Prior to the acquisition of
FAAC and Epsilor,  we were organized  into two  divisions:  Defense and Security
Products  (consisting  of IES,  MDT,  MDT Armor and Arocon),  and Electric  Fuel
Batteries  (consisting  of EFL  and  EFB).  We  have  reported  our  results  of
operations for 2003 and 2002 in accordance with these earlier divisions, and our
financial  results for 2003 and 2002 do not include  the  activities  of FAAC or
Epsilor.

     Background

         We   began   work   in   1990   on  the   research,   development   and
commercialization  of an advanced  Zinc-Air battery system for powering electric
vehicles,  work that  continues  to this  day,  under  the name  "Electric  Fuel
Corporation";  we changed our name to Arotech  Corporation  in  September  2003.
Beginning in 1998, we also began to apply our Zinc-Air  fuel cell  technology to
the defense industry, by receiving and performing a series of contracts from the
U.S. Army's  Communications-Electronics  Command (CECOM) to develop and evaluate
advanced primary Zinc-Air fuel cell packs. This effort culminated in 2002 in our
receipt of a National  Stock  Number,  a Department  of Defense  catalog  number
assigned to products authorized for use by the U.S. military, and our subsequent
receipt in 2002 and 2003 of a total of $9.3  million in delivery  orders for our
newly designated BA-8180/U military batteries.

         We further  enhanced our  capabilities in the defense  industry through
our purchase in the third  quarter of 2002 of IES and MDT. In the first  quarter
of 2004,  we added two new  subsidiaries,  with  their  business  lines,  to our
company: FAAC and Epsilor.



                                       2
<PAGE>


         Between 1998 and 2002, we were also engaged in the design,  development
and  commercialization  of our  proprietary  Zinc-Air fuel cell  technology  for
portable consumer electronic devices such as cellular telephones,  PDAs, digital
cameras and  camcorders.  In October 2002, we  discontinued  retail sales of our
consumer  battery  products  because of the high costs  associated with consumer
marketing and low volume manufacturing.

         We were  incorporated in Delaware in 1990 under the name "Electric Fuel
Corporation," and we changed our name to "Arotech  Corporation" on September 17,
2003.  Unless  the  context  requires  otherwise,  all  references  to us  refer
collectively  to  Arotech   Corporation  and  Arotech's   wholly-owned   Israeli
subsidiaries,  EFL and Epsilor; its majority-owned Israeli subsidiaries, MDT and
MDT Armor; and its wholly-owned United States subsidiaries, EFB, IES, Arocon and
FAAC.

         For financial information  concerning the business segments in which we
operate, see Note 15 of the Notes to the Consolidated Financial Statements.  For
financial information about geographic areas in which we engage in business, see
Note 15.c of the Notes to the Consolidated Financial Statements.

     Simulation, Training and Consulting Division

         USE-OF-FORCE TRAINING

         Through our wholly-owned subsidiary, IES Interactive Training, Inc., we
provide  specialized "use of force" training for police,  security personnel and
the military.  We offer products and services that allow  organizations to train
their personnel in safe, productive, and realistic environments. We believe that
our   training   systems   offer  more   functionality,   greater   flexibility,
unprecedented  realism  and a wider  variety  of  user  interface  options  than
competing products.  Our systems are sold to corporations,  government agencies,
military and law enforcement  professionals around the world. The simulators are
currently  used  by  some  of the  worlds  leading  training  academies  and law
enforcement  agencies,  including  (in the United  States)  the FBI,  the Secret
Service, the Bureau of Alcohol,  Tobacco and Firearms,  the Customs Service, the
Federal  Protective  Service,  the Border  Patrol,  the Bureau of Engraving  and
Printing,  the Coast Guard, the Federal Law Enforcement  Training  Centers,  the
Department  of  Health  and  Human  Services,   the  California   Department  of
Corrections,  NASA, police departments in Texas (Houston),  Michigan  (Detroit),
D.C.,  California  (Fresno and the  California  Highway  Patrol),  Massachusetts
(Brookline),  Virginia  (Newport  News and the State  Police  Academy),  Arizona
(Maricopa   County),   universities  and  nuclear  power  plants,   as  well  as
international  users such as the Israeli  Defense  Forces,  the German  National
Police,  the Royal  Thailand Army,  the Hong Kong Police,  the Russian  Security
Police, and over 500 other training departments worldwide.

         Our  interactive  training  systems vary from the  powerful  Range 3000
use-of-force  simulator  system  to the  multi-faceted  A2Z  Classroom  Training
system.  The Range  3000 line of  simulators  addresses  the entire use of force
training  continuum  in law  enforcement,  allowing  the trainee to use posture,
verbalization,  soft hand skills,  impact  weapons,  chemical  spray,  low-light
electronic  weapons and lethal force in a scenario based classroom  environment.
The A2Z  Classroom  Trainer  provides  the  trainer  with real  time  electronic
feedback from every student through wireless handheld  keypads.  The combination
of interactivity  and instant response assures that learning takes place in less
time with higher retention.

         VEHICLE SIMULATORS

         Through  our  wholly-owned  subsidiary,  FAAC  Corporation,  we provide
simulators,  systems  engineering  and  software  products to the United  States
military,   government   and  private   industry.   FAAC's   fully   interactive
driver-training  systems feature  state-of-the-art  vehicle simulator technology
enabling  training in situation  awareness,  risk analysis and decision  making,
emergency  reaction  and  avoidance  procedures,   and  conscientious  equipment
operation.  FAAC has an installed base of 179 simulators that have  successfully
trained over 80,000  drivers.  FAAC's customer base includes all branches of the
Department of Defense, state and local governments, and commercial entities.



                                       3
<PAGE>

         We  believe  that FAAC is the  premier  developer  of  validated,  high
fidelity  analytical models and simulations of tactical air and land warfare for
all  branches  of  the   Department  of  Defense  and  its  related   industrial
contractors.  Simulations  developed  by FAAC are found in systems  ranging from
instrumented  air  combat  and  maneuver  ranges  (such as Top Gun) to full task
training devices such as the F-18 Weapon Tactics Trainer.

         FAAC supplies  on-board software to support weapon launch decisions for
the F-15,  F-18, and Joint Strike Fighter  fighter  aircraft.  Pilots benefit by
having highly accurate presentations of their weapon's  capabilities,  including
susceptibility  to target  defensive  reactions.  FAAC designed and developed an
Instructor  operator station,  mission operator station and real-time,  database
driven electronic combat environment for the special  operational forces aircrew
training system. The special operational forces aircrew training system provides
a full range of  aircrew  training,  including  initial  qualification,  mission
qualification,  continuation,  and upgrade  training,  as well as combat mission
rehearsal.

         SECURITY CONSULTING

         Arocon  Security  Corporation  focuses on protecting  life,  assets and
operations  with  minimum  hindrance to personal  freedom and daily  activities.
Arocon  Security,  which provides  security  consulting and other services,  has
signed an agreement with Rafael Armament  Development  Authority Ltd.,  Israel's
leading  defense  research  and  development  company,  to market and  implement
certain of Rafael's security products and technology in the United States.

     Battery and Power Systems Division

         ZINC-AIR FUEL CELLS, BATTERIES AND CHARGERS FOR THE MILITARY

         We have  been  engaged  in  research  and  development  in the field of
Zinc-Air  electrochemistry and battery design for over ten years, as a result of
which we have developed our current Zinc-Air technology and its applications. We
have  successfully  applied our technology to our high-energy  battery packs for
military and security  applications.  We have also applied our technology to the
development  of a  refuelable  Zinc-Air  fuel  cell for  powering  zero-emission
electric vehicles.  Through these efforts,  we have sought to position ourselves
as a world  leader in the  application  of  Zinc-Air  technology  to  innovative
primary and refuelable power sources.

         Our  primary  existing  battery  product for the  military  and defense
sectors is a 12/24 volt, 800 watt-hour battery pack for battlefield power, which
is based on our Zinc-Air  fuel cell  technology,  weighs only six pounds and has
approximately  twice the energy  capacity per pound of the U.S.  Army's standard
lithium-sulfur  dioxide  battery  packs - the  BA-8180/U  battery,  which  offer
extended-use  portable power using our commercial Zinc-Air cell technology.  Our
BA-8180/U  battery has received a National Stock Number (a Department of Defense
catalog number  assigned to products  authorized for use by the U.S.  military),
making our  batteries  available  for  purchase  by all units of the U.S.  Armed
Forces.



                                       4
<PAGE>

         We believe that our Zinc-Air  batteries  provide the highest energy and
power density  combination  available today in the defense  market,  making them
particularly  appropriate  where long  missions  are  required and low weight is
important.

         LITHIUM BATTERIES AND CHARGING SYSTEMS FOR THE MILITARY

         Recent developments and improvements in lithium rechargeable  batteries
have  caused  the US  military,  as well as  armies  worldwide,  to  shift  many
battery-operated    devices   to    cost-effective    rechargeable    batteries.
Non-rechargeable  batteries  continue to be the leading  source of energy in war
and  during  limited  conflicts.  For more  than  ten  years,  our  wholly-owned
subsidiary   Epsilor  Electronic   Industries,   Ltd.  has  developed  and  sold
rechargeable  and primary lithium  batteries and smart chargers to the military,
and to private industry in the Middle East, Europe and Asia.

         ELECTRIC VEHICLE

         Our electric vehicle effort,  conducted through our subsidiary Electric
Fuel Battery Corporation, continues to focus on finding a strategic partner that
can lead the way to eventual  commercialization  of the Zinc-Air  energy system.
Our  all-electric  bus,  powered  by our  Zinc-Air  fuel  cell  technology,  has
demonstrated a world-record 127-mile range under rigorous urban conditions.

         LIFEJACKET LIGHTS

         We produce  water-activated  lifejacket lights for commercial  aviation
and marine applications based on our patented water-activated  magnesium-cuprous
chloride  battery  technology.  We intend  to  continue  to work  with  original
equipment  manufacturers  (OEMs),  distributors and end-user companies to expand
our market  share in the aviation and marine  segments.  We presently  sell five
products in the safety  products  group,  three for use with marine life jackets
and two for use with aviation life vests.  All five products are certified under
applicable international marine and aviation safety regulations.

     Armored Vehicle Division

         Through our majority-owned MDT Protective Industries Ltd. and MDT Armor
Corporation  subsidiaries,  we specialize in using state-of-the-art  lightweight
ceramic materials, special ballistic glass and advanced engineering processes to
fully armor vans and cars.  MDT is a leading  supplier to the Israeli  military,
Israeli  special  forces and  special  services.  MDT's  products  are proven in
intensive  battlefield  situations and under actual terrorist attack conditions,
and are designed to meet the demanding  requirements of governmental and private
sector customers worldwide.

     Facilities

         Our principal executive offices are located at 632 Broadway,  New York,
New York  10012,  and our  telephone  number at our  executive  offices is (646)
654-2107.  Beginning April 15, 2004, we will move to new headquarters located at
250 West 57th Street, Suite 310, New York, New York 10107, and our new telephone
number will be (212) 258-3222.  Our corporate  website is  www.arotech.com.  Our
periodic  reports  to the  Securities  Exchange  Commission,  as well as  recent
filings relating to transactions in our securities by our executive officers and
directors,  that have been filed with the Securities and Exchange  Commission in
EDGAR  format are made  available  through  hyperlinks  located on the  investor
relations page of our website,  at  http://www.arotech.com/compro/investor.html,
as soon as reasonably  practicable after such material is  electronically  filed
with or furnished to the SEC.  Reference  to our  websites  does not  constitute
incorporation  of any of the  information  thereon or linked  thereto  into this
annual report.



                                       5
<PAGE>

         The offices and facilities of our three of our principal  subsidiaries,
EFL, MDT and Epsilor,  are located in Israel (in Beit  Shemesh,  Lod and Dimona,
respectively,  all of which are within Israel's pre-1967  borders).  Most of our
senior management is located at EFL's  facilities.  IES's offices and facilities
are located in Littleton, Colorado, FAAC's offices and facilities are located in
Ann Arbor,  Michigan,  and the offices and  facilities  of EFB and MDT Armor are
located in Auburn, Alabama.

Simulation, Training and Consulting Division

     Use-of-Force Training

         We conduct our interactive  training  activities through our subsidiary
IES  Interactive  Training,  Inc.  ("IES"),  a  Delaware  corporation  based  in
Littleton, Colorado. IES is a leading provider of interactive, multimedia, fully
digital training simulators for law enforcement,  security, military and similar
applications.  With a  customer  base  of over  500  customers  in  over  twenty
countries around the world, IES is a leader in the supply of simulation training
products to military,  law  enforcement  and corporate  client  communities.  We
believe,  based  on our  general  knowledge  of  the  size  of  the  interactive
use-of-force  market,  our specific  knowledge  of the extent of our sales,  and
discussions we have held with customers at trade shows,  etc., that IES provides
more than 35% of the  worldwide  market for  government  and  military  judgment
training simulators.

         INTRODUCTION

         IES offers consumers the following  interactive  training  products and
services:

         >>       Range 3000 - providing  use of force  simulation  for military
                  and law  enforcement.  We  believe  that the Range 3000 is the
                  most  technologically  advanced judgment training simulator in
                  the world.

         >>       A2Z  Classroom  Trainer - a  state-of-the-art  computer  based
                  training  (CBT) system that allows  students to interact  with
                  realistic  interactive  scenarios  projected  life-size in the
                  classroom.

         >>       Range FDU (Firearms Diagnostic Unit) - a unique combination of
                  training and interactive  technologies that give instructors a
                  first-person perspective of what trainees are seeing and doing
                  when firing a weapon.

         >>       Summit   Training    International   -   providing   relevant,
                  cost-effective  professional training services and interactive
                  courseware  for law  enforcement,  corrections  and  corporate
                  clients.

         >>       IES Studio  Productions  - providing  cutting edge  multimedia
                  video  services  for law  enforcement,  military  and security
                  agencies,   utilizing  the  newest  equipment  to  create  the
                  training services required by the most demanding authorities.



                                       6
<PAGE>

         Our  products  feature  state  of the art all  digital  video  formats,
ultra-advanced  laser-based lane detection for optimal accuracy and performance,
customer-based  authoring  of  training  scenarios,  and  95%  COTS  (commercial
off-the-shelf)-based system.

         IES's  revenues  during  2001,  2002 and 2003 were  approximately  $3.5
million, $5.1 million and $8.0 million, respectively.

         PRODUCTS

         Below is a description of each of the core products and services in the
IES line.

              Range 3000 "Use of Force" Simulator

         We  believe  that the Range  3000,  which IES  launched  in late  2002,
combines the most  powerful  operational  hardware and software  available,  and
delivers  performance  unobtainable  by any competing  product  presently on the
market.

         The Range 3000 simulator  allows training with respect to the full "Use
of Force" continuum.  Training can be done on an individual basis, or as many as
four members of a team can participate simultaneously and be scored and recorded
individually. Topics of training include (but are not limited to):

         >>       Officer's Presence and Demeanor -  Picture-on-picture  digital
                  recordings  of the trainee's  actions  allows visual review of
                  the trainee's  reaction,  body  language and weapons  handling
                  during  the course of the  scenario,  which then can be played
                  back for debriefing of the trainee's actions.

         >>       Verbalization - Correct phrases,  timing,  manner and sequence
                  of an officer's  dialogue is integrated within the platform of
                  the system,  allowing the situation to escalate or de-escalate
                  through the officer's own words in the context of the scenario
                  and in conjunction with the trainer.

         >>       Less-Than-Lethal  Training - Training in the use of non-lethal
                  devices  such as Taser,  OC (pepper  spray),  batons and other
                  devices  can be used with the video  training  scenarios  with
                  appropriate reactions of each.

         >>       Soft Hand Tactics - Low level  physical  control  tactics with
                  the use of additional  equipment such as take-down dummies can
                  be used.

         >>       Firearms  Training and Basic  Marksmanship - Either  utilizing
                  laser  based  training   weapons  or  in  conjunction  with  a
                  live-fire screen, the use of "Live Ammunition" training can be
                  employed on the system.

         The interactive  training scenarios are projected either through single
or  multiple  screens  and  projectors,  allowing  IES to  immerse a trainee  in
true-to-life  training scenarios and incorporating one or all the above training
issues in the "Use of Force" continuum.

              A2Z Classroom Trainer

         The A2Z is a state-of-the-art Computer Based Training (CBT) system that
allows  students to interact  with  realistic  interactive  scenarios  projected
life-size in the classroom.



                                       7
<PAGE>

         Using individual  hand-held keypads, the students can answer true/false
or multiple choice questions.  Based on the student's performance,  the scenario
will branch and unfold to a virtually  unlimited  variety of different  possible
outcomes of the student's actions. The system logs and automatically scores each
and every trainee's response and answer. At the end of the scenario,  the system
displays a session results summary from which the trainer can debrief the class.

         The advanced A2Z Courseware Authoring Tools allow the trainer easily to
create complete customized interactive courses and scenarios.

         The Authoring  Tools harness  advances in digital video and multimedia,
allowing  the trainer to capture  video and  graphics  from any source.  The A2Z
allows the  trainer  to combine  his or her  insight,  experience  and skills to
recreate a realistic learning  environment.  The A2Z Training System is based on
the well-known  PC-Pentium  technology  and Windows XPTM operated.  The menu and
mouse operation make the A2Z user-friendly.

         The  individual  keypads  are  connected  "wirelessly."  The  system is
completely portable and may be setup within a matter of minutes.

     Key advantages:

         >>       Provides   repeatable   training   to  a  standard   based  on
                  established policy

         >>       Quick  dissemination and reinforcement of correct behavior and
                  policies

         >>       Helps reduces liability

         >>       More efficient than  "traditional and redundant"  role-playing
                  methods

         >>       Realistic scenarios instead of outdated "play-acting"

         >>       Interactive training of up to 250 students simultaneously with
                  wireless keypads

         >>       Easy Self-Authoring of interactive training content

         >>       PC-Pentium platform facilitates low cost of ownership

         >>       Easy to use Windows XP-based software

         >>       Easy to deploy in any classroom

         Range FDU

         The Range FDU (firearm  diagnostics  unit) is a unique  combination  of
training and  interactive  technologies  that give  instructors  a  first-person
perspective  of what  trainees  are seeing and doing when  firing a weapon.  The
Range FDU is the only firearms training technology of its kind.

         With the Range FDU,  firearms  instructors can see the trainees' actual
sight alignment to the target as well as measure trigger pressure against proper
trigger pressure graphs, making corrective instruction simple and effective.  In
addition,  the Range FDU records a trainee's  recoil control,  grip and stance -
allowing the instructor to playback the  information in slow motion or real time
to better  analyze  the  trainee's  actions  and more  accurately  diagnose  any
deficiencies.



                                       8
<PAGE>

         The Range FDU also has the  ability to record the  firearm  instruction
session to either DVD or VHS,  allowing  both the trainee and the  instructor to
review it at a later time.  Trainees  now have a  diagnostic  tool that they can
learn  from,  even  after  their  training  has  been  completed.  In  addition,
instructors can build a library for each trainee to record progress.

         The Range FDU provides the following benefits:

         >>       Fall of shot feedback

         >>       Trigger pressure analysis

         >>       Recoil control, grip and stance assessment

         >>       Sight alignment

         >>       Sight picture analysis and target reacquisition

         Summit Training International

         Summit Training International (STI) is a wholly-owned subsidiary of IES
Interactive  Training.  STI  provides  relevant,   cost-effective   professional
training  seminars,  consulting  services,  and  interactive  courseware for law
enforcement,  corrections,  and corporate clients. STI's emphasis and goal is to
create a "total  training"  environment  designed to address  the  cutting  edge
issues faced today. STI provides  conferences  throughout the United States, and
develops  courseware  dealing with these important topics.  The incorporation of
IES Interactive Systems creates an intense learning  environment and adds to the
realism of the trainee's experience.

         Conferences

         STI has provided  conferences  throughout  the United  States,  on such
topics as:

         >>       Recruiting and Retention of Law  Enforcement  and  Corrections
                  Personnel

         >>       Ethics and Integrity

         >>       Issues of Hate Crimes

         >>       Traffic Stops and Use of Force

         >>       Community and Corporate Partnerships for Public Safety

         >>       Creating a Safe School Environment

         In addition to these national and regional conferences, STI designs and
produces training to address specific department issues. STI has a distinguished
cadre  of  instructors   that  allows   adaptation  of  programs  to  make  them
specifically focused for a more intense learning  experience.  The A2Z Classroom
Trainer is  incorporated  into the "live"  presentation  creating a  stimulating
interactive training experience.

         Courseware

         STI develops  courseware  for use  exclusively  with IES's  interactive
systems.  Courses are designed to addresses specific  department issues, and can
be customized to fit each agency's  needs.  These courses are available in boxed
sets that  provide  the  customer  with a  turn-key  training  session.  The A2Z
Classroom Trainer and the Range 3000 XP-4 are used to deliver the curriculum and
create a virtual  world  that the  trainees  respond  and  react  to.  Strategic


                                       9
<PAGE>

relationships  with  high  profile  companies  such as H&K  Firearms,  and Taser
International,  provide  customers  with  training  that deals with cutting edge
issues facing law  enforcement  today.  The  incorporation  of STI's  courseware
library along with simulation  systems allows training to remain  consistent and
effective, giving customers more value for their training dollar.

         IES Studio Productions

         IES Studio  Productions,  a division of IES, provides  multimedia video
services for law enforcement,  military and security  agencies,  and others. IES
Studio Productions creates interactive  courseware and interactive scenarios for
the Range  3000,  Video  Training  Scenarios  and all types of video  production
services.  With the latest in media equipment,  IES Studio Productions  provides
all media and marketing services to IES Interactive Training in-house.

         MARKETING

         IES markets its products and services to domestic and international law
enforcement,  military and other federal agencies and to various  companies that
serve them,  through  attendance and  presentations at conferences,  exhibits at
trade shows,  seminars at law  enforcement  academies and  government  agencies,
through its web pages on the Internet,  and to its compiled database of prospect
and customer  names.  IES's  salespeople are also its marketing team. We believe
that this is effective for several  reasons:  (1) customers  appreciate  talking
directly  with  salespeople  who can answer a wide range of technical  questions
about methods and features,  (2) our  salespeople  benefit from direct  customer
contact through gaining an appreciation  for the environment and problems of the
customer,  and (3) the relationships we build through  peer-to-peer  contact are
useful in the military, police and federal agency market.

         IES also  uses its web pages on the  Internet  for such  activities  as
providing product information and software updates.

         IES markets  augmentative  and  alternative  law  enforcement  products
through a network of employee  representatives and independent resellers.  These
products include but are not limited to products manufactured by:

         >>       Bristlecone Products

         >>       Airmunitions Inc.

         >>       Taser Inc.

         >>       ASP Inc.

         >>       H&K Training Centers

         At the present time IES has six sales  representatives based in Denver,
eight domestic  independent  distributors,  and fifteen independent  resellers /
representatives  overseas.  IES also has three inside sales/support  persons who
answer  telephone  inquiries  on IES's 800 line and  Internet,  and who can also
provide  technical  support.  Additional  outside  salespersons  and independent
dealers and resellers are being actively recruited at this time.



                                       10
<PAGE>

         IES  typically   participates  in  over  thirty  industry   conferences
annually,  held  throughout the United States and in other  countries,  that are
attended  by  our  potential  customers  and  their  respective  purchasing  and
budgeting decision makers. A significant  percentage of IES's sales of products,
both software and hardware, are sold through leads developed at these shows.

         IES and others in the  industry  demonstrate  their  products  at these
conferences and present  technical papers that describe the application of their
technologies  and the  effectiveness  of their products.  IES also advertises in
selected publications of interest to potential customers.

         CUSTOMERS

         Most of  IES's  customers  are law  enforcement  agencies,  both in the
United  States  (federal,  state and local)  and  worldwide.  Purchasers  of IES
products have included (in the United States) the FBI, the Secret  Service,  the
Bureau of  Alcohol,  Tobacco and  Firearms,  the  Customs  Service,  the Federal
Protective Service, the Border Patrol, the Bureau of Engraving and Printing, the
Coast Guard,  the Federal Law Enforcement  Training  Centers,  the Department of
Health and Human  Services,  the  California  Department of  Corrections,  NASA,
police  departments in Texas (Houston),  Michigan  (Detroit),  D.C.,  California
(Fresno and the California Highway Patrol), Massachusetts (Brookline),  Virginia
(Newport  News  and  the  State  Police  Academy),  Arizona  (Maricopa  County),
universities and nuclear power plants,  as well as  international  users such as
the Israeli Defense Forces, the German National Police, the Royal Thailand Army,
the Hong Kong Police,  the Russian Security Police,  and over 500 other training
departments worldwide.

         The mix of customers has historically  been  approximately 40% city and
state agencies, 30% federal agencies, and 30% international.  During 2003, IES's
order from the German  National  Police  accounted  for 16% of our revenues on a
consolidated basis.

         COMPETITION

         IES competes  against a number of  established  companies  that provide
similar  products  and  services,  many  of  which  have  financial,  technical,
marketing, sales, manufacturing,  distribution and other resources significantly
greater  than ours.  There are also  companies  whose  products  do not  compete
directly,  but are sometimes closely related.  Firearms Training Systems,  Inc.,
Advanced  Interactive   Systems,   Inc.,  and  LaserShot  Inc.  are  IES's  main
competitors.

         We believe the key factors in our competing  successfully in this field
will be our ability to develop  simulation  software  and related  products  and
services to effectively train law enforcement and military to today's standards,
our  ability to develop  and  maintain a  proprietary  technologically  advanced
hardware, and our ability to develop and maintain relationships with departments
and government agencies.

         Vehicle Simulators

         Through  our  wholly-owned  subsidiary,  FAAC  Corporation,  we provide
simulators,  systems  engineering  and  software  products to the United  States
military,   government   and  private   industry.   FAAC's   fully   interactive
driver-training  systems feature  state-of-the-art  vehicle simulator technology
enabling  training in situation  awareness,  risk analysis and decision  making,
emergency  reaction  and  avoidance  procedures,   and  conscientious  equipment
operation.  FAAC  has an  installed  base  of  over  179  simulators  that  have
successfully  trained over 80,000  drivers.  FAAC's  customer  base includes all
branches of the U.S.  Department of Defense,  state and local  governments,  and
commercial entities.



                                       11
<PAGE>

         INTRODUCTION

         Based in Ann Arbor, Michigan, FAAC is a premier developer of validated,
high fidelity analytical models and simulations of tactical air and land warfare
for all  branches  of the  Department  of  Defense  and its  related  industrial
contractors.  Simulations  developed  by FAAC are found in systems  ranging from
instrumented  air  combat  and  maneuver  ranges  (such as Top Gun) to full task
training  devices  such as the F-18  Weapon  Tactics  Trainer.  FAAC is also the
leading  supplier of wheeled  vehicle  simulators  to the U.S.  Armed Forces for
mission-critical vehicle training. Management believes that FAAC has held a 100%
market share in U.S.  military wheeled  simulators since 1999 and holds a market
share in excess of 50% in commercial wheeled vehicle simulators.

         Simulators  are  cost-effective  solutions,  enabling  users to  reduce
overall  aircraft and ground  vehicle usage,  vehicle  maintenance  costs,  fuel
costs,  repairs,  and spares expenditures.  For example,  FAAC's Medium Tactical
Vehicle Replacement (MTVR) simulators have reduced total driver training time by
35%. Many  customers have reduced  actual  "behind-the-wheel"  time by up to 50%
while still  maintaining or improving safety.  Additionally,  for customers with
multiple  simulators,  the  corresponding  increase in the student to instructor
ratio has reduced instructor cost per student.

         The  implementation of FAAC simulators has led to measurable  benefits.
North American Van Lines,  one of FAAC's earliest vehicle  simulator  customers,
has shown a 22% reduction in preventable  accidents  since it began using FAAC's
simulators.  The German Army, one of FAAC's earliest Military Vehicle customers,
showed  better  driver  testing  scores in 14 of 18 driver  skills  compared  to
classroom  and live driver  training  results.  Additionally,  the New York City
Transit Authority  documented a 43% reduction in preventable  accidents over its
first six months of use and has reduced its driver hiring and training "washout"
by 50%.

         Simulators  can produce more drastic  situations  than can  traditional
training,  which  inherently  produces  drivers that are more skilled in diverse
driving  conditions.  For example,  while many first-time  drivers will learn to
drive  during  the  summer  months,  they are not  trained  to  drive in  wintry
conditions.  Simulators can produce these and other  situations,  such as a tire
blowout  or having to react to a driver  cutting  off the  trainee,  effectively
preparing the driver for adverse conditions.

         FAAC supplies  on-board software to support weapon launch decisions for
the F-15,  F-18, and Joint Strike Fighter  fighter  aircraft.  Pilots benefit by
having highly accurate presentations of their weapon's  capabilities,  including
susceptibility  to target  defensive  reactions.  FAAC designed and developed an
Instructor  operator station,  mission operator station and real-time,  database
driven electronic combat environment for the special  operational forces aircrew
training system. The special operational forces aircrew training system provides
a full range of  aircrew  training,  including  initial  qualification,  mission
qualification,  continuation,  and upgrade  training,  as well as combat mission
rehearsal.



                                       12
<PAGE>

         FAAC operates in two primary business areas: Vehicle Simulations, which
focuses on the  development and delivery of complete  driving  simulations for a
wide range of vehicle types - such as trucks,  automobiles,  buses, fire trucks,
police cars,  ambulances,  airport ground vehicles,  and military vehicles - for
commercial,  governmental and foreign customers; and Military Operations,  which
conducts tactical air and land combat analysis and develops  analytical  models,
simulations,  and "turnkey"  training  systems for the U.S.  military.  In 2003,
Vehicle  Simulations  accounted for  approximately  75% of FAAC's revenues,  and
Military Operations accounted for approximately 25% of FAAC's revenues.

         FAAC's  revenues during 2001,  2002 and 2003 were  approximately  $12.2
million, $15.2 million and $9.8 million, respectively.

         PRODUCT LINES

         Below is a description of FAAC's products and product lines.

              Vehicle Simulations

                  Military Vehicles

         Military Vehicles is FAAC's largest business segment.  Military vehicle
simulators  are  highly  realistic  vehicle  simulators  that  include  variable
reactive  traffic  and  road  conditions,  the  capacity  to  customize  driving
conditions  to be  geography-specific,  and training in hazardous  and emergency
conditions.  FAAC has several  large  contracts  and task orders in the Military
Vehicles business, including (i) the MTVR contract to develop vehicle simulators
and  related  training  services  for the U.S.  Marine  Corps;  (ii) a series of
scheduled General Services Administration  purchases of simulators with the U.S.
Army to  supply 78  simulators  for 25  training  sites;  and  (iii) a  two-year
contract  with the U.S.  Navy  Seabees  to  supply  eight  simulators  for three
training sites. Management estimates that FAAC's software trained 9,000 soldiers
at four sites in 2002.

         FAAC's  military   vehicle   simulators   provide   complete   training
capabilities  based on integrated,  effective  simulation  solutions to military
vehicle  operators in the U.S. Armed Forces.  FAAC's flagship  military  vehicle
simulation  product is its MTVR  Operator  Driver  Simulator,  developed for the
USMC.  The MTVR ODS concept is  centered on a pod of up to six Student  Training
Stations (STS) and a single controlling  Instructor  Operator Station (IOS). The
STS  realistically  simulates the form,  fit, and feel of the MTVR vehicle.  The
high-fidelity  version of the STS  consists  of a modified  production  cab unit
mounted on a full  six-degree-of-freedom  motion platform. The STS provides over
an  180-degree  field  of view  into a  realistically  depicted  virtual  world,
simulating  a variety of on-road and  off-road  conditions.  The IOS is the main
simulation control point supporting the instructor's role in simulator training.
The  IOS  initializes  and  configures  the  attached  STS,   conducts  training
scenarios,  assesses student  performance,  and maintains scenarios and approved
curriculum.

         FAAC's  software   solution   provides  a  complete  operator  training
curriculum  based  upon  integrated   simulation   training.   Military  vehicle
simulators  enable  students to learn proper  operational  techniques  under all
terrain,  weather, road, and traffic conditions.  Instructors can use simulators
as  the  primary   instructional  device,   quantitatively   evaluating  student
performance under controlled,  repeatable scenarios.  This monitoring,  combined
with the  ability  to create  hazardous  and  potentially  dangerous  situations
without  risk  to  man  or  material,   results  in  well-trained   students  at
significantly less cost than through the use of traditional training techniques.
In  addition  to standard  on-road  driver  training,  FAAC's  military  vehicle
simulators can provide training in such tasks as:



                                       13
<PAGE>

         >>       Off-road  driving on severe slopes,  including muddy or swampy
                  terrain;

         >>       Night vision goggle and blackout conditions;

         >>       Convoy training; and

         >>       The use of the Central  Tire  Inflation  System in response to
                  changing terrain.

         In addition to simulation  systems,  FAAC offers  on-site  operator and
maintenance staff,  train-the-trainer courses, curriculum development,  scenario
development, system maintenance, software upgrades, and warranty packages to its
U.S. Armed Forces customers.

         Commercial Vehicles

         Commercial  Vehicles is FAAC's second  largest  business  segment.  The
Commercial  Vehicles business is comprised of technology  similar to that of the
Military  Vehicles  product line and also is  customized to reflect the specific
vehicle  being  simulated.  FAAC  serves  four  primary  customer  bases  in the
Commercial  Vehicles  business:  transit,  municipal,   airport,  and  corporate
customers.

         Transit

         Transit  customers  represent  an  attractive  customer  base  as  they
generally  have  access to their own funds,  which often  exempts  them from the
lengthy and complex process of requesting  funds from a governing body. FAAC has
provided simulators to ten leading transit  authorities,  including the New York
City Transit Authority, Washington, D.C. Metro, and Dallas Area Rapid Transit.

         Municipal

         FAAC targets municipal customers in police departments, hospitals, fire
departments,  and  departments  of  transportation  for  sales of its  municipal
product. FAAC's customers include the Mexico Department of Education, California
Department  of  Transportation,  and the Fire  Department  of New York.  FAAC is
developing  an  industry  advisory  group  focusing on the  municipal  market to
identify  and  address  customer  needs.  Additionally,  FAAC  has  developed  a
simulator  module to extend the  simulation  once  police,  fire,  or  emergency
medical service personnel reach the incident location.  FAAC management believes
that  this  represents  another  of  FAAC's  bases of  differentiation  over its
competition.

         Airport

         FAAC was a pioneer in  providing  simulation  software  to  airports to
facilitate training personnel in adverse  conditions,  including the Detroit and
Toronto airports.



                                       14
<PAGE>

         Corporate

         FAAC targets  corporate  fleets and "for-hire"  haulers as customers of
the  corporate  simulator  product.  These  customers  use  simulators  to train
personnel  effectively  as well as to  avoid  the  brand  damage  that  could be
associated with poor driver  performance.  To date, FAAC has provided simulators
to customers such as Schlumberger Oil Services, Kramer Entertainment,  and North
American Van Lines.

         Military Operations

         FAAC  provides  air combat  range  software,  missile  launch  envelope
decision support software,  the SimBuilder(TM)  simulation software product, and
Weapon System Trainer software through the Military Operations business line.

         Air Combat Range Software

         FAAC serves the U.S. Air Force Air Combat Training System and U.S. Navy
Tactical  Aircrew  Training  System with its air combat training range software.
Air combat  training  ranges allow pilots to train and evaluate new tactics in a
controlled airborne  environment.  Air "battles" are extremely  realistic,  with
FAAC  software  determining  the outcome of weapon  engagements  based on launch
conditions and the target aircraft defensive reactions.

         Missile Launch Envelope Software

         Onboard weapon  decision-making  software  enables pilots to assimilate
the complex  information  presented to them in F-15 and F-18  fighter  aircraft.
FAAC  provides its missile  launch  envelope  software to the U.S.  Navy and Air
Force through its subcontracting relationships with Boeing.

         Weapon System Trainer Software

         FAAC has  successfully  transitioned  software  from U.S. Navy Tactical
Aircrew  Training  Systems  to over 15 Weapon  Systems  Trainers  built by prime
contractors such as L-3, Boeing, Northrop Grumman, and Lockheed Martin.

         SIMBuilder(TM)

         The SimBuilder(TM)  simulation  software product is designed to provide
weapons simulation models for use in training environments for launched weapons.
This software enables foreign end-users to use weapons simulation models similar
to the U.S. military without classified U.S. weapons data. Militaries of Canada,
Taiwan, and Singapore currently use SimBuilders(TM).

         MARKETING

         The sales  and  marketing  effort at FAAC  focuses  on  developing  new
business  opportunities as well as generating  follow-on sales of simulators and
upgrades.  FAAC currently employs four dedicated sales representatives who focus
on   Commercial   Vehicles,   Military   Operations,   and   Military   Vehicles
opportunities.  Furthermore,  two additional  FAAC employees spend a significant
portion of their time in sales.  Various members of senior  management  serve as
effective sales  representatives in the generation of municipal,  military,  and
corporate  business.   FAAC  also  retains  the  services  of  four  independent
consultants who act as marketing agents on FAAC's behalf. These  representatives
are largely  commission-based  agents who focus on  particular  products  and/or
regions  (such as  airport  customers,  Texas,  California,  and Eglin Air Force
Base).  Finally,  FAAC has four  customers  that  have  agreements  wherein  the
companies support FAAC marketing efforts and market FAAC products  themselves in
exchange for commissions and/or free upgrade services.



                                       15
<PAGE>

         FAAC's  sales  representatives  are  salaried  employees  with  minimal
commission-based  revenue.  Independent  consultants  generally do not receive a
base salary and  receive 5% to 10%  commissions  on the amount of business  that
they  generate  each year.  The  majority of FAAC's sales  representatives  have
engineering  backgrounds that they leverage to anticipate the technical needs of
FAAC's dynamic  customer base and targeted  markets.  Additionally,  the program
manager and service department assist FAAC in gaining repeat business.

         Developing  a pipeline  of  follow-on  work is one of the tasks for all
program  managers.  FAAC has a long  history of repeat and  follow-on  work with
programs  such as F-15 and F-18 ZAP (over 20 contracts  with  Boeing),  the U.S.
Navy Tactical Aircrew  Training System (a series of 6 sequential  contracts over
the last 25 years), and F-18 Weapon Tactics Trainer (series of 20 contracts with
the simulator manufacturer).

         FAAC  also  aggressively  pursues  several  marketing   initiatives  to
complement  its  experienced  sales  force.  FAAC's  most  successful  marketing
strategy  includes the  formation of industry  advisory  groups.  Such  advisory
groups,  which consist of simulation  users within  select  industries,  conduct
regular  seminars to educate  transit and similar  agencies on the  benefits and
challenges of simulation-based  training, as well as to share training concepts,
curriculums,  and experiences.  These sessions not only serve as excellent sales
and  marketing  tools to  generate  orders  but also  have  created  significant
goodwill with customers.  FAAC management  believes that these industry advisory
groups have proven to be particularly successful in cooperative industries, such
as transit, where users are self-funded and do not compete with one another.

         CUSTOMERS

         FAAC has  long-term  relationships,  many of over ten years'  duration,
with the U.S. Air Force,  U.S. Navy,  U.S.  Army,  and most major  Department of
Defense  training and simulation prime  contractors and related  subcontractors.
The quality of FAAC's  customer  relationships  is  illustrated  by the multiple
program  contract awards it has earned with many of its customers.  For example,
under a series of 20 subcontracts  over 15 years, FAAC has provided the tactical
environment  and F-18 weapons and avionics models for the F/A-18 Weapons Tactics
Trainer.  FAAC has served as a  subcontractor  for the F/A-18 WTT through  three
distinct prime contractor tenures.

         COMPETITION

         FAAC's technical  excellence,  superior product  reliability,  and high
customer  satisfaction  have enabled FAAC to develop  market  leadership  and an
attractive  competitive position.  Several potential competitors in the military
segment are large,  diversified  defense and aerospace  conglomerates who do not
focus on FAAC's  specific  niches.  As such, FAAC is able to serve certain large
military contracts through strategic  agreements with these organizations or can
compete directly with these organizations based on FAAC's strength in developing
higher quality  software  solutions.  In commercial  market  applications,  FAAC
competes against smaller, less sophisticated software companies.



                                       16
<PAGE>

         FAAC differentiates itself from its competition on several bases:

         >>       Leading  Technology  -  Management  believes  that FAAC offers
                  better-developed,  more dynamic software than its competitors.
                  Additionally,   FAAC   incorporates   leading   graphics   and
                  motion-cueing technologies in its systems to provide customers
                  with the most realistic simulation experience on the market.

         >>       Long History in the Simulation Software Business - As a market
                  leader  in the  simulation  software  business  for more  than
                  thirty  years,   FAAC's   professionals   understand  customer
                  requirements and operating environments. Thus, FAAC builds its
                  software to meet and exceed demanding customers' expectations.

         >>       Low-Cost   Research  and  Development   Capabilities  for  New
                  Products  -  FAAC's  customers  benefit  from  government  and
                  commercial  funding of research  and  development  and the low
                  cost of subsequent adaptation.  As such, internally funded new
                  product  development  costs have been less than  $100,000  per
                  year since 1999.

         >>       Service  Reputation  - FAAC  is  known  for  providing  better
                  service than the competition, a characteristic that drives new
                  business within FAAC's chosen markets.

         >>       Standardized  Development  Processes - FAAC generally delivers
                  its products to the market more  quickly than its  competition
                  and at  higher  quality  due to its  standardized  development
                  processes.

         Below is a  description  of FAAC's  competition  organized  by  product
lines.

         Vehicle Simulations

         Military Vehicles

         FAAC has been the sole provider of wheeled vehicle simulation solutions
to the U.S.  military  since  1999.  FAAC's  devotion to  developing  realistic,
comprehensive  products  for a wide range of vehicle  types  positions it as the
preferred  simulation  provider  within this market  niche.  FAAC's  strategy of
identifying a training need,  isolating  government funds, and then developing a
customized training solution has led to considerable  successes.  This approach,
which  differs from the "build first and market  later"  strategy  employed by a
number of FAAC's competitors,  effectively  identifies market  opportunities and
provides  a  better  product  to  the  military  customer.  Diversified  defense
companies  and  commercial  simulation  providers  have  attempted  to enter the
military wheeled vehicle market but have been  unsuccessful  thus far.  Although
FAAC's  management  believes  that  market  penetration  by these  companies  is
ultimately  inevitable,  FAAC's  established  brand,  understanding  of customer
requirements,   and  engineering  expertise  provide  FAAC  with  a  competitive
advantage  in this market  segment.  FAAC's  primary  competitors  for  military
vehicle simulation solutions include Lockheed Martin Corporation's Information &
Technology   Services  Group,   Raydon   Corporation,   and  the  Cubic  Defense
Applications division of Cubic Corporation.



                                       17
<PAGE>

         Commercial Vehicles

         A handful of simulation product and service companies currently compete
with FAAC's targeted  commercial  driving  simulator  markets.  However,  FAAC's
marketing and development of selected  commercial market segments has positioned
FAAC as a leading  provider  of  commercial  simulation  solutions.  Competition
within  each  market  segment  varies,  but the  following  companies  generally
participate in selected driving simulator market opportunities: GE Capital I-Sim
(a subsidiary of GE Capital  Commercial  Equipment  Financing),  Doron Precision
Systems,   Lockheed-Martin   Corporation's   LMIS  Division,   Global  SIM,  and
USADriveSafe, Inc.

         Military Operations

         Currently  no  significant  competitors  participate  in the market for
FAAC's tactical environment  software,  and there are essentially no independent
competitors  that  exist in the market for  FAAC's  decision  support  software.
Competition  for  software  to  support  tactical  environment  requirements  in
aircraft weapon systems trainers comes from the  manufacturers of the simulators
themselves  and from a handful of  companies  who produce  tactical  environment
software.  FAAC's  primary  competitors  for training range  software,  decision
support software, and weapons system trainer software solutions include Lockheed
Martin  Corporation,  L-3  Communications  Holdings,  Raytheon Company,  Science
Applications  International  Corporation,   Dynetics,  Inc.,  and  Georgia  Tech
Research Institute.

         Security Consulting

         Arocon  Security  Corporation  focuses on protecting  life,  assets and
operations  with  minimum  hindrance to personal  freedom and daily  activities.
Arocon  Security,  which provides  security  consulting and other services,  has
signed an agreement with Rafael Armament  Development  Authority Ltd.,  Israel's
leading  defense  research  and  development  company,  to market and  implement
certain of Rafael's security products and technology in the United States.

Battery and Power Systems Division

     Zinc-Air Fuel Cells, Batteries and Chargers for the Military

         We base our strategy in the field of Zinc-Air military batteries on the
development  and  commercialization  of our  next-generation  Zinc-Air fuel cell
technology,  as applied in our  batteries  that we produce  for the U.S.  Army's
Communications  and Electronics  Command  (CECOM).  We will continue to seek new
applications  for our  technology  in  defense  projects,  wherever  synergistic
technology and business benefits may exist. We intend to continue to develop our
battery  products for defense  agencies,  and plan to sell our  products  either
directly to such agencies or through prime contractors.

         Since 1998 we have  received and  performed a series of contracts  from
CECOM to  develop  and  evaluate  advanced  primary  Zinc-Air  fuel cell  packs.
Pursuant to these  contracts,  we  developed  and began  selling in 2002 a 12/24
volt, 800 watt-hour  battery pack for battlefield  power,  which is based on our
Zinc-Air  fuel cell  technology,  weighs  only six pounds and has  approximately
twice the energy capacity per pound of the U.S.  Army's standard  lithium-sulfur
dioxide battery packs - the BA-8180/U battery.



                                       18
<PAGE>

         In the second half of 2002, our five-year program with CECOM to develop
a Zinc-Air  battery for  battlefield  power  culminated  in the  assignment of a
National Stock Number and a $2.5 million delivery order for the newly designated
BA-8180/U  battery.  Subsequent to this initial $2.5 million  delivery order, we
received in 2003 an additional $6.8 million in follow-on orders from the Army.

         Our batteries have been used in both  Afghanistan  (Operation  Enduring
Freedom) and in Iraq  (Operation  Iraqi Freedom).  The significant  contribution
that our batteries made to both these  endeavors was recognized by General Tommy
R. Franks, then the Commander of United States Central Command (USCENTCOM),  who
said in a letter to EFB dated  July 3,  2003,  "Your  efforts  in  managing  and
supplying  zinc-air  batteries were seen as nothing less than  spectacular.  The
long  hours,  hard  work,  and  personal  sacrifices  made in  support  of these
operations  have  ensured  our War  Fighters  had  the  necessary  resources  to
successfully conduct their missions without interruption."

         Our Zinc-Air  fuel cells,  batteries  and chargers for the military are
manufactured through our Electric Fuel Battery Corporation subsidiary.  In 2003,
EFB's facilities were granted ISO 9001 "Top Quality Standard" certification.

         PRODUCTS

         Zinc-Air Power Packs

         BA-8180/U

         Electric Fuel Zinc-Air power packs are  lightweight,  low-cost  primary
Zinc-Air  batteries  with up to twice the energy  capacity  per pound of primary
lithium (LiSO2) battery packs,  which are the most popular batteries used in the
US  military  today.   Zinc-Air   batteries  are  inherently  safe  in  storage,
transportation, use, and disposal.

         The BA-8180/U is a 12/24 volt, 800 watt-hour battery pack approximately
the size and  weight  of a  notebook  computer.  The  battery  is based on a new
generation of  lightweight,  30 ampere-hour  cells developed by us over the last
five years with partial funding by CECOM.  Each BA-8180/U  battery pack contains
24 cells.

         The  battery  has  specific  energy  of  up  to  350  Wh/kg,  which  is
substantially  higher than that of any competing disposable battery available to
the defense and  security  industries.  By way of  comparison,  the  BA-5590,  a
popular LiSO2  battery  pack,  has only 175 Wh/kg.  Specific  energy,  or energy
capacity  per  unit of  weight,  translates  into  longer  operating  times  for
battery-powered  electronic equipment,  and greater portability as well. Because
of lower cost per watt-hour,  the BA-8180/U can provide substantial cost savings
to the Army when deployed for longer missions,  even for  applications  that are
not man-portable.

         CECOM has  assigned  a  National  Stock  Number  (NSN) to our  Zinc-Air
battery,  making it possible to order and stock the battery for use by the Armed
Forces.  CECOM also assigned the designation  BA-8180/U to our Zinc-Air battery,
the first time an official US Army battery  designation  was ever  assigned to a
Zinc-Air battery.



                                       19
<PAGE>

         Based on extensive  contacts with the US and foreign military agencies,
we believe that a significant  market  exists for the  BA-8180/U  both in the US
Armed Forces and abroad.

         8140/U

         The BA-8140/U is a new product, presently being field tested and at its
initial  procurement  stages.  The BA-8140/U is a smaller version of our 8180/U,
which we developed at the request of CECOM. It is  approximately  half the size,
weight and  capacity of our 8180/U,  and is  appropriate  for smaller  hand-held
communications devices.

         Adapters

         The  BA-8180/U  is a battery,  but in order to connect it to a specific
piece of equipment,  an adapter must be used. In order to provide  compatibility
between the BA-8180/U and various items of military equipment, we supply various
types  of   electrical   interface   adapters  for  the   BA-8180/U,   including
equipment-specific  adapters  for the  AN/PRC-119  SINCGARS  and  SINCGARS  ASIP
tactical  radio sets,  and a generic  interface for items of equipment that were
designed to interface  with a BA-5590 or equivalent  battery.  Each of the three
interfaces  was also  assigned  a  national  stock  number  (NSN) by  CECOM.  In
addition,  we are in the process of adding more  electrical  interfaces  for the
BA-8180/U.  These will address  various  applications,  including  other radios,
night vision, missile launchers and chemical detectors.

         Hybrids

         We have also developed  interface adapters for other items of equipment
which  require  higher  power than the  BA-8180/U  can  provide  by itself.  For
example,  we have  developed  a hybrid  battery  system  comprising  a BA-8180/U
battery pack and two small rechargeable lead-acid packs. Even with the weight of
the lead-acid  batteries,  this hybrid system powers a satellite  communications
terminal for  significantly  longer than an  equivalent  weight of BA-5590 LiSO2
battery packs. We have also developed  experimental hybrid systems incorporating
other   rechargeable   technologies,   such   as   lithium-ion   batteries   and
ultracapacitors.

         Forward Field Chargers

         One of the  initial  goals to develop  high  energy  density  and power
density Zinc-Air was to deploy them as forward field chargers. It was envisioned
that a man portable  power pack would be required by the  dismounted  soldier to
charge the range of rechargeable  batteries now  proliferating  the military.  A
high efficiency  forward field charger has been developed which enables either a
BB-390/U  (NiMH) or a BB-2590/U  (Li-ion)  to receive  multiple  charges  from a
single BA-8180/U.

         Other Zinc-Air Products

         A  fourth  generation  of  Zinc-Air  products  has been  developed  for
applications  where volume is  critical,  and/or where the power to energy ratio
needs to be  significantly  higher  than  that of the  BA-8180/U.  These  "Gen4"
Zinc-Air products consist of an air cathode folded around a zinc electrode. Gen4
was originally  developed for the Marine Corps Dragon Eye UAV, which requires up
to 200 W from a battery that fits into its sleek  fuselage and which weighs less
than one kilogram.  Along the way, it was recognized  that the Gen4 design could
be  applied to other  battery  missions  requiring  high power as well as energy
density, such as Land Warrior and Objective Force Warrior soldier systems, where
up to 300 Wh of  energy  are  required  of a 24 hour  battery  that must be worn
conformably,  at minimal weight.  For these systems the battery currently limits
functionality, and Gen4 zinc-air may be the enabling technology.



                                       20
<PAGE>

         We are currently  under contract with the U.S.  military and an Israeli
security agency,  to demonstrate the feasibility of Zinc-Air  batteries for both
unmanned  aerial  vehicles  (UAV)  and  micro-air   vehicles  (MAV)   platforms,
respectively.   Short-term   development  goals  include  the  optimization  and
integration  of  cell   components  for   performance   and   manufacturability.
System-level  objectives  include  refinement  of  battery  envelope  design and
vehicle  interfaces,  and continued  actual  flight  testing.  During 2003,  our
Zinc-Air battery  successfully powered a Dragon Eye unmanned drone and an MAV in
test  flights,   outperforming  a  competing   technology,   a  high-performance
lithium-ion polymer battery.

         UAVs

         Man-portable  UAVs  are  considered  to  be an  increasingly  important
battlefield tool for  reconnaissance  and  surveillance of enemy  positions.  At
present,  power  sources  available  to the  military  provide  only  marginally
adequate  operating  times  for these  UAVs.  For  example,  the  Marine  Corps'
DragonEye system,  operating off primary lithium batteries, can run for 30 to 60
minutes.  We expect  to  achieve  a cruise  time of at least two hours  using an
equivalent weight of Zinc-Air cells. Our Zinc-Air battery successfully powered a
Dragon Eye unmanned drone in a test flight in June 2003.

         MAVs

         Development  of  electrically  propelled  MAVs has been hampered by the
lack of a satisfactory battery solution.  Achievement of our development targets
will enable a Zinc-Air  battery to power a typical  5-oz.  MAV for as long as 30
minutes.  Our Zinc-Air battery  successfully  powered an MAV in a test flight in
June 2003, outperforming a competing technology, a high-performance  lithium-ion
polymer battery.

         MARKETS/APPLICATIONS

         Being an external  alternative to the popular lithium based  BA-5590/U,
the BA-8180 can be used in many applications operated by the 5590. The BA-8180/U
can be used for a variety of military applications, including:

         >>       Tactical radios

         >>       SIGINT systems

         >>       Training systems

         >>       SATCOM radios

         >>       Nightscope power

         >>       Guidance systems

         >>       Surveillance systems

         >>       Sensors



                                       21
<PAGE>

         CUSTOMERS

         EFB's   principal   customer   during   2003   was  the   U.S.   Army's
Communications-Electronics   Command  (CECOM),  sales  to  which  accounted  for
approximately 27% of our revenues in 2003.

         COMPETITION

         The  BA-8180/U is the only  Zinc-Air  battery to hold a US Army battery
designation.   It  does,  however,   compete  with  other  primary  (disposable)
batteries,  and primarily lithium based batteries.  In some cases,  primarily in
training missions, it will also compete with rechargeable batteries.

         Zinc-Air  batteries are inherently  safer than primary  lithium battery
packs  in  storage,  transportation,  use,  and  disposal,  and  are  more  cost
effective. They are lightweight,  with up to twice the energy capacity per pound
of primary lithium battery packs.  Zinc-Air  batteries for the military are also
under development by Rayovac Corporation.  Rayovac's military Zinc-Air batteries
utilize  cylindrical  cells,  rather than the prismatic cells that we developed.
While  cylindrical  cells may provide  higher  specific power than our prismatic
cells,  we believe they will generally  have lower energy  densities and be more
difficult to manufacture.

         The  most  popular  competing  primary  battery  in use by the US Armed
Forces is the BA-5590,  which uses  lithium-sulfur  dioxide  (LiSO2) cells.  The
largest  suppliers of LiSO2 batteries to the US military are believed to be Saft
America Inc and Eagle Picher  Technologies LLC. The battery  compartment of most
military  communications  equipment,  as well as other  military  equipment,  is
designed for the x90 family of  batteries,  of which the BA-5590  battery is the
most commonly  deployed.  Another primary battery in this family is the BA-5390,
which  uses  lithium-manganese  dioxide  (LiMnO2)  cells.  Suppliers  of  LiMnO2
batteries include Ultralife Batteries Inc., Saft and Eagle Picher.

         Rechargeable  batteries  in the  x90  family  include  lithium-ion  and
nickel-metal  hydride  batteries which may be used in training missions in order
to save the higher costs associated with primary batteries. Because of the short
usage time per charge cycle,  rechargeable batteries are not considered suitable
for use in combat.

         Our BA-8180 does not fit inside the battery compartment of any military
equipment, and therefore is connected externally using an interface adapter that
we also sell to the Army.  Our battery  offers  greatly  extended  mission time,
along with lower total  mission cost,  and these  significant  advantages  often
greatly outweigh the slight inconvenience of fielding an external battery.

         MANUFACTURING

         EFB has  established  a battery  factory at our new location in Auburn,
Alabama,  where we have leased 15,000 square feet of light industrial space from
the city of  Auburn.  We also  have  production  capabilities  for some  battery
components at the facility of EFL in Beit Shemesh,  Israel.  Both the facilities
in  Auburn  and  those in Beit  Shemesh  have  received  ISO 9001  "Top  Quality
Standard" certification.



                                       22
<PAGE>

     Lithium Batteries and Charging Systems for the Military

         We sell lithium  batteries and charging systems to the military through
our  subsidiary  Epsilor  Electronic  Industries,  Ltd., an Israeli  corporation
established in 1985 that we purchased early in 2004.

         Epsilor  specializes  in the design  and  manufacture  of  primary  and
rechargeable batteries,  related electronic circuits and associated chargers for
military  applications.  Epsilor  has  experience  in  working  with  government
agencies,  the military and large  corporations.  Epsilor's  technical  team has
significant expertise in the fields of electrochemistry,  electronics,  software
and battery design, production, packaging and testing.

         PRODUCTS

         Epsilor currently  produces over 50 different products in the following
categories:

         >>       Primary batteries;

         >>       Rechargeable batteries;

         >>       Smart chargers;

         >>       State of charge indicators; and

         >>       Control and monitoring battery circuits

         Epsilor's batteries are based on  commercially-available  battery cells
that we  purchase  from  several  leading  suppliers,  with  proprietary  energy
management  circuitry  and  software.  Epsilor's  battery  packs are designed to
withstand  harsh  environments,  and have a track  record of years of service in
armies worldwide.

         Epsilor  produces  a wide  range  of  primary  batteries  based  on the
following chemistries: lithium sulfur dioxide, lithium thionyl chloride, lithium
manganese  dioxide and  alkaline.  The  rechargeable  battery  chemistries  that
Epsilor  employs are:  nickel  cadmium,  nickel metal  hydride and  lithium-ion.
Epsilor manufactures single and multi-channel smart chargers for nickel cadmium,
nickel metal hydride and lithium-ion batteries.

         Epsilor  has  designed  a  number  of  sophisticated  state  of  charge
indicators.  These  are  employed  in  Epsilor's  products  and are also sold as
components  to other  battery  pack  manufacturers.  Epsilor  also  develops and
manufactures control systems for high rate primary  battery-packs and monitoring
systems for rechargeable battery-packs.

         MARKETS/APPLICATIONS

         Epsilor's  target  markets are military and security  entities  seeking
high-end  solutions for their power source needs.  By their nature,  the sell-in
cycles are long and the resultant  entry  barriers are high.  This is due to the
high cost of developing custom designs and the long period needed to qualify any
product for military use.

         Epsilor's present customers include:

         >>       Armed forces in the Middle East and Asia;



                                       23
<PAGE>

         >>       Military original equipment manufacturers (OEMs); and

         >>       Various battery manufacturers.

         COMPETITION

         Epsilor's main competitors are Bren-tronics  Inc. in the United States,
which controls much of the U.S.  rechargeable market, and AEA Battery Systems (a
wholly owned subsidiary of AEA Technology plc) in the United Kingdom,  which has
the majority of the English  military  market.  On the primary end of the market
there are a host of  players  who  include  the cell  manufacturers  themselves,
including Saft S.A. and Ultralife Batteries, Inc.

         It  should  be noted  that a number  of OEMs,  such as  Motorola,  have
internal  engineering  groups that can develop  competitive  products  in-house.
However,  on many occasions they outsource such activities in order to stabilize
their staffing level.

         MARKETING

         Epsilor  markets to its existing  customers  through  direct sales.  To
generate  new  customers  and  applications,   Epsilor  relies  on  its  working
relationship  with a  selection  of OEMs,  with the intent of having  these OEMs
design Epsilor products into their  equipment,  thereby creating a market with a
high entry barrier.

         MANUFACTURING

         Epsilor has developed and built battery  production  lines for military
batteries and chargers which have been ISO-9001 certified since 1994. We believe
that Epsilor's  19,000 square foot facility in Dimona,  Israel has the necessary
capabilities and operations to support its production cycle.

     Electric Vehicles

         We believe  that  electric  buses  represent a  particularly  important
market for electric  vehicles in the United  States.  Transit  buses  powered by
diesel engines  operate in large urban areas where  congestion is a fact of life
and  traffic  is  largely  stop-and-go.  As  a  result,  they  are  the  leading
contributor to inner city toxic emissions, and are a major factor for those U.S.
cities that have been  designated  as in  "non-attainment"  with  respect to air
quality  standards.  Moreover,  the U.S.  Environmental  Protection  Agency  has
identified  particulate  emissions from diesel engine emissions as a carcinogen.
Electric  Fuel-powered  full-size  vehicles,   capable  of  clean,   long-range,
high-speed  travel,  could fulfill the needs of transit operators in all weather
conditions, with fast, cost-effective refueling. An all-electric,  full-size bus
powered by the Electric  Fuel system can provide to transit  authorities  a full
day's  operating  range  for both  heavy  duty city and  suburban  routes in all
weather conditions.

         THE ELECTRIC FUEL ZINC-AIR ENERGY SYSTEM FOR ELECTRIC VEHICLES

         The Electric Fuel Zinc-Air Energy System consists of:

         >>       an in-vehicle,  Zinc-Air fuel cell unit consisting of a series
                  of Zinc-Air cells and refuelable zinc-fuel anode cassettes;



                                       24
<PAGE>

         >>       a battery  exchange unit for fast vehicle  turn-around that is
                  equivalent to the time needed to refuel a diesel bus;

         >>       an  automated   battery   refueling  system  for  mechanically
                  replacing depleted zinc-fuel cassettes with charged cassettes;
                  and

         >>       a  regeneration  system  for  electrochemical   recycling  and
                  mechanical repacking of the discharged fuel cassettes.

         With  its   proprietary   high-power   air   cathode   and  zinc  anode
technologies,   our  Zinc-Air  fuel  cell  delivers  a  unique   combination  of
high-energy  density and  high-power  density,  which  together  power  electric
vehicles with speed, acceleration,  driving range and driver convenience similar
to that of conventionally powered vehicles.

         THE  DEPARTMENT  OF   TRANSPORTATION-FEDERAL   TRANSIT   ADMINISTRATION
         ZINC-AIR ALL ELECTRIC TRANSIT BUS PROGRAM

         In the  United  States,  our  Zinc-Air  technology  is the  focus  of a
Zinc-Air All Electric Bus  demonstration  program the costs and  expenditures of
which are 50%  offset by  subcontracting  fees  paid by the U.S.  Department  of
Transportation's  Federal  Transit  Administration  (FTA).  The test  program is
designed  to prove  that an  all-electric  bus can meet  these and all other Los
Angeles and New York  Municipal  Transit  Authority  mass  transit  requirements
including  requirements  relating to performance,  speed,  acceleration and hill
climbing.

         The bus used in the program,  which includes  General  Electric and the
Regional Transportation Commission of Southern Nevada (RTC) as project partners,
is  a  standard  40-foot  (12.2  meter)  transit  bus  manufactured  by  NovaBus
Corporation.  It has a capacity  of 40 seated and 37 standing  passengers  and a
gross vehicle weight of 39,500 lbs. (17,955 kg.). The all-electric hybrid system
consists of an Electric Fuel Zinc-Air fuel cell as the primary energy source, an
auxiliary battery to provide supplementary power and recuperation of energy when
braking.  Ultracapacitors  enhance this  supplementary  power,  providing faster
throughput and higher current in both directions than the auxiliary  battery can
supply on its own. The vehicle  draws  cruising  energy from the  Zinc-Air  fuel
cell, and supplementary  power for  acceleration,  merging into traffic and hill
climbing, from the auxiliary battery and ultracapacitors.

         During  Phase  II  of  performance   testing,  our  bus  was  driven  a
record-breaking 127 miles, more than 100 of them under the rigorous  stop-and-go
diving  conditions  of the Society of  Automotive  Engineers'  Central  Business
District cycle with a full passenger load. We  demonstrated  our bus in a public
demonstration in Las Vegas, Nevada in November 2001, and in Washington, D.C., on
Capitol Hill,  with the  participation  of certain  members of the United States
Senate,  in March 2002.  We have now completed  Phase III of the project,  which
focused on installation,  testing and  commissioning of new generation  advanced
ultracapacitors  and  associated   interface  controls,   and  culminated  in  a
performance  evaluation  test in  Schenectady  and  Albany,  New York,  with the
participation of New York Assembly Speaker Sheldon Silver, in November 2003.

         Phase IV of the  program,  which we began in  October  2003,  is a $1.5
million  cost-shared  program  (half  of  which  is  funded  by the  FTA and the
remainder  by the  program  partners,  including  us) that  will  explore  steps
necessary for  commercializing the all-electric  zinc-air/ultracapacitor  hybrid
bus. It will focus on continued  optimization of the propulsion system developed
in previous phases, on additional vehicle and system testing,  including testing
alternative   advanced  auxiliary  battery   technologies,   and  on  evaluating
alternative zinc anodes, which are more commercially available in North America.



                                       25
<PAGE>

         COMPETITION

         We  believe  that our  products  must be  available  at a price that is
competitive with alternative  technologies,  particularly those intended for use
in zero or  low-emission  vehicles.  Besides other battery  technologies,  these
include  hydrogen  fuel  cells,   "hybrid  systems"  that  combine  an  internal
combustion engine and battery technologies,  and use of regular or low-pollution
fuels such as gasoline,  diesel,  compressed natural gas, liquefied natural gas,
ethanol  and  methanol.  Other  alternative  technologies  presently  use costly
components,  including  use of flywheels and  catalytic  removal of  pollutants.
These various technologies are at differing stages of development and any one of
them, or a new  technology,  may prove to be more cost  effective,  or otherwise
more readily  acceptable  by consumers,  than the Electric Fuel Zinc-Air  Energy
System for electric vehicles. In addition, the California Air Resource Board has
expressed  to  us  concerns  about  the  costs   associated  with  the  Zinc-Air
regeneration  infrastructure  as  compared  to  battery  technologies  that  use
electrical recharging.

         An area of increased  development  has been that of hydrogen  fuel cell
powered  vehicles,  spearheaded  by  the  Ballard  Corporation's  solid  polymer
electrolyte hydrogen-air fuel cell program. Major automobile companies have made
significant  investments in this  technology.  We believe that vehicles based on
hydrogen fuel cells are many years away from commercialization, with significant
issues of hydrogen  production  and storage.  We feel that  storing  hydrogen in
containers  on board  vehicles may be risky and involves  major  investments  in
infrastructure  for  highly-pressurized  hydrogen,  and that using  methanol for
making hydrogen on board vehicles is highly  complex,  costly and risky. We also
believe that competing Zinc-Air technologies,  such as those offered by Metallic
Power  (Carlsbad,   California)  and  Powerzinc   Electric  (City  of  Industry,
California),  are at a much earlier stage of  development,  not just in terms of
size and number of cells,  modules and demonstrations in electric vehicles,  but
also in  terms  of the  scale  of  development  effort.  We are not  aware  of a
competing  Zinc-Air  development  effort  that  could  yield a  product  that is
superior to ours in terms of vehicle performance or life-cycle cost.

         Lifejacket Lights

         In 1996,  we began to produce and market  lifejacket  lights built with
our  patented  magnesium-cuprous  chloride  batteries,  which are  activated  by
immersion  in water  (water-activated  batteries),  for the  aviation and marine
safety and emergency  markets.  At present we have a product line  consisting of
five lifejacket light models, three for use with marine life jackets and two for
use with aviation life vests, all of which work in both freshwater and seawater.
Each of our  lifejacket  lights is  certified  for use by relevant  governmental
agencies  under  various U.S. and  international  regulations.  We  manufacture,
assemble and package all our  lifejacket  lights in our factory in Beit Shemesh,
Israel.

         MARKETING

         We market  our  marine  safety  products  through  our own  network  of
distributors  in Europe,  the United  States,  Asia and  Oceania.  We market our
lights to the  commercial  aviation  industry in the United  States  exclusively
through The Burkett  Company of Houston,  Texas,  which receives a commission on
sales.



                                       26
<PAGE>

         COMPETITION

         Two  of  the  largest  manufacturers  of  aviation  and  marine  safety
products,   including  TSO  and   SOLAS-approved   lifejacket  lights,  are  ACR
Electronics  Inc.  of  Hollywood,  Florida,  and Pains  Wessex  McMurdo  Ltd. of
England.  Other  significant  competitors in the marine market include Daniamant
Aps of Denmark, and SIC of Italy.

Armored Vehicle Division

     MDT Protective Industries and MDT Armor

         INTRODUCTION

         MDT Protective Industries Ltd. was established in Israel in 1989 as one
of Israel's first car armoring companies,  and is Israel's leader in lightweight
armoring  of  vehicles,  ranging  from  light  tactical  vehicles  to  passenger
vehicles.  With two production lines, MDT specializes in using  state-of-the-art
lightweight ceramic materials,  special ballistic glass and advanced engineering
processes to fully armor vans and cars. MDT is a leading supplier to the Israeli
military,  Israeli special forces and special services. MDT's products have been
proven in intensive  battlefield  situations and under actual  terrorist  attack
conditions,  and are designed to meet the demanding requirements of governmental
and private sector customers worldwide.

         MDT has acquired many years of battlefield  experience in Israel. MDT's
vehicles have provided  proven  life-saving  protection for their  passengers in
incidents of rock  throwing,  handgun and assault  rifle  attack at  point-blank
range,  roadside  bombings and suicide  bombings.  In fact,  to our knowledge an
MDT-armored  vehicle has never  experienced  bullet  penetration  into a vehicle
cabin under attack.  MDT also uses its  technology to protect  vehicles  against
vandalism.

         In 2003, MDT Armor established  operations in a new facility in Auburn,
Alabama.  Soon  thereafter,  the United States General  Services  Administration
(GSA)  awarded  a  five-year   contract  to  MDT  Armor  for  vehicle  armoring,
establishing  a pricing  schedule  for  armoring of GM Suburban  and Toyota Land
Cruiser SUVs and of GM Savana/Express  passenger vans. With this contract, these
armored vehicles became available for purchase  directly by all federal agencies
beginning December 1, 2003.

         MDT's  revenues  during  2001,  2002 and 2003 were  approximately  $6.8
million, $6.4 million and $3.4 million, respectively.

         THE ARMORING PROCESS

         Armoring a vehicle  involves much more than just adding "armor plates."
It  includes  professional  and  secure  installation  of  a  variety  of  armor
components - inside  doors,  dashboards,  and all other areas of  passenger  and
engine compartments. MDT uses overlapping sections to ensure protection from all
angles,  and installs  armored  glass in the  windshield  and  windows.  MDT has
developed certain unique features,  such as new window operation mechanisms that
can raise windows rapidly despite their increased  weight,  gun ports,  run-flat
tires,  and more.  MDT  developed  the  majority of the  materials  that it uses
in-house,  or in conjunction with Israeli  companies  specializing in protective
materials.



                                       27
<PAGE>

         In order to armor a vehicle,  MDT first  disassembles  the  vehicle and
removes the interior paneling,  passenger seats, doors,  windows,  etc. MDT then
fortifies the entire body of the vehicle,  including  the roof,  motor and other
critical  components,  and  reinforces  the door hinges.  MDT achieves  firewall
protection  from frontal  assault with  carefully  designed  overlapping  armor.
Options, such as air-conditioning, seating modifications and run-flat tires, are
also available.  MDT fixes the armoring into the shell of the vehicle,  ensuring
that the  installation  and finishing is according to the standards set for that
particular  model.  MDT then  reassembles  the vehicle as close to its  original
appearance as possible.

         Once MDT has ensured  full vehicle  protection,  it places a premium on
retaining the original vehicle's look and feel to the extent possible, including
enabling  full  serviceability  of the vehicle,  thereby  rendering the armoring
process   "invisible."   MDT  works  with  its  customers  to  understand  their
requirements,  and  together  with the customer  develops an optimized  armoring
solution.  A flexible  design-to-cost  process helps evaluate  tradeoffs between
heavy and light materials and various levels of protection.

         By  working  within  the  vehicle  manufacturer's  specifications,  MDT
maintains stability,  handling,  center-of-gravity and overall integrity.  MDT's
methods  minimize  impact  on  payload,  and do not  obstruct  the  driver's  or
passengers'  views.  In most cases all the original  warranties  provided by the
manufacturer are still in effect.

         ARMORING MATERIALS

         MDT offers a variety of armoring materials, optimized to the customer's
requirements.   MDT  uses  ballistic  steel,   composite  materials   (including
Kevlar(R),  Dyneema(R)  and composite  armor steel) as well as special  ceramics
developed  by MDT,  together  with  special  armored  glass.  MDT uses  advanced
engineering  techniques  and "light"  composite  materials,  and avoids,  to the
extent  possible,  using  traditional  "heavy"  materials  such as armored steel
because of the added weight,  which impairs the driving performance and handling
of the vehicle.

         All  materials  used  by MDT  meet  not  only  international  ballistic
standards,  but also the far more stringent requirements set down by the Israeli
military,  the  Israeli  Ministries  of Defense  and  Transport,  and the Israel
Standards  Institute.  MDT's  factory has also been granted the ISO 9002 quality
standards award.

         PRODUCTS AND SERVICES

         MDT armors a variety  of  vehicles  for both  commercial  and  military
markets.  At present,  MDT offers armoring for  approximately  thirty  different
models of motor vehicles.

         In the military market, MDT armors:

         >>       troop  and  personnel   carriers  (such  as  vehicles  in  the
                  Mercedes-Benz Vario and Sprinter lines);

         >>       front-line police and military vehicles;



                                       28
<PAGE>

         >>       command vehicles (such as the Land Rover Defender 4x4);

         >>       specialty vehicles.

         In the commercial market, MDT armors:

         >>       sports utility  vehicles (such as the GM Suburban,  the Toyota
                  Land Cruiser and the Land Rover Defender);

         >>       passenger  vans (such as the  Chevrolet  Savana,  the  General
                  Motors Vandura and the Ford Econoline).

         SALES AND MARKETING

         Most of MDT's business has historically come from Israel,  although MDT
has armored  vehicles under  contracts  from  companies in  Yugoslavia,  Mexico,
Colombia,  South Africa and Singapore,  and MDT recently received a $5.5 million
order from the United States. MDT's principal customer at present is the Israeli
Ministry of Defense.  Other customers include Israeli government  ministries and
agencies, private companies, medical services and private clients.

         MDT markets its vehicle  armoring  through Israeli  vehicle  importers,
both pursuant to marketing  agreements  and  otherwise,  and directly to private
customers. Most sales are through vehicle importers.

         MDT holds  exclusive  armoring  contracts  with  Israel's  sole General
Motors and  Chevrolet  distributors.  This means  that these  distributors  will
continue to honor the original  vehicle warranty on armored versions of vehicles
sold by them only if the armoring was done by MDT.

         CUSTOMERS

         MDT's  principal  customer  during  2003 was the  Israeli  Ministry  of
Defense,  sales to which  accounted for  approximately  17% of our  consolidated
revenues in 2003.

         COMPETITION

         The global armored car industry is highly  fragmented.  Major suppliers
include both vehicle  manufacturers  and  aftermarket  specialists.  As a highly
labor-intensive process, vehicle armoring is numerically dominated by relatively
small businesses. Industry estimates place the number of companies doing vehicle
armoring in the range of around 500  suppliers  globally.  While  certain  large
companies may armor several  hundred cars annually,  most of these companies are
smaller  operations  that may armor in the range of five to fifty cars per year.
In 2002,  MDT armored  over 130 vehicles  against  weapons and  explosives,  and
another approximately 300 vehicles against vandalism.

         Among   vehicle   manufacturers,    Mercedes-Benz   has   the   largest
vehicle-armoring  market  share,  estimated  at around 7% of the global  market.
Among aftermarket specialists,  the largest share of the vehicle-armoring market
is held by  O'Gara-Hess  & Eisenhardt.  Other  aftermarket  specialists  include
International  Armoring Corp. Lasco, Texas Armoring and Chicago Armor (Moloney).
Many  of  these  companies  have   financial,   technical,   marketing,   sales,
manufacturing, distribution and other resources significantly greater than ours.



                                       29
<PAGE>

         We believes the key factors in our competing successfully in this field
will be our ability to penetrate new military and  paramilitary  markets outside
of Israel, particularly in North and South America and in Europe.

Backlog

We  generally  sell  our  products  under  standard   purchase  orders.   Orders
constituting  our backlog are subject to changes in delivery  schedules  and are
typically  cancelable  by our  customers  until a  specified  time  prior to the
scheduled delivery date. Accordingly, our backlog is not necessarily an accurate
indication  of future sales.  As of December 31, 2003 and 2002,  our backlog for
the  following  years  was   approximately   $17.2  million  and  $7.2  million,
respectively,  divided among our product  lines as follows  (backlog for product
lines  acquired after December 31, 2003 is given as it stood at such date in the
books of the seller, prior to the acquisition):

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------
              Division                            Product Line                    2003           2002
------------------------------------------------------------------------------------------------------------
<S>                                                                           <C>            <C>
                                    Use-of-force training.................... $     334,000  $   2,690,000
Simulation, Training and
Consulting Division
------------------------------------------------------------------------------------------------------------
                                    Vehicle simulators*......................     6,206,000              -
                                    Security consulting......................        60,000              -
------------------------------------------------------------------------------------------------------------
                                    Zinc-Air batteries for the military......     5,250,000      2,700,000
Battery and Power Systems
Division
------------------------------------------------------------------------------------------------------------
                                    Lithium batteries for the military*......     3,800,000              -
------------------------------------------------------------------------------------------------------------
                                    Electric vehicle.........................       436,000        420,000
------------------------------------------------------------------------------------------------------------
                                    Water-activated batteries................       144,000        300,000
------------------------------------------------------------------------------------------------------------
Armored Vehicle Division            Car armoring.............................       931,000      1,040,000
--------------------                ------------------------------------------------------------------------
                                         TOTAL:.............................. $  17,161,000  $   7,150,000
--------------------                ------------------------------------------------------------------------
</TABLE>

* Not owned at December 31, 2002.

Patents and Trade Secrets

         We rely on  certain  proprietary  technology  and seek to  protect  our
interests through a combination of patents,  trademarks,  copyrights,  know-how,
trade secrets and security measures,  including confidentiality  agreements. Our
policy  generally is to secure  protection  for  significant  innovations to the
fullest  extent  practicable.  Further,  we  seek  to  expand  and  improve  the
technological  base and  individual  features of our  products  through  ongoing
research and development programs.

         We rely on the laws of unfair  competition and trade secrets to protect
our  proprietary  rights.  We  attempt to protect  our trade  secrets  and other
proprietary  information through  confidentiality and non-disclosure  agreements
with customers, suppliers, employees and consultants, and through other security
measures.  However,  we may be unable to detect the unauthorized use of, or take
appropriate steps to enforce our intellectual  property rights.  Effective trade
secret  protection  may not be available  in every  country in which we offer or
intend to offer our  products  and  services to the same extent as in the United
States.  Failure to adequately  protect our intellectual  property could harm or
even destroy our brands and impair our ability to compete effectively.  Further,
enforcing our  intellectual  property  rights could result in the expenditure of
significant  financial and  managerial  resources and may not prove  successful.
Although we intend to protect our rights  vigorously,  there can be no assurance
that these measures will be successful.



                                       30
<PAGE>

Research and Development

         Research and  development is conducted by IES in Denver,  Colorado;  by
FAAC in Ann Arbor,  Michigan; by MDT in Lod, Israel; by EFB in Auburn,  Alabama;
by Epsilor in Dimona, Israel; and by EFB and EFL in Beit Shemesh, Israel. During
the years ended December 31, 2003, 2002 and 2001, our gross research and product
development  expenditures were approximately $1.1 million, $2.2 million and $4.2
million,  respectively,  including  research  and  development  in  discontinued
operations.  During  these  periods,  the Office of the Chief  Scientist  of the
Israel  Ministry of Industry and Trade (the "Chief  Scientist")  participated in
our research and development  efforts relating to our consumer battery business,
thereby reducing our gross research and product development  expenditures in the
amounts of approximately $26,000,  $49,000 and $705,000 for the years 2003, 2002
and 2001, respectively.

         EFL has certain contingent  royalty  obligations to Chief Scientist and
the Israel-U.S. Binational Industrial Research and Development Foundation (BIRD,
which apply (in respect of continuing  operations)  only to our Electric Vehicle
program. As of December 31, 2003, our total outstanding  contingent liability in
this connection was approximately $10.1 million.

Employees

         As of February 29, 2004, we had 219 full-time employees  worldwide.  Of
these employees,  4 hold doctoral degrees and 20 hold other advanced degrees. Of
the total, 52 employees were engaged in product  research and  development,  125
were engaged in  production  and  operations,  12 were engaged in marketing  and
sales, and 30 were engaged in general and administrative  functions. Our success
will  depend in large  part on our  ability to attract  and retain  skilled  and
experienced employees.

         We and our  employees  are not  parties  to any  collective  bargaining
agreements.  However,  as certain  of our  employees  are  located in Israel and
employed by EFL, MDT or Epsilor, certain provisions of the collective bargaining
agreements between the Histadrut (General Federation of Labor in Israel) and the
Coordination  Bureau of Economic  Organizations  (including  the  Manufacturers'
Association of Israel) are applicable to EFL's, MDT's and Epsilor's employees by
order (the  "Extension  Order") of the Israeli  Ministry  of Labor and  Welfare.
These  provisions  principally  concern  the length of the work day and the work
week, minimum wages for workers,  contributions to a pension fund, insurance for
work-related  accidents,  procedures for dismissing employees,  determination of
severance pay and other conditions of employment,  including  certain  automatic
salary adjustments based on changes in the Israeli CPI.

         Israeli law generally  requires  severance  pay upon the  retirement or
death  of  an  employee  or  termination   of  employment   without  due  cause;
additionally,  some of our senior employees have special severance arrangements,
certain  of which  are  described  under  "Item  11.  Executive  Compensation  -
Employment   Contracts,"   below.  We  currently  fund  our  ongoing   severance
obligations by making monthly payments to approved  severance funds or insurance
policies.  In addition,  Israeli  employees  and  employers  are required to pay
specified  sums to the  National  Insurance  Institute,  which is similar to the
United  States  Social  Security  Administration.  Since  January 1, 1995,  such
amounts also include payments for national health insurance. The payments to the
National  Insurance  Institute are  approximately  15.6% of wages,  of which the
employee   contributes   approximately   62%   and  the   employer   contributes
approximately  38%. The  majority of the  permanent  employees  of EFL,  about a
quarter of the permanent employees of MDT, and one of the permanent employees of
Epsilor,  are covered by "managers'  insurance," which provides life and pension
insurance  coverage with customary benefits to employees,  including  retirement
and  severance  benefits.  We  contribute  14.33%  to 15.83%  (depending  on the
employee) of base wages to such plans and the permanent employees  contribute 5%
of their base wages.



                                       31
<PAGE>

         In 1993, an Israeli court held that  companies  that are subject to the
Extension Order are required to make pension  contributions  exclusively through
contributions  to Mivtachim  Social  Institute of Employees Ltd., a pension fund
managed by the Histadrut.  We  subsequently  reached an agreement with Mivtachim
with respect to providing coverage to certain production  employees and bringing
ourselves  into  conformity  with the court  decision.  The  agreement  does not
materially increase our pension costs or otherwise  materially  adversely affect
its  operations.  Mivtachim  has agreed not to assert any claim  against us with
respect to any of our past  practices  relating  to this  matter.  Although  the
arrangement does not bind employees with respect to instituting  claims relating
to any  nonconformity  by us, we believe that the likelihood of the assertion of
claims by employees is low and that any  potential  claims by employees  against
us, if successful, would not result in any material liability to us.

ITEM 2. PROPERTIES

         Our New York  headquarters,  constituting  approximately  4,000  square
feet,  is  located in New York City and  subleased  on a  month-to-month  basis.
Beginning April 15, 2004, we will move to new corporate headquarters  consisting
of  approximately  1,100 square feet,  at 250 West 57th Street in New York City,
pursuant to an agreement of lease expiring in June 2009. Under the terms of this
lease,  we have an option to request an increase in our leased space of at least
50%, and the failure to provide such increased  space in the same building would
enable us to terminate the lease without penalty.

         The Auburn, Alabama research and manufacturing  facility,  constituting
approximately 15,000 square feet, is leased from the City of Auburn through July
2004,  with an option to extend the lease for an  additional  1 1/2 years at the
same rent and for another three years thereafter at a 10% rent increase. We also
have an option to expand  to 30,000  square  feet,  and we have free use of this
additional space through mid-2004.

         Our management and administrative facilities and research,  development
and  production  facilities  for the  manufacture  and  assembly of our Survivor
Locator Lights,  constituting  approximately  18,300 square feet, are located in
Beit Shemesh,  Israel,  located between  Jerusalem and Tel-Aviv (within Israel's
pre-1967 borders).  The lease for these facilities in Israel expires on December
31, 2007;  we have the ability to terminate the lease every two years upon three
months'  written notice.  Moreover,  we may terminate the lease at any time upon
twelve months written notice.

         Our  Epsilor  subsidiary  rents  approximately  19,000  square  feet of
factory,  office and warehouse space in Dimona, Israel, in Israel's Negev desert
(within Israel's pre-1967 borders), on a month-to-month basis.



                                       32
<PAGE>

         Our IES subsidiary rents  approximately 8,900 square feet of office and
warehouse  space in  Littleton,  Colorado,  approximately  ten miles  outside of
Denver, pursuant to a lease expiring in September 2005, with an option to extend
the lease for an additional  five years, or until September 2010. IES also holds
an option under certain circumstances to rent an additional 3,200 square feet of
contiguous space.

         Our FAAC subsidiary  rents  approximately  17,800 square feet of office
and  warehouse  space in Ann Arbor,  Michigan,  pursuant to a lease  expiring in
February 2005,  with an option to extend the lease for an additional five years,
or until February 2010.

         Our MDT  subsidiary  rents  approximately  20,000 square feet of office
space in Lod,  Israel,  near Ben-Gurion  International  airport (within Israel's
pre-1967 borders) pursuant to a lease renewable on an annual basis.

         We  believe  that our  existing  facilities  are  adequate  to meet our
current and foreseeable future needs.

ITEM 3. LEGAL PROCEEDINGS

         As of the date of this  filing,  there were no material  pending  legal
proceedings against us.

         In October 2003,  I.E.S.  Group,  the parent company of IES Electronics
Industries  Ltd.,  the  seller  from  which we  purchased  the assets of our IES
subsidiary in 2002,  filed a lawsuit in Tel-Aviv  District  Court against us and
certain of our past and present  officers.  The complaint alleged breaches by us
of certain of our agreements  with IES  Electronics  Industries  Ltd. and claims
monetary damages in the amount of approximately $3 million.

         On  February  4,  2004,  we entered  into an  agreement  settling  this
litigation.  Pursuant to the terms of the settlement  agreement,  in addition to
agreeing to dismiss their lawsuit with prejudice,  IES Electronics agreed (i) to
cancel our $450,000  debt to them that had been due on December  31,  2003,  and
(ii)  to  transfer  to us  title  to  certain  certificates  of  deposit  in the
approximate principal amount of $112,000. In consideration of the foregoing,  we
issued to IES  Electronics  (i)  450,000  shares of our common  stock,  and (ii)
five-year  warrants to purchase up to an additional 450,000 shares of our common
stock at a purchase price of $1.91 per share.

         The  foregoing   description  of  our  settlement  agreement  with  IES
Electronics  is  qualified  in its  entirety by  reference to the summary of the
settlement  agreement filed as an exhibit to our Current Report on Form 8-K that
we filed with the SEC on February 5, 2004.

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

         None.



                                       33
<PAGE>
                                     PART II

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

         Since  February  1994,  our common  stock has been traded on the Nasdaq
National Market. Our Nasdaq ticker symbol is currently "ARTX"; prior to February
2003, our Nasdaq ticker symbol was "EFCX." The following  table sets forth,  for
the periods  indicated,  the range of high and low closing  prices of our common
stock on the Nasdaq National Market System:

Year Ended December 31, 2003                    High        Low
                                                ----        ---
    Fourth Quarter..........................  $   2.86    $   1.28
    Third Quarter...........................  $   1.62    $   0.81
    Second Quarter..........................  $   1.19    $   0.49
    First Quarter...........................  $   0.66    $   0.43

Year Ended December 31, 2002
    Fourth Quarter..........................  $   1.06    $   0.61
    Third Quarter...........................  $   1.59    $   0.83
    Second Quarter..........................  $   1.68    $   0.73
    First Quarter...........................  $   2.20    $   1.42

         As of February 29, 2004 we had  approximately  300 holders of record of
our common stock.

Dividends

         We have never paid any cash dividends on our common stock. The Board of
Directors presently intends to retain all earnings for use in our business.  Any
future  determination  as to payment of dividends will depend upon our financial
condition  and  results of  operations  and such  other  factors as the Board of
Directors deems relevant.

Recent Sales of Unregistered Securities

     Sale of Debentures

         Pursuant  to  the  terms  of  a  Securities  Purchase  Agreement  dated
September 30, 2003 (the "Purchase Agreement") by and between Arotech Corporation
and six institutional investors (the "Debenture Holders"), we issued and sold to
the  Debenture  Holders (i) an aggregate  principal  amount of  $5,000,000 in 8%
secured convertible  debentures due September 30, 2006,  convertible into shares
of our common stock at any time after  January 1, 2004 at a conversion  price of
$1.15 per share, and (ii) three-year  warrants to purchase up to an aggregate of
1,250,000  shares of our common  stock at any time  after  January 1, 2004 at an
exercise price of $1.4375 per share.

         The Debenture  Holders also had the right, at their option, at any time
prior to  September  30, 2006,  to purchase up to an  additional  $6,000,000  in
debentures (the "Additional  Debentures")  convertible into shares of our common
stock at any time  after  January  1,  2004 at a  conversion  price of $1.45 per
share,  and to receive  warrants  to purchase up to an  aggregate  of  1,500,000
shares of our common  stock at any time after  January 1, 2004 (the  "Additional
Warrants")  at an exercise  price of $1.8125 per share.  The  Debenture  Holders
exercised  this right  pursuant  to  Amendment  and  Exercise  Agreements  dated
December 10, 2003.



                                       34
<PAGE>

         We also  granted to the  Debenture  Holders  supplemental  warrants  to
purchase  up to an  aggregate  of  1,038,000  shares of our  common  stock  (the
"Supplemental   Warrants"  and,  together  with  the  Additional  Warrants,  the
"Warrants")  at an exercise  price of $2.20 per share (the closing  price of our
common  stock on December  10,  2003 was $1.70 per share)  and, on December  18,
2003,  we issued to the  Debenture  Holders the  Additional  Debentures  and the
Warrants.

         As of  February  29,  2004,  we  had  $7,225,000  principal  amount  of
Debentures outstanding.

         Under the terms of the  Purchase  Agreement,  we granted the  Debenture
Holders  a  first  position   security  interest  in  the  stock  of  MDT  Armor
Corporation,  the assets of our IES Interactive Training,  Inc. subsidiary,  the
stock  of  our  subsidiaries,  and  in any  stock  that  we  acquire  in  future
Acquisitions (as defined in the Purchase Agreement).

         The foregoing  description of our agreement with the Debenture  Holders
is qualified in its entirety by reference to the  agreements  with the Debenture
Holders  filed as exhibits to our Current  Report on Form 8-K that we filed with
the SEC on December 23, 2003.

         We issued  the above  securities  in  reliance  on the  exemption  from
registration  provided by Section 4(2) of the Securities Act as  transactions by
an issuer not involving a public offering.  The issuance of these securities was
without the use of an  underwriter,  and the shares of common  stock were issued
with restrictive  legends permitting  transfer thereof only upon registration or
an exemption under the Act.

     Issuance of Warrants in Connection with an Offering of Registered Shares

         Pursuant to the terms of a Securities  Purchase Agreement dated January
7, 2004 (the "SPA") by and between us and several  institutional  investors (the
"Investors"),  we issued and sold to the Investors  registered  stock off of our
effective shelf registration  statement,  and three-year warrants to purchase up
to an aggregate of  9,840,426  shares of our common stock at any time  beginning
six months after closing (the  "Warrants")  at an exercise price per share equal
to $1.88. The common stock underlying the Warrants was not registered.

         The  foregoing  description  of our  agreement  with the  Investors  is
qualified  in its entirety by reference  to the  agreements  with the  Investors
filed as exhibits  to our Current  Report on Form 8-K that we filed with the SEC
on January 9, 2004.

         We issued the Warrants in reliance on the exemption  from  registration
provided by Section 4(2) of the Securities Act as  transactions by an issuer not
involving a public  offering.  The issuance of these  securities was without the
use of an  underwriter,  and the Warrants were issued with  restrictive  legends
permitting  transfer thereof and of the shares underlying the Warrants only upon
registration or an exemption under the Act.

     Issuance of Shares to a Consultant

         Under the terms of an independent  contractor  agreement between us and
InteSec  Group LLC, we pay InteSec a  commission  in stock of 5% of the military
battery sales that InteSec brings to us from U.S. and NATO defense, security and
military  entities and U.S. defense  contractors.  Pursuant to the terms of this
agreement, in February 2004, we issued 74,215 shares to InteSec.



                                       35
<PAGE>

         We issued  the above  securities  in  reliance  on the  exemption  from
registration  provided by Section 4(2) of the Securities Act as  transactions by
an issuer not involving a public offering.  The issuance of these securities was
without the use of an  underwriter,  and the shares of common  stock were issued
with restrictive  legends permitting  transfer thereof only upon registration or
an exemption under the Act.

ITEM 6.  SELECTED FINANCIAL DATA

         The selected financial  information set forth below with respect to the
consolidated  financial  statements  for  each of the five  fiscal  years in the
period ended  December 31, 2003,  and with respect to the balance  sheets at the
end of each such fiscal year has been  derived from our  consolidated  financial
statements  audited by Kost, Forer,  Gabbay & Kassierer,  independent  certified
public accountants in Israel and a member firm of Ernst & Young Global.

         The results of operations,  including revenue,  operating expenses, and
financial  income of the consumer  battery  segment for the years ended December
31, 2003, 2002,  2001, 2000 and 1999 have been  reclassified in the accompanying
statements of  operations  as  discontinued  operations.  Our balance  sheets at
December  31,  2003,  2002,  2001,  2000 and 1999 give  effect the assets of the
consumer battery business as discontinued  operations  within current assets and
liabilities.  Thus, the financial  information  presented  herein  includes only
continuing operations.

         The financial information set forth below is qualified by and should be
read in conjunction with the Consolidated Financial Statements contained in Item
8 of this Report and the notes thereto and "Item 7. Management's  Discussion and
Analysis of Financial Condition and Results of Operations," below.



                                       36
<PAGE>

<TABLE>
<CAPTION>
                                                                            Year Ended December 31,
                                                  ------------------------------------------------------------------------------
                                                       1999            2000           2001            2002            2003
                                                       ----            ----           ----            ----            ----
                                                                  (dollars in thousands, except per share data)

Statement of Operations Data:
<S>                                                 <C>             <C>             <C>            <C>             <C>
Revenues........................................    $    2,422      $    1,490      $    2,094     $    6,407      $   17,326
Research and development expenses and costs of
  revenues......................................         3,867           1,985           2,448          5,108          12,141
Selling, general and administrative expenses
  and amortization of intangible assets.........         2,754           3,434           3,934          5,982          10,594
Operating loss..................................        (4,198)         (3,929)         (4,288)        (4,683)         (5,409)
Financial income (expenses), net................           190             544             263            100          (3,470)
Loss before minority interest in loss
  (earnings) of subsidiary and tax expenses.....        (4,008)         (3,385)         (4,026)        (4,583)         (8,879)
Taxes on income.................................            (6)              -               -              -            (396)
Minority interest in loss (earnings) of
  subsidiary....................................             -               -               -           (355)            157
Loss from continuing operations.................        (4,014)         (3,385)         (4,026)        (4,938)         (9,118)
Income (loss) from discontinued operations......        (2,902)         (8,596)        (13,261)       (13,566)            110
Net loss for the period.........................        (6,916)        (11,981)        (17,287)       (18,504)         (9,008)
Deemed dividend to certain shareholders of
  common stock..................................             -               -          (1,197)             -               -
Net loss attributable to shareholders of common
  stock ........................................    $   (6,916)     $  (11,981)     $  (18,483)    $  (18,504)     $   (9,008)
Basic and diluted net loss per share from
  continuing operations.........................    $    (0.28)     $    (0.18)     $    (0.21)    $    (0.15)     $    (0.23)
Loss per share for combined operations..........    $    (0.48)     $    (0.62)     $    (0.76)    $    (0.57)     $    (0.23)
Weighted average number of common shares used
  in computing basic and diluted net loss per
  share (in thousands)..........................        14,334          19,243          24,200         32,382          38,890


                                                                               As At December 31,
                                                  ------------------------------------------------------------------------------
                                                       1999            2000           2001            2002            2003
Balance Sheet Data:
Cash, cash equivalents, investments in
  marketable debt securities and restricted
  collateral deposits...........................    $    2,556      $   11,596      $   12,672     $    2,091      $   14,391
Receivables and other assets*...................         5,215          13,771          11,515          7,895           8,898
Property and equipment, net of depreciation.....         2,258           2,289           2,221          2,555           2,293
Goodwill and other intangible assets, net.......             -               -               -          7,522           7,440
Total assets....................................    $   10,029      $   27,656      $   26,408     $   20,063      $   33,022
Current liabilities*............................    $    3,427      $    4,787      $    3,874     $    7,272      $    6,860
Long-term liabilities...........................         2,360           2,791           3,126          3,753           4,118
Stockholders' equity............................         4,242          20,078          19,408          9,038          22,044
Total liabilities and stockholders equity*......    $   10,029      $   27,656      $   26,408     $   20,063      $   33,022
</TABLE>


------------------------------------

* Includes assets and liabilities, as applicable, from discontinued operations.



                                       37
<PAGE>

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

         The  following  Management's   Discussion  and  Analysis  of  Financial
Condition and Results of Operations  contains  forward-looking  statements  that
involve  inherent risks and  uncertainties.  When used in this  discussion,  the
words "believes,"  "anticipated," "expects," "estimates" and similar expressions
are intended to identify such  forward-looking  statements.  Such statements are
subject to certain risks and  uncertainties  that could cause actual  results to
differ materially from those projected. Readers are cautioned not to place undue
reliance on these  forward-looking  statements,  which speak only as of the date
hereof.  We  undertake  no  obligation  to  publicly  release  the result of any
revisions to these forward-looking statements that may be made to reflect events
or  circumstances  after  the  date  hereof  or to  reflect  the  occurrence  of
unanticipated  events.  Our actual  results could differ  materially  from those
anticipated in these  forward-looking  statements as a result of certain factors
including,  but not limited to, those set forth elsewhere in this report. Please
see "Risk  Factors,"  below,  and in our other filings with the  Securities  and
Exchange Commission.

         The following  discussion  and analysis  should be read in  conjunction
with the Consolidated  Financial  Statements contained in Item 8 of this report,
and the notes  thereto.  We have rounded  amounts  reported  here to the nearest
thousand,  unless such amounts are more than 1.0 million, in which event we have
rounded such amounts to the nearest hundred thousand.

General

         We are a defense and security products and services company, engaged in
three business areas:  interactive  simulation for military, law enforcement and
commercial  markets;  batteries  and  charging  systems  for the  military;  and
high-level armoring for military,  paramilitary and commercial  vehicles.  Until
September 17, 2003, we were known as Electric  Fuel  Corporation.  We operate in
three business units:

         >>       we develop, manufacture and market advanced hi-tech multimedia
                  and interactive digital solutions for use-of-force and driving
                  training of military,  law enforcement and security personnel,
                  as well as offering  security  consulting  and other  services
                  (our Simulation, Training and Consulting Division);

         >>       we  manufacture  and sell  Zinc-Air and lithium  batteries for
                  defense and security products and other military  applications
                  and we pioneer advancements in Zinc-Air battery technology for
                  electric  vehicles (our Battery and Power  Systems  Division);
                  and

         >>       we utilize  sophisticated  lightweight  materials and advanced
                  engineering  processes to armor vehicles (our Armored  Vehicle
                  Division).

         Early  in 2004,  we  acquired  two new  businesses:  FAAC  Corporation,
located in Ann Arbor, Michigan,  which provides simulators,  systems engineering
and software  products to the United  States  military,  government  and private
industry  (which  we have  placed in our  Simulation,  Training  and  Consulting
Division),  and Epsilor Electronic Industries,  Ltd., located in Dimona, Israel,
which develops and sells  rechargeable  and primary lithium  batteries and smart
chargers to the military and to private industry in the Middle East,  Europe and
Asia (which we have placed in our Battery and Power Systems Division).  Prior to
the  acquisition  of FAAC and Epsilor,  we were  organized  into two  divisions:
Defense and Security  Products  (consisting  of IES, MDT, MDT Armor and Arocon),
and Electric Fuel  Batteries  (consisting  of EFL and EFB). We have reported our
results  of  operations  for 2003  and 2002 in  accordance  with  these  earlier
divisions,  and our  financial  results  for 2003 and  2002 do not  include  the
activities of FAAC or Epsilor.



                                       38
<PAGE>

Critical Accounting Policies

         The preparation of financial  statements  requires us to make estimates
and assumptions  that affect the reported  amounts of assets and liabilities and
the disclosure of contingent liabilities at the date of the financial statements
and the reported  amounts of revenues and expenses during the reporting  period.
On an ongoing basis,  we evaluate our estimates and judgments,  including  those
related to revenue recognition,  allowance for bad debts, inventory,  impairment
of  intangible  assets and  goodwill.  We base our  estimates  and  judgments on
historical  experience  and on  various  other  factors  that we  believe  to be
reasonable  under the  circumstances,  the  results  of which form the basis for
making  judgments about the carrying  values of assets and liabilities  that are
not  readily  apparent  from  other  sources.  Under  different  assumptions  or
conditions, actual results may differ from these estimates.

         We believe the following critical  accounting  policies,  among others,
affect our more  significant  judgments and estimates used in the preparation of
our consolidated financial statements.

     Revenue Recognition and Bad Debt

         We generate revenues primarily from sales of multimedia and interactive
digital training systems and use-of-force  simulators  specifically targeted for
law enforcement and firearms training and from service contracts related to such
sales; from providing  lightweight  armoring services of vehicles;  from sale of
zinc-air  battery  products for defense  applications;  and, to a lesser extent,
from development  services and long-term  arrangements  subcontracted by the U.S
government.  We  recognize  revenues  in respect of products  when,  among other
things,   we  have   delivered   the  goods  being   purchased  and  we  believe
collectibility  to be reasonably  assured.  We do not grant a right of return to
our customers. We perform ongoing credit evaluations of our customers' financial
condition and we require collateral as deemed necessary. We make judgments as to
our ability to collect  outstanding  receivables  and provide  allowances  for a
portion of such receivables when and if collection becomes doubtful.  Provisions
are  made  based  upon  a  specific  review  of  all   significant   outstanding
receivables.  In determining the provision, we analyze our historical collection
experience  and  current  economic  trends.  If the  historical  data  we use to
calculate  the  allowance  provided for doubtful  accounts  does not reflect the
future ability to collect  outstanding  receivables,  additional  provisions for
doubtful  accounts may be needed and the future  results of operations  could be
materially affected.

         Revenues  from  development  services  are  recognized  using  contract
accounting  on a  percentage  of  completion  method,  based  on  completion  of
agreed-upon  milestones and in accordance  with the "Output  Method" or based on
the time and material  basis.  Provisions  for estimated  losses on  uncompleted
contracts are recognized in the period in which the likelihood of such losses is
determined.



                                       39
<PAGE>

         The complexity of the estimation  process and the issues related to the
assumptions,  risks  and  uncertainties  inherent  with the  application  of the
percentage of completion  method of accounting affect the amounts of revenue and
related expenses reported in our consolidated financial statements.

     Inventories

         Our policy for  valuation  of  inventory  and  commitments  to purchase
inventory, including the determination of obsolete or excess inventory, requires
us to perform a detailed  assessment  of inventory  at each balance  sheet date,
which  includes a review of, among other  factors,  an estimate of future demand
for products within specific time horizons,  valuation of existing inventory, as
well as product lifecycle and product development plans. The estimates of future
demand that we use in the  valuation of inventory  are the basis for our revenue
forecast,  which is also used for our short-term  manufacturing plans. Inventory
reserves are also provided to cover risks  arising from  slow-moving  items.  We
write down our inventory for estimated  obsolescence or  unmarketable  inventory
equal to the difference  between the cost of inventory and the estimated  market
value based on assumptions about future demand and market conditions.  We may be
required to record additional  inventory  write-down if actual market conditions
are less favorable than those projected by our  management.  For fiscal 2003, no
significant changes were made to the underlying assumptions related to estimates
of inventory valuation or the methodology applied.

     Goodwill

         Our  business  acquisitions  typically  result  in the  recognition  of
goodwill  and other  intangible  assets,  which affect the amount of current and
future period charges and amortization  expenses.  The determination of value of
these components of a business  combination,  as well as associated asset useful
lives,  requires our  management  to make  various  estimates  and  assumptions.
Estimates  using  different,  but each  reasonable,  assumptions  could  produce
significantly  different results. We test goodwill for possible impairment on an
annual  basis and at any other time if an event occurs or  circumstances  change
that would more likely than not reduce the fair value of a reporting  unit below
its  carrying  amount.  Such  impairment  loss  is  measured  by  comparing  the
recoverable amount of an asset with its carrying value. The determination of the
value  of  goodwill  requires  our  management  to  make  assumptions  regarding
estimated  future cash flows and other  factors to determine the fair value of a
respective  asset. If these estimates or the related  assumptions  change in the
future, we could be required to record impairment  charges.  Any material change
in our  valuation  of assets in the future  and any  consequent  adjustment  for
impairment could have a material adverse impact on our future reported financial
results.

     Impairment of long-lived assets and intangibles

         Long-lived assets and certain identifiable intangibles are reviewed for
impairment in accordance with Statement of Financial Accounting Standard No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets" whenever events
or changes in  circumstances  indicate that the carrying  amount of an asset may
not be recoverable.  Recoverability  of the carrying amount of assets to be held
and used is measured by a comparison  of the carrying  amount of an asset to the
future  undiscounted  cash flows expected to be generated by the assets. If such
assets are  considered  to be  impaired,  the  impairment  to be  recognized  is
measured by the amount by which the  carrying  amount of the assets  exceeds the
fair value of the assets.  Assets to be disposed of are reported at the lower of
the carrying  amount or fair value less selling costs.  As of December 31, 2003,
no impairment losses have been identified.



                                       40
<PAGE>

         The determination of the value of such long-lived and intangible assets
requires  management to make assumptions  regarding  estimated future cash flows
and other factors to determine the fair value of the  respective  assets.  These
estimates  have been based on our business plans for the entities  acquired.  If
these  estimates or the related  assumptions  change in the future,  we could be
required to record impairment  charges.  Any material change in our valuation of
assets in the future and any consequent  adjustment for impairment  could have a
material adverse impact on our future reported financial results.

Functional Currency

         We consider the United  States dollar to be the currency of the primary
economic  environment  in which we and our Israeli  subsidiary  EFL operate and,
therefore,  both we and EFL have adopted and are using the United  States dollar
as our functional currency.  Transactions and balances originally denominated in
U.S.  dollars are presented at the original  amounts.  Gains and losses  arising
from non-dollar transactions and balances are included in net income.

         The majority of financial  transactions of our Israeli subsidiaries MDT
and Epsilor is in New Israel Shekels ("NIS") and a substantial  portion of MDT's
and Epsilor's costs is incurred in NIS.  Management believes that the NIS is the
functional currency of MDT and Epsilor. Accordingly, the financial statements of
MDT and Epsilor  have been  translated  into U.S.  dollars.  All  balance  sheet
accounts have been translated  using the exchange rates in effect at the balance
sheet date.  Statement  of  operations  amounts have been  translated  using the
average exchange rate for the period. The resulting translation  adjustments are
reported as a component of accumulated other comprehensive loss in shareholders'
equity.

Executive Summary

         The following executive summary includes, where appropriate, discussion
of  our  two  new  subsidiaries,   FAAC  Incorporated  and  Epsilor   Electronic
Industries,  Ltd.,  that we  purchased  early  in  2004.  The  results  of these
subsidiaries  are not included in our results of  operations  for 2003 and 2002,
but are included in this  discussion to the extent that they are relevant to our
anticipated financial condition and results of operations going forward.

     Divisions and Subsidiaries

         We  operate  primarily  as  a  holding  company,  through  our  various
subsidiaries,  which we have organized into three  divisions.  Our divisions and
subsidiaries (all 100% owned, unless otherwise noted) are as follows:

         >>       Our Simulation,  Training and Consulting Division,  consisting
                  of:

                  o        IES Interactive Training, Inc., located in Littleton,
                           Colorado,  which provides  specialized "use of force"
                           training  for  police,  security  personnel  and  the
                           military ("IES");

                  o        FAAC  Incorporated,  located in Ann Arbor,  Michigan,
                           which provides  simulators,  systems  engineering and
                           software  products  to the  United  States  military,
                           government and private industry ("FAAC"); and



                                       41
<PAGE>

                  o        Arocon Security Corporation, located in New York, New
                           York,  which provides  security  consulting and other
                           services,  focusing on  protecting  life,  assets and
                           operations with minimum hindrance to personal freedom
                           and daily activities ("Arocon").

         >>       Our Battery and Power Systems Division, consisting of:

                  o        Electric Fuel Battery Corporation, located in Auburn,
                           Alabama,  which  manufactures and sells Zinc-Air fuel
                           sells,  batteries  and  chargers  for  the  military,
                           focusing on applications  that demand high energy and
                           light weight ("EFB");

                  o        Epsilor  Electronic  Industries,   Ltd.,  located  in
                           Dimona, Israel (in Israel's Negev desert area), which
                           develops and sells  rechargeable  and primary lithium
                           batteries  and smart  chargers to the military and to
                           private industry in the Middle East,  Europe and Asia
                           ("Epsilor"); and

                  o        Electric Fuel (E.F.L.) Ltd., located in Beit Shemesh,
                           Israel,  which  produces  water-activated  lifejacket
                           lights   for    commercial    aviation   and   marine
                           applications, and which conducts our Electric Vehicle
                           effort,   focusing  on  obtaining  and   implementing
                           demonstration projects in the U.S. and Europe, and on
                           building broad industry partnerships that can lead to
                           eventual  commercialization  of our  Zinc-Air  energy
                           system for electric vehicles ("EFL").

         >>       Our Armored Vehicle Division, consisting of:

                  o        MDT  Protective  Industries,  Ltd.,  located  in Lod,
                           Israel,  which specializes in using  state-of-the-art
                           lightweight  ceramic  materials,   special  ballistic
                           glass and  advanced  engineering  processes  to fully
                           armor vans and cars, and is a leading supplier to the
                           Israeli military,  Israeli special forces and special
                           services ("MDT") (75.5% owned); and

                  o        MDT Armor  Corporation,  located in Auburn,  Alabama,
                           which conducts MDT's United States  activities  ("MDT
                           Armor") (88% owned).

         Prior to the  acquisition  of FAAC and Epsilor,  we were organized into
two divisions:  Defense and Security Products (consisting of IES, MDT, MDT Armor
and Arocon),  and Electric Fuel  Batteries  (consisting of EFL and EFB). We have
reported our results of operations  for 2003 and 2002 in  accordance  with these
earlier divisions.

     Overview of Results of Operations

         We incurred  significant  operating losses for the years ended December
31, 2003, 2002 and 2001. While we expect to continue to derive revenues from the
sale of products that we manufacture and the services that we provide, there can
be no assurance that we will be able to achieve or maintain  profitability  on a
consistent basis.



                                       42
<PAGE>

         During 2003,  we  substantially  increased our revenues and reduced our
operating  loss,  from $18.5  million in 2002 to $9.0 million in 2003.  This was
achieved through a combination of cost-cutting  measures and increased revenues,
particularly from the sale of Zinc-Air  batteries to the military and from sales
of interactive  training  systems by IES. We believe that our new  acquisitions,
FAAC and Epsilor, will contribute to our goal of achieving profitability.

         We regard  moving the company to a positive  cash flow  situation  on a
consistent  basis to be an important  goal, and we are focused on achieving that
goal for the second half of 2004 and beyond.  In this  connection,  we note that
most of our business lines historically have had weaker first halves than second
halves, and weaker first quarters than second quarters. We expect this to be the
case for 2004 as well.

         A  portion  of our  operating  loss  during  2003  arose as a result of
non-cash  charges.  These charges were primarily related to our acquisitions and
to our raising capital. Because we anticipate continuing these activities during
2004, we expect to continue to incur such non-cash charges in the future.

         Non-cash charges related to acquisitions  arise when the purchase price
for  an  acquired   company   exceeds  the  company's  book  value.  In  such  a
circumstance,  a portion  of the excess of the  purchase  price is  recorded  as
goodwill,  and a portion as  intangible  assets.  In the case of  goodwill,  the
assets  recorded as goodwill  are not  amortized;  instead,  we are  required to
perform an annual  impairment  review.  If we determine,  through the impairment
review process,  that goodwill has been impaired,  we must record the impairment
charge in our  statement  of  operations.  Intangible  assets are  amortized  in
accordance with their useful life.  Accordingly,  for a period of time following
an acquisition, we incur a non-cash charge in the amount of a fraction (based on
the useful life of the intangible  assets) of the amount  recorded as intangible
assets.  Such non-cash  charges will  continue  during 2004;  additionally,  our
acquisitions of FAAC and Epsilor will result in our incurring  similar  non-cash
charges beginning in 2004.

         As a  result  of the  application  of the  above  accounting  rule,  we
incurred  non-cash  charges in the amount of $865,000 during 2003. See "Critical
Accounting Policies - Goodwill," above.

         The  non-cash  charges  that  relate  to  our  financings  occurred  in
connection  with  our  sale of  convertible  debentures  with  warrants,  and in
connection  with our  repricing of certain  warrants and grants of new warrants.
When we issue  convertible  debentures,  we record an expense  for a  beneficial
conversion  feature  that is amortized  ratably over the life of the  debenture.
When a  debenture  is  converted,  however,  the  entire  remaining  unamortized
beneficial  conversion feature expense is immediately  recognized in the quarter
in which the  debenture  is  converted.  Similarly,  when we issue  warrants  in
connection  with  convertible  debentures,  we record an expense  for  financial
expenses  that is  amortized  ratably  over  the term of the  warrant;  when the
warrant is exercised,  the entire  remaining  unamortized  financial  expense is
immediately recognized in the quarter in which the warrant is exercised.  As and
to the  extent  that our  remaining  convertible  debentures  and  warrants  are
converted and exercised, we would incur similar non-cash charges going forward.



                                       43
<PAGE>

         As a  result  of the  application  of the  above  accounting  rule,  we
incurred non-cash charges in the amount of $3.4 million during 2003.

         Additionally,  in an  effort  to  improve  our cash  situation  and our
shareholders'  equity,  and in order to reduce  the  number  of our  outstanding
warrants,  during 2003 we induced holders of certain of our warrants to exercise
their warrants by lowering the exercise  price of the warrants to  approximately
market value in exchange for immediate exercise of such warrants, and by issuing
to such  investors a lower  number of new warrants at a higher  exercise  price.
Under such  circumstances,  accounting rules require us to record a compensation
expense in an amount  determined  based upon the fair value of the new  warrants
(using a Black-Scholes  pricing  model).  As and to the extent that we engage in
similar warrant  repricings and issuances in the future,  we would incur similar
non-cash charges.

         As a  result  of the  application  of the  above  accounting  rule,  we
incurred non-cash charges in the amount of $388,000 during 2003.

         We also  incurred a non-cash  charge in the amount of  $839,000  during
2003  arising out of the shares and  warrants we granted to IES  Electronics  in
connection  with the settlement of our litigation  with them, as a result of and
expense in an amount  determined  based  upon the fair  value of these  warrants
(using a Black-Scholes pricing model). This charge is not expected to recur.

     Overview of Financial Condition and Operating Performance

         We shut down our  money-losing  consumer  battery  operations and began
acquiring new businesses in the defense and security field in 2002.  Since then,
we have  concentrated on eliminating our operating deficit and moving Arotech to
cash-flow positive operations. In order to do this, we have focused on acquiring
businesses with strong revenues and profitable operations.

         In our  Defense and  Security  Products  Division,  MDT  experienced  a
slowdown in revenues  during 2003 because  MDT's  primary  customer,  the Israel
Defense Forces, reduced orders as a result of cuts in that portion of its budget
that it can spend in  Israel.  We noted  this trend in 2003 and began to work on
reversing it by opening production facilities for MDT Armor in Auburn,  Alabama.
As of December 31, 2003, our backlog for MDT totaled $931,000, most of which was
from orders from customers other than the Israel Defense Forces.

         IES had record sales in 2003; IES sales have grown from $3.5 million in
2001 (before we owned it) to more than $8.0 million in 2003.  We attribute  this
to a number of  substantial  orders,  such as orders from the German  Police and
from the United States  Department of Health and Human Services.  Since sales of
new IES simulation systems (as opposed to upgrades and add-ons) have a very long
sales cycle,  it is difficult to predict what sales will be like in 2004.  As of
December 31, 2003, our backlog for IES totaled $334,000.

         In our Electric  Fuel  Batteries  Division,  EFB had its first sales in
2003.  These sales were almost  exclusively  from the United States Army,  which
continues to use our BA-8180 Zinc-Air battery for its CECOM division. We believe
the war in Iraq had a substantial positive effect on our sales in 2003. However,
we are hopeful that since the war came at a time when we were just beginning the
introduction  of our  batteries  to the Army,  much of the falloff in use of our
products that would normally be expected to occur at the war's end (which is not
presently  anticipated  to occur in the  immediate  future)  will be  offset  by
growing  acceptance  of our  batteries by soldiers in the field and their supply
officers. As of December 31, 2003, our backlog for EFB totaled $5.3 million.



                                       44
<PAGE>

         We do not  anticipate a  substantial  change in our revenues  from EFL,
either from the  water-activated  battery line or from the electric vehicle.  In
this  connection,  we have  begun  an  effort  to find  external  financing  for
development  of our  electric  vehicle  in the  form of a  partnership  or joint
venture,  but there can be no assurance that we will succeed in this effort, and
we do not anticipate that our electric vehicle program will provide  significant
revenues in 2004.

         We anticipate that our acquisitions of Epsilor and FAAC, which occurred
in January 2004, will add to our revenues, our gross profit and our cash flow in
2004.

Results of Operations

     Preliminary Note

         Results for the years  ended  December  31,  2003 and 2002  include the
results of IES and MDT for such periods as a result of our acquisitions of these
companies  early in the third quarter of 2002.  However,  the results of IES and
MDT were not included in our operating  results for the full year ended December
31,  2002.  Accordingly,  the  following  year-to-year  comparisons  should  not
necessarily be relied upon as indications of future performance.

         In addition,  results are net of the operations of the retail  consumer
battery  products,  which  operations were  discontinued in the third quarter of
2002.

         Following  is a table  summarizing  our results of  operations  for the
years  ended  December  31,  2003 and 2002,  after  which we present a narrative
discussion and analysis:

<TABLE>
<CAPTION>
                                                           Year Ended December 31,
                                                   ----------------------------------------
                                                          2003                 2002
                                                   -------------------  -------------------
Revenues:
<S>                                                <C>                <C>
     Defense and Security Products................ $      11,457,741     $      4,724,443
     Electric Fuel Batteries......................         5,868,899            1,682,296
     All other....................................                 -                    -
                                                   -------------------  -------------------
                                                    $     17,326,641     $      6,406,739
Cost of revenues:

     Defense and Security Products................  $      6,566,252     $      2,380,387
     Electric Fuel Batteries......................         4,521,588            2,041,361
     All other....................................                 -                    -
                                                   -------------------  -------------------
                                                    $     11,087,840     $      4,421,748
Research and development expenses.:

     Defense and Security Products................  $        216,800     $        175,796
     Electric Fuel Batteries......................           836,608              510,123
     All other....................................                 -                    -
                                                   -------------------  -------------------
                                                    $      1,053,408     $        685,919
Sales and marketing expenses:

     Defense and Security Products................  $      2,418,017     $        636,066
     Electric Fuel Batteries......................           926,872              673,601
     All other....................................           187,747                    -
                                                   -------------------  -------------------
                                                    $      3,532,636     $      1,309,669
</TABLE>


                                       45
<PAGE>


<TABLE>
<CAPTION>
                                                           Year Ended December 31,
                                                   ----------------------------------------
                                                          2003                 2002
                                                   -------------------  -------------------
General and administrative expenses:
<S>                                                 <C>                  <C>
     Defense and Security Products................  $      1,519,458     $        833,610
     Electric Fuel Batteries......................           188,655               89,945
     All other....................................         4,488,666            3,099,548
                                                   -------------------  -------------------
                                                    $      6,196,779     $      4,023,103
Financial expense (income):
     Defense and Security Products................  $       (139,668)    $         (4,556)
     Electric Fuel Batteries......................             7,936                    -
     All other....................................         3,602,191              (95,895)
                                                   -------------------  -------------------
                                                    $      3,470,459     $       (100,451)
Tax expenses:
     Defense and Security Products................ $         393,303     $              -
     Electric Fuel Batteries......................                 -                    -
     All other....................................             2,890                    -
                                                   -------------------  -------------------
                                                    $        396,193     $              -
Amortization of intangible assets:
     Defense and Security Products................  $        864,910     $        649,543
     Electric Fuel Batteries......................                 -                    -
     All other....................................                 -                    -
                                                   -------------------  -------------------
                                                    $        864,910     $        649,543
Minority interest in loss (profit) of subsidiaries:
     Defense and Security Products................  $        156,900     $       (355,360)
     Electric Fuel Batteries......................                 -                    -
     All other....................................                 -                    -
                                                   -------------------  -------------------
                                                    $        156,900     $       (355,360)
Net loss from continuing operations:

     Defense and Security Products................  $        224,431     $        301,765
     Electric Fuel Batteries......................           612,760            1,632,734
     All other....................................         8,281,493            3,003,653
                                                   -------------------  -------------------
                                                    $      9,118,684     $      4,938,152
Net loss (profit) from discontinued operations:

     Defense and Security Products................  $              -     $              -
     Electric Fuel Batteries......................          (110,410)          13,566,206
     All other....................................                 -                    -
                                                   -------------------  -------------------
                                                    $       (110,410)    $     13,566,206
Net loss:

     Defense and Security Products................  $        224,431     $        301,765
     Electric Fuel Batteries......................           502,350           15,198,940
     All other....................................         8,281,493            3,003,653
                                                   -------------------  -------------------
                                                    $      9,008,274     $     18,504,358
                                                   ===================  ===================
</TABLE>

     Fiscal Year 2003 compared to Fiscal Year 2002

         Revenues.   During  2003,  we  (through  our  subsidiaries)  recognized
revenues as follows:

         >>       IES   recognized   revenues  from  the  sale  of   interactive
                  use-of-force  training  systems  and  from  the  provision  of
                  warranty services in connection with such systems;

         >>       MDT recognized  revenues from payments under vehicle  armoring
                  contracts and for service and repair of armored vehicles;

         >>       EFB  recognized  revenues  from  the  sale  of  batteries  and
                  adapters  to  the  military,  and  under  certain  development
                  contracts with the U.S. Army;



                                       46
<PAGE>

         >>       Arocon recognized revenues under consulting agreements; and

         >>       EFL recognized revenues from the sale of lifejacket lights and
                  from subcontracting fees received in connection with Phase III
                  of  the  United  States  Department  of  Transportation  (DOT)
                  electric  bus  program,  which  began in October  2002 and was
                  completed in March 2004.  Phase IV of the DOT  program,  which
                  began in October 2003,  did not result in any revenues  during
                  2003.

         Revenues from  continuing  operations  for the year ended  December 31,
2003 totaled  $17.3  million,  compared to $6.4 million for 2002, an increase of
$10.9  million,  or 170%.  This  increase was  primarily the result of increased
sales  attributable  to IES and EFB, as well as the  inclusion of IES and MDT in
our results for the full year of 2003 but only part of 2002.

         In 2003,  revenues  were $11.5  million for the  Defense  and  Security
Products  Division  (compared  to $4.7  million  in 2002,  an  increase  of $6.7
million,  or 143%, due primarily to increased  sales on the part of IES, as well
as the  inclusion  of IES and MDT in our  results  for the full year of 2003 but
only part of 2002),  and $5.9 million for the Electric Fuel  Batteries  Division
(compared to $1.7 million in the comparable  period in 2002, an increase of $4.2
million,  or 249%, due primarily to increased sales to the U.S. Army on the part
of EFB).

         Cost of  revenues  and gross  profit.  Cost of revenues  totaled  $11.1
million  during  2003,  compared  to $4.4  million in 2002,  an increase of $6.7
million,  or 151%, due to increased cost of goods sold,  particularly by IES and
EFB, as well as the inclusion of IES and MDT in our results for the full year of
2003 but only part of 2002.

         Direct  expenses for our two  divisions  during 2003 were $10.9 million
for the Defense and  Security  Products  Division  (compared  to $4.4 million in
2002, an increase of $6.5  million,  or 150%,  due primarily to increased  sales
attributable  to IES, as well as the inclusion of IES and MDT in our results for
the full year of 2003 but only part of 2002),  and $5.9 million for the Electric
Fuel Batteries  Division  (compared to $3.1 million in the comparable  period in
2002, an increase of $2.9 million,  or 94%, due primarily to increased  sales on
the part of EFB to the U.S. Army).

         Gross  profit was $6.2 million  during  2003,  compared to $2.0 million
during 2002, an increase of $4.3 million,  or 214%. This increase was the direct
result of all factors  presented above,  most notably the increased sales of IES
and EFB,  as well as the  inclusion  of IES and MDT in our  results for the full
year of 2003 but only part of 2002. In 2003, IES contributed $4.1 million to our
gross profit, EFB contributed $1.6 million, and MDT contributed $833,000.

         Research and development  expenses.  Research and development  expenses
for 2003 were $1.1  million,  compared  to  $686,000  in 2002,  an  increase  of
$367,000,  or 54%.  This  increase was primarily  because  certain  research and
development  personnel  who had  worked  on the  discontinued  consumer  battery
operations  during  2002 (the  expenses of which are not  reflected  in the 2002
number above) were  reassigned to military  battery  research and development in
2003.



                                       47
<PAGE>

         Sales and marketing  expenses.  Sales and  marketing  expenses for 2003
were $3.5  million,  compared  to $1.3  million  in 2002,  an  increase  of $2.2
million,  or 170%.  This  increase was primarily  attributable  to the following
factors:

         >>       The inclusion of the sales and  marketing  expenses of IES and
                  MDT in our  results for the full year of 2003 but only part of
                  2002;

         >>       An  increase  in  IES's  sales  activity  during  2003,  which
                  resulted  in both  increased  sales  and  increased  sales and
                  marketing expenses during 2003; and

         >>       We incurred expenses for consultants in the amount of $810,000
                  in  connection  with our CECOM  battery  program with the U.S.
                  Army and $345,000 in connection  with our security  consulting
                  business.

         General  and  administrative   expenses.   General  and  administrative
expenses  for 2003 were $6.2  million,  compared  to $4.0  million  in 2002,  an
increase of $2.2 million,  or 54%. This increase was primarily  attributable  to
the following factors:

         >>       The  inclusion of the general and  administrative  expenses of
                  IES and MDT in our  results for the full year of 2003 but only
                  part of 2002;

         >>       Expenses in 2003 in  connection  with a litigation  settlement
                  agreement, in the amount of $864,000, that were not present in
                  2002;

         >>       Expenses in 2003 in connection with warrant repricings, in the
                  amount of $388,000, that were not present in 2002;

         >>       Legal and consulting  expenses in 2003 in connection  with our
                  convertible  debentures,  in the amount of $484,000, that were
                  not present in 2002; and

         >>       Expenses  in 2003  in  connection  with  the  start-up  of our
                  security consulting business in the United States and with the
                  beginning  of  operations  of  MDT  Armor,  in the  amount  of
                  250,000, that were not present in 2002.

         Financial income  (expense).  Financial  expense totaled  approximately
$3.5  million in 2003  compared to  financial  income of  $100,000  in 2002,  an
increase of $3.6 million.  This increase was due  primarily to  amortization  of
compensation  related  to the  issuance  of  convertible  debentures  issued  in
December  2002 and  during  2003 in the  amount of $3.4  million,  and  interest
expenses related to those debentures in the amount of $376,000.

         Tax expenses.  We and our Israeli subsidiary EFL incurred net operating
losses during 2003 and 2002 and,  accordingly,  we were not required to make any
provision for income taxes.  MDT and IES had taxable income,  and accordingly we
were  required to make  provision  for income taxes in the amount of $396,000 in
2003. We were able to offset IES's federal taxes against our loss carryforwards.
In 2002 we did not accrue any tax  expenses  due to our belief  that we would be
able to utilize our loss carryforwards against MDT's taxable income,  estimation
was revised in 2003. Of the amount accrued in 2003,  approximately  $352,000 was
accrued on account of income in 2002.



                                       48
<PAGE>

         Amortization   of  intangible   assets  and  in-process   research  and
development.  Amortization  of  intangible  assets  totaled  $865,000  in  2003,
compared to $649,000 in 2002, an increase of $215,000,  or 33%,  resulting  from
amortization  of these assets  subsequent to our  acquisition  of IES and MDT in
2002. Of this $215,000  increase,  $169,000 was  attributable to IES and $46,000
was attributable to MDT.

         Loss from  continuing  operations.  Due to the factors cited above,  we
reported a net loss from continuing operations of $9.1 million in 2003, compared
to a net loss of $4.9 million in 2002, an increase of $4.2 million, or 85%.

         Profit  (loss) from  discontinued  operations.  In the third quarter of
2002, we decided to discontinue  operations  relating to the retail sales of our
consumer  battery  products.  Accordingly,  all revenues and expenses related to
this segment have been  presented in our  consolidated  statements of operations
for the years ended  December 31, 2003 and 2002 in an item  entitled  "Loss from
discontinued operations."

         Profit from discontinued operations in 2003 was $110,000, compared to a
net loss of $13.6  million in 2002, a decrease of $13.7  million.  This decrease
was  the  result  of the  elimination  of the  losses  from  these  discontinued
operations   beginning  with  the  fourth  quarter  of  2002.  The  profit  from
discontinued  operations was primarily from  cancellation  of past accruals made
unnecessary by the closing of the discontinued operations.

         Net loss.  Due to the factors  cited  above,  we reported a net loss of
$9.0  million  in  2003,  compared  to a net loss of $18.5  million  in 2002,  a
decrease of $9.5 million, or 51%.

     Fiscal Year 2002 compared to Fiscal Year 2001

         Revenues.  Revenues  from  continuing  operations  for the  year  ended
December 31, 2002 totaled $6.4  million,  compared to $2.1 million for 2001,  an
increase of $4.3 million, or 206%. This increase was primarily the result of the
inclusion of IES and MDT in our results in 2002.

         During  2002,  we  recognized  revenues  from the  sale of  interactive
use-of-force training systems (through our IES subsidiary),  from payments under
vehicle armoring  contracts  (through our MDT subsidiary),  and from the sale of
lifejacket  lights,  as well as under  contracts with the U.S.  Army's CECOM for
deliveries of batteries and for design and procurement of production tooling and
equipment.  We also  recognized  revenues from  subcontracting  fees received in
connection with Phase II of the United States Department of Transportation (DOT)
program,  which began in the fourth  quarter of 2001 and was  completed  in July
2002,  and  Phase  III of the DOT  program,  which  began in  October  2002.  We
participate  in this program as a member of a consortium  seeking to demonstrate
the  ability  of  the  Electric  Fuel  battery  system  to  power  a  full-size,
all-electric  transit bus. The total  program cost of Phase II was $2.7 million,
50% of which was covered by the DOT  subcontracting  fees.  Subcontracting  fees
cover  less  than  all of the  expenses  and  expenditures  associated  with our
participation in the program. In 2001, we derived revenues  principally from the
sale of  lifejacket  lights,  under  contracts  with the U.S.  Army's  CECOM for
deliveries of batteries and for design and procurement of production tooling and
equipment  and from  subcontracting  fees  received in  connection  with the DOT
program.



                                       49
<PAGE>

         In 2002,  revenues  were $4.7  million  for the  Defense  and  Security
Products Division  (compared to $0 in 2001), due to the inclusion of IES and MDT
in our 2002 results,  and $1.7 million for the Electric Fuel Batteries  Division
(compared  to $2.1  million in the  comparable  period in 2001,  a  decrease  of
$411,000,  or  20%),  due  primarily  to  $471,000  in  revenues  from a  German
consortium  project  relating to our electric vehicle that were included in 2001
but that did not exist in 2002.  Of the $4.7  million  increase  in Defense  and
Security  Products  revenues,  $2.0 million was attributable to the inclusion of
IES in our results in 2002 and $2.7 million was attributable to the inclusion of
MDT in our results in 2002.

         Cost of  revenues  and gross  profit.  Cost of  revenues  totaled  $4.4
million  during  2002,  compared  to $2.0  million in 2001,  an increase of $2.4
million, or 122%, due to the inclusion of IES and MDT in our 2002 results.

         Direct expenses for our two divisions during 2002 were $4.4 million for
the Defense and Security Products Division  (compared to $0 in 2001), due to the
inclusion of IES and MDT in our 2002 results,  and $3.1 million for the Electric
Fuel Batteries  Division  (compared to $2.3 million in the comparable  period in
2001, an increase of $767,000, or 33%), due primarily to the following factors:

         >>       We  began  to ramp up  production  at our  CECOM  facility  in
                  Alabama in anticipation of the CECOM order that we received in
                  December 2002; and

         >>       We wrote  off  certain  disqualified  CECOM  inventory  in the
                  amount of $116,000.

         Of the $4.4 million  increase in Defense and Security  Products  direct
expenses,  $2.1 million was  attributable to the inclusion of IES in our results
in 2002 and $2.3 million was attributable to the inclusion of MDT in our results
in 2002.

         Gross profit was $2.0 million during 2002,  compared to $101,000 during
2001,  an increase of $1.9  million.  This increase was the direct result of all
factors  presented above,  most notably the inclusion of IES and MDT in our 2002
results.  In 2002,  IES  contributed  $1.3 million to our gross profit,  and MDT
contributed  $1.1  million,  which was offset by a gross loss of $360,000 in our
other divisions.

         Research and development  expenses.  Research and development  expenses
for 2002 were  $686,000,  compared to $456,000 in 2001, an increase of $230,000,
or 50%. This  increase was  primarily the result of the inclusion of IES,  which
accounted for $130,000 of the increase, in our 2002 results.

         Sales and marketing  expenses.  Sales and  marketing  expenses for 2002
were $1.3 million, compared to $106,000 in 2001, an increase of $1.2 million, or
1,136%. This increase was primarily attributable to the following factors:

         >>       We had sales and marketing  expenses in 2002 related to IES of
                  $572,000, which we did not have in 2001;



                                       50
<PAGE>

         >>       We had sales and marketing  expenses in 2002 related to MDT of
                  $63,000, which we did not have in 2001; and

         >>       We incurred expenses for consultants,  primarily lobbyists, in
                  the amount of $128,000 in connection with our Electric Vehicle
                  program and  $441,000  in  connection  with our CECOM  battery
                  program with the U.S. Army.

         General  and  administrative   expenses.   General  and  administrative
expenses  for 2002  were $4.0  million  compared  to $3.8  million  in 2001,  an
increase of $196,000,  or 5%. This  increase was primarily  attributable  to the
inclusion of IES and MDT in our results beginning with the third quarter,  which
increased general and administrative  expenses by approximately  $839,000.  This
increase  was offset by a decrease  in general  and  administrative  expenses of
$643,000, resulting from:

         >>       the dismissal of our litigation with  Electrofuel  Inc., which
                  resulted in a decrease in  litigation-related  legal expenses;
                  and

         >>       the settlement of our dispute with a former  employee on terms
                  that  resulted  in a savings to us over the amount that we had
                  set aside on our books.

         Financial  income.  Financial  income,  net of  interest  expenses  and
exchange  differentials,  totaled  approximately  $100,000  in 2002  compared to
$263,000  in 2001,  a  decrease  of  $163,000,  or 62%.  This  decrease  was due
primarily  to lower  interest  rates and lower  balances of invested  funds as a
result of our use of the proceeds of private placements of our securities.

         Income taxes. We and our Israeli  subsidiary EFL incurred net operating
losses during 2002 and 2001 and,  accordingly,  we were not required to make any
provision for income taxes. MDT had taxable income,  but we may use EFL's losses
to offset MDT's  income,  and  accordingly  MDT has made no provision for income
taxes.

         Amortization of intangible  assets.  Amortization of intangible  assets
totaled  $649,000 in 2002,  compared to $0 in 2001,  due to the inclusion of IES
and  MDT  in  our  2002  results.  Of  this  $649,000  increase,   $551,000  was
attributable  to the  inclusion  of IES in our  results in 2002 and  $98,000 was
attributable to the inclusion of MDT in our results in 2002.

         Loss from  continuing  operations.  Due to the factors cited above,  we
reported a net loss from continuing operations of $4.9 million in 2002, compared
to a net loss of $4.0 million in 2001, an increase of $913,000, or 22%.

         Loss from  discontinued  operations.  In the third  quarter of 2002, we
decided to discontinue  operations  relating to the retail sales of our consumer
battery products. Accordingly, all revenues and expenses related to this segment
have been  presented in our  consolidated  statements of operations for the year
ended December 31, 2002 in an item entitled "Loss from discontinued operations."

         Loss from discontinued  operations in 2002 was $13.6 million,  compared
to $13.3 million in 2001, an increase of $306,000,  or 2%. This increase was the
result of a  write-off  of fixed  inventory  and  assets  in the  amount of $7.1
million in connection with our discontinuation of the operations relating to the
retail sales of our consumer battery products at the end of the third quarter of
2002,  which was not entirely offset by the elimination of the losses from these
discontinued operations beginning with the fourth quarter of 2002.



                                       51
<PAGE>

         Net loss.  Due to the factors  cited  above,  we reported a net loss of
$18.5  million in 2002,  compared  to a net loss of $17.3  million  in 2001,  an
increase of $1.2 million, or 7%.

Liquidity and Capital Resources

         As  of  December  31,  2003,  we  had  cash  and  cash  equivalents  of
approximately $13.7 million, compared with $1.5 million as of December 31, 2002,
an increase of $12.2  million,  or 839%.  The increase in cash was primarily the
result of sales of our  securities  during 2003.  In January  2004, we raised an
additional  $17.8  million,  net of expenses,  through  additional  sales of our
securities.  As of  February  29,  2004,  our cash  totaled  approximately  $4.2
million, not including approximately $9.1 million held in restricted deposits to
fund future  obligations in connection  with such  acquisitions,  primarily as a
result of our use of cash for the Epsilor and FAAC acquisitions.

         We used available funds in 2003 primarily for working capital needs. We
increased  our  investment  in fixed  assets by  $585,000  during the year ended
December 31, 2003, primarily in the Electric Fuel Batteries Division.  Our fixed
assets amounted to $2.3 million as at year end.

         Net cash used in operating  activities from  continuing  operations for
2003 and 2002 was $3.0  million and $3.5  million,  respectively,  a decrease of
$465,000, or 13%. This decrease was primarily the result of changes in operating
assets and liabilities, such as accounts payable and inventory.

         Net  cash  used in  investing  activities  for  2003  and 2002 was $1.8
million and $5.4 million, respectively, a decrease of $3.6 million, or 66%. This
decrease was primarily the result of our  investment in the  acquisition  of IES
and MDT in 2002.

         Net cash provided by financing  activities  for 2003 and 2002 was $17.4
million and $3.1 million,  respectively,  an increase of $14.3 million, or 464%.
This increase was primarily the result of higher amounts of funds raised through
sales of our securities in 2003 compared to 2002.

         During  2003,  certain of our  employees  exercised  options  under our
registered  employee  stock option plan.  The proceeds to us from the  exercised
options were approximately $434,000.

         On  September  30,  2003 we issued  and sold to  various  institutional
investors an aggregate  $5,000,000  principal  amount of 8% Secured  Convertible
Debentures due September 30, 2006, as more fully described in the Current Report
on Form 8-K that we filed with the Securities and Exchange Commission on October
3, 2003.

         On  December  18,  2002 we  issued  and sold to  various  institutional
investors an aggregate  $6,000,000  principal  amount of 8% Secured  Convertible
Debentures due December 31, 2006, as more fully  described under "Item 5. Market
For Registrant's Common Equity and Related Stockholder Matters - Recent Sales of
Unregistered Securities," above.



                                       52
<PAGE>

         We have approximately  $10.5 million in long term debt outstanding,  of
which $8.4  million was  convertible  debt,  and  approximately  $6.9 million in
short-term debt.

         We believe that our present cash  position and  anticipated  cash flows
from  operations  should be  sufficient  to satisfy our current  estimated  cash
requirements  through the next year.  Over the long term, we will need to become
profitable,  at least on a cash-flow basis,  and maintain that  profitability in
order to avoid future capital requirements. Additionally, we would need to raise
additional capital in order to fund any future acquisitions.

         Our current  debt  agreements  grant to our  investors a right of first
refusal on any future  financings,  except for underwritten  public offerings in
excess of $30 million.  We do not believe  that this  covenant  will  materially
limit our ability to undertake future financings.

Effective Corporate Tax Rate

         Arotech and EFL have  incurred  net  operating  losses or had  earnings
arising from  tax-exempt  income during the years ended December 31, 2001,  2002
and 2003 and  accordingly  no provision for income taxes was required.  Taxes in
these  entities  paid in 2001,  2002 and 2003 are  primarily  composed of United
States federal alternative minimum taxes.

         As of December 31, 2003, we had U.S. net operating  loss carry forwards
of  approximately  $17.0  million that are  available to offset  future  taxable
income,  expiring  primarily in 2015, and foreign net operating and capital loss
carry forwards of approximately $84.0 million,  which are available indefinitely
to offset future taxable income.

Contractual Obligations

         The following table lists our  contractual  obligations and commitments
as of December 31, 2003:

<TABLE>
<CAPTION>
   Contractual Obligations                                     Payment Due by Period
------------------------------ ------------------------------------------------------------------------------------
                                    Total       Less Than 1 Year    1-3 Years        3-5 Years     More than 5 Years
------------------------------ ---------------- ---------------- ---------------- ---------------- ----------------
<S>                             <C>              <C>              <C>              <C>              <C>
Long-term debt*...............  $  8,525,000     $           -    $   8,525,000    $          -     $           -
Short-term debt...............  $    190,849     $     190,849    $           -    $          -     $           -
Operating lease obligations...  $    590,778     $     393,512    $     197,266    $          -     $           -
Severance obligations.........  $  1,749,391     $     183,056    $   1,387,738    $          -     $     178,597
</TABLE>


-------------------
*  Includes   convertible   debentures  in  the  gross  amount  of   $8,375,000.
   Unamortized  financial expenses related to the beneficial  conversion feature
   of these convertible debentures amounted to $7,493,056 at year end.

                                  RISK FACTORS

         The  following  factors,  among others,  could cause actual  results to
differ  materially  from those contained in  forward-looking  statements made in
this Report and presented elsewhere by management from time to time.

Business-Related Risks

     We have had a history of losses and may incur future losses.

         We were  incorporated in 1990 and began our operations in 1991. We have
funded  our  operations  principally  from funds  raised in each of the  initial
public offering of our common stock in February 1994;  through subsequent public
and  private  offerings  of our  common  stock and  equity  and debt  securities
convertible  into  shares of our common  stock;  research  contracts  and supply
contracts;  funds  received  under  research  and  development  grants  from the
Government  of  Israel;  and  sales  of  products  that we and our  subsidiaries
manufacture.  We have incurred significant operating losses since our inception.
Additionally,  as of  December  31,  2003,  we had  an  accumulated  deficit  of
approximately  $110.0  million.  There can be no assurance  that we will ever be
able to maintain  profitability  consistently or that our business will continue
to exist.



                                       53
<PAGE>

         Our existing  indebtedness  may adversely  affect our ability to obtain
additional  funds and may  increase  our  vulnerability  to economic or business
downturns.

         Our indebtedness  aggregated  approximately $8.7 million as of December
31, 2003. Accordingly, we are subject to the risks associated with indebtedness,
including:

         o        we must  dedicate a portion of our cash flows from  operations
                  to pay debt service costs and, as a result, we have less funds
                  available  for  operations,  future  acquisitions  of consumer
                  receivable portfolios, and other purposes;

         o        it may be more  difficult and  expensive to obtain  additional
                  funds through financings, if available at all;

         o        we are more vulnerable to economic  downturns and fluctuations
                  in  interest  rates,   less  able  to  withstand   competitive
                  pressures  and less  flexible  in  reacting  to changes in our
                  industry and general economic conditions; and

         o        if we default under any of our existing debt instruments or if
                  our  creditors  demand  payment  of a  portion  or  all of our
                  indebtedness,  we may not have  sufficient  funds to make such
                  payments.

The  occurrence  of any of these events could  materially  adversely  affect our
results of  operations  and financial  condition and adversely  affect our stock
price.

         The agreements  governing the terms of our debentures  contain numerous
affirmative  and negative  covenants that limit the discretion of our management
with respect to certain business matters and place restrictions on us, including
obligations on our part to preserve and maintain our assets and  restrictions on
our  ability  to incur or  guarantee  debt,  to merge with or sell our assets to
another  company,  and to make  significant  capital  expenditures  without  the
consent of the  debenture  holders.  Our  ability to comply with these and other
provisions of such agreements may be affected by changes in economic or business
conditions or other events beyond our control.

         Failure to comply with the terms of our  debentures  could  result in a
default that could have material adverse consequences for us.

         A failure to comply with the  obligations  contained  in our  debenture
agreements could result in an event of default under such agreements which could
result in an acceleration  of the debentures and the  acceleration of debt under
other instruments evidencing indebtedness that may contain cross-acceleration or
cross-default  provisions.  If the  indebtedness  under the  debentures or other
indebtedness  were to be accelerated,  there can be no assurance that our assets
would be sufficient to repay in full such indebtedness.



                                       54
<PAGE>

         We have  pledged a  substantial  portion  of our  assets to secure  our
borrowings.

         Our debentures are secured by a substantial  portion of our assets.  If
we default under the indebtedness  secured by our assets,  those assets would be
available  to the secured  creditors to satisfy our  obligations  to the secured
creditors, which could materially adversely affect our results of operations and
financial condition and adversely affect our stock price.

     We need significant amounts of capital to operate and grow our business.

         We require  substantial  funds to market our  products  and develop and
market  new  products.  To the  extent  that we are  unable  to  fully  fund our
operations  through  profitable  sales  of our  products  and  services,  we may
continue to seek additional funding, including through the issuance of equity or
debt securities. However, there can be no assurance that we will obtain any such
additional  financing in a timely manner or on acceptable  terms.  If additional
funds are raised by issuing equity  securities,  stockholders  may incur further
dilution. If additional funding is not secured, we will have to modify,  reduce,
defer or eliminate parts of our anticipated future commitments and/or programs.

     We may not be successful in operating a new business.

         Prior to the  acquisitions of IES and MDT in 2002 and the  acquisitions
of FAAC and Epsilor  early in 2004,  our primary  business was the marketing and
sale of products based on primary and refuelable  Zinc-Air fuel cell  technology
and  advancements  in battery  technology for defense and security  products and
other military  applications,  electric vehicles and consumer electronics.  As a
result of our  acquisitions,  a  substantial  component  of our  business is the
marketing and sale of hi-tech multimedia and interactive  training solutions and
sophisticated  lightweight  materials and advanced engineering processes used to
armor  vehicles.  These are new businesses  for us and our management  group has
limited  experience  operating  these  types  of  businesses.  Although  we have
retained our acquired  companies'  management  personnel,  we cannot assure that
such  personnel  will  continue to work for us or that we will be  successful in
managing this new business.  If we are unable to successfully  operate these new
businesses, our business, financial condition and results of operations could be
materially impaired.

     Our acquisition strategy involves various risks.

         Part of our  strategy is to grow through the  acquisition  of companies
that will  complement  our existing  operations or provide us with an entry into
markets  we  do  not  currently  serve.  Growth  through  acquisitions  involves
substantial  risks,  including  the risk of improper  valuation  of the acquired
business and the risk of inadequate integration.  There can be no assurance that
suitable  acquisition  candidates  will  be  available,  that we will be able to
acquire  or  manage   profitably  such  additional   companies  or  that  future
acquisitions  will  produce  returns that justify our  investments  therein.  In
addition,  we may compete  for  acquisition  and  expansion  opportunities  with
companies that have  significantly  greater  resources than we do.  Furthermore,
acquisitions  could disrupt our ongoing business,  distract the attention of our
senior  managers,  make it  difficult  to maintain  our  operational  standards,
controls and  procedures  and subject us to contingent and latent risks that are
different, in nature and magnitude, than the risks we currently face.

         We may  finance  future  acquisitions  with  cash  from  operations  or
additional debt or equity financings.  There can be no assurance that we will be
able to generate  internal cash or obtain  financing  from  external  sources or
that,  if  available,  such  financing  will be on terms  acceptable  to us. The
issuance  of  additional  common  stock to  finance  acquisitions  may result in
substantial  dilution to our stockholders.  Any debt financing may significantly
increase  our  leverage and may involve  restrictive  covenants  which limit our
operations.



                                       55
<PAGE>

     We may not successfully integrate our new acquisitions.

         In light of our recent acquisitions of IES, MDT, FAAC and Epsilor,  our
success will depend in part on our ability to manage the combined  operations of
these companies and to integrate the operations and personnel of these companies
along with our other  subsidiaries  and divisions  into a single  organizational
structure.  There  can be no  assurance  that we  will  be  able to  effectively
integrate   the   operations   of  our   subsidiaries   and  divisions  and  our
newly-acquired businesses into a single organizational structure. Integration of
these operations could also place additional pressures on our management as well
as on our key  technical  resources.  The  failure to  successfully  manage this
integration could have an adverse material effect on us.

         If we  are  successful  in  acquiring  additional  businesses,  we  may
experience  a period of rapid  growth  that could place  significant  additional
demands on, and require us to expand,  our management,  resources and management
information  systems.  Our failure to manage any such rapid  growth  effectively
could have a material  adverse  effect on our  financial  condition,  results of
operations and cash flows.

     If we are  unable to manage  our  growth,  our  operating  results  will be
impaired.

         We are  currently  experiencing  a period  of  growth  and  development
activity which could place a significant  strain on our personnel and resources.
Our  activity  has  resulted  in  increased  levels of  responsibility  for both
existing and new management personnel. Many of our management personnel have had
limited or no experience in managing growing companies. We have sought to manage
our  current  and  anticipated  growth  through the  recruitment  of  additional
management and technical  personnel and the  implementation  of internal systems
and controls.  However, our failure to manage growth effectively could adversely
affect our results of operations.

     A significant portion of our business is dependent on government contracts.

         Many of the  customers  of IES and FAAC to date have been in the public
sector of the U.S., including the federal,  state and local governments,  and in
the public sectors of a number of other  countries,  and most of MDT's customers
have been in the public sector in Israel, in particular the Ministry of Defense.
Additionally,  all of EFB's sales to date of battery  products  for the military
and  defense  sectors  have been in the public  sector in the United  States.  A
significant  decrease in the overall level or allocation of defense  spending or
law  enforcement in the U.S. or other  countries  could have a material  adverse
effect on our future  results of  operations  and financial  condition.  MDT has
already  experienced  a slowdown in orders  from the  Ministry of Defense due to
budget  constraints  and a requirement  of U.S. aid to Israel that a substantial
proportion of such aid be spent in the U.S.,  where MDT has only recently opened
a factory in operation.

         Sales to public  sector  customers  are  subject to a  multiplicity  of
detailed  regulatory  requirements  and public policies as well as to changes in
training and purchasing  priorities.  Contracts with public sector customers may
be conditioned upon the continuing  availability of public funds,  which in turn
depends upon  lengthy and complex  budgetary  procedures,  and may be subject to
certain pricing  constraints.  Moreover,  U.S. government contracts and those of
many  international  government  customers  may  generally be  terminated  for a
variety  of  factors  when it is in the best  interests  of the  government  and
contractors may be suspended or debarred for misconduct at the discretion of the
government.  There can be no assurance  that these  factors or others  unique to
government  contracts or the loss or suspension of necessary regulatory licenses
will not have a material  adverse effect on our future results of operations and
financial condition.



                                       56
<PAGE>

     Our U.S. government contracts may be terminated at any time and may contain
other unfavorable provisions.

         The U.S.  government  typically  can  terminate  or  modify  any of its
contracts  with us either  for its  convenience  or if we  default by failing to
perform under the terms of the applicable contract. A termination arising out of
our default could expose us to liability and have a material  adverse  effect on
our ability to re-compete for future contracts and orders.  Our U.S.  government
contracts  contain  provisions  that allow the U.S.  government to  unilaterally
suspend us from receiving new contracts pending resolution of alleged violations
of  procurement  laws or  regulations,  reduce the value of existing  contracts,
issue  modifications  to a contract  and control and  potentially  prohibit  the
export of our products, services and associated materials.

         A negative  audit by the U.S.  government  could  adversely  affect our
business,  and we might not be  reimbursed by the  government  for costs that we
have expended on our contracts.

         Government  agencies  routinely  audit  government   contracts.   These
agencies review a contractor's  performance on its contract,  pricing practices,
cost structure and compliance with applicable  laws,  regulations and standards.
If we are  audited,  we  will  not be  reimbursed  for  any  costs  found  to be
improperly  allocated  to a specific  contract,  while we would be  required  to
refund any improper costs for which we had already been  reimbursed.  Therefore,
an  audit  could  result  in a  substantial  adjustment  to our  revenues.  If a
government audit uncovers improper or illegal  activities,  we may be subject to
civil and criminal penalties and administrative sanctions, including termination
of  contracts,  forfeitures  of  profits,  suspension  of  payments,  fines  and
suspension  or  debarment  from doing  business  with United  States  government
agencies.   We  could  suffer  serious   reputational  harm  if  allegations  of
impropriety were made against us. A governmental determination of impropriety or
illegality,  or an  allegation  of  impropriety,  could have a material  adverse
effect on our business, financial condition or results of operations.

     We may be liable for  penalties  under a variety of  procurement  rules and
regulations,  and changes in government  regulations  could adversely impact our
revenues, operating expenses and profitability.

         Our defense and commercial businesses must comply with and are affected
by various  government  regulations  that  impact our  operating  costs,  profit
margins and our internal organization and operation of our businesses. Among the
most significant regulations are the following:

         o        the U.S. Federal Acquisition  Regulations,  which regulate the
                  formation,   administration   and  performance  of  government
                  contracts;

         o        the  U.S.   Truth  in   Negotiations   Act,   which   requires
                  certification  and  disclosure of all cost and pricing data in
                  connection with contract negotiations; and



                                       57
<PAGE>

         o        the U.S. Cost Accounting  Standards,  which impose  accounting
                  requirements  that  govern  our right to  reimbursement  under
                  certain cost-based government contracts.

         These  regulations  affect how we and our customers do business and, in
some instances,  impose added costs on our businesses. Any changes in applicable
laws could adversely affect the financial  performance of the business  affected
by the changed  regulations.  With  respect to U.S.  government  contracts,  any
failure to comply with  applicable  laws could  result in contract  termination,
price or fee  reductions or suspension or debarment  from  contracting  with the
U.S. government.

     Our  operating  margins may decline under our  fixed-price  contracts if we
fail to estimate  accurately  the time and  resources  necessary  to satisfy our
obligations.

         Some of our contracts are fixed-price contracts under which we bear the
risk of any cost overruns. Our profits are adversely affected if our costs under
these contracts exceed the assumptions that we used in bidding for the contract.
In  2003,  approximately  36% of our  revenues  were  derived  from  fixed-price
contracts for both defense and non-defense related government contracts.  Often,
we are  required to fix the price for a contract  before we finalize the project
specifications, which increases the risk that we will mis-price these contracts.
The complexity of many of our engagements  makes accurately  estimating our time
and resources more difficult.

     If we are  unable to retain  our  contracts  with the U.S.  government  and
subcontracts under U.S. government prime contracts in the competitive  rebidding
process, our revenues may suffer.

         Upon expiration of a U.S.  government  contract or subcontract  under a
U.S.  government  prime contract,  if the government  customer  requires further
services of the type provided in the contract, there is frequently a competitive
rebidding  process.  We cannot  guarantee that we, or if we are a  subcontractor
that the prime contractor,  will win any particular bid, or that we will be able
to replace  business lost upon expiration or completion of a contract.  Further,
all U.S.  government  contracts  are  subject  to protest  by  competitors.  The
termination of several of our significant  contracts or nonrenewal of several of
our significant contracts, could result in significant revenue shortfalls.

         We cannot  assure  you of market  acceptance  of our  electric  vehicle
technology.

         Our  batteries  for the defense  industry and a signal light powered by
water-activated batteries for use in life jackets and other rescue apparatus are
the only commercial  Zinc-Air  battery  products we currently have available for
sale.  Significant  resources will be required to develop and produce additional
products utilizing this technology on a commercial scale. Additional development
will be  necessary  in order to  commercialize  our  technology  and each of the
components of the Electric Fuel System for electric  vehicles.  We cannot assure
you that we will be able to successfully develop,  engineer or commercialize our
Zinc-Air energy system.  The likelihood of our future success must be considered
in light of the risks, expenses,  difficulties and delays frequently encountered
in connection  with the operation and  development  of a relatively  early stage
business and with development activities generally.



                                       58
<PAGE>

         We  believe  that  public  pressure  and  government   initiatives  are
important factors in creating an electric vehicle market.  However, there can be
no  assurance  that there will be  sufficient  public  pressure or that  further
legislation or other governmental  initiatives will be enacted,  or that current
legislation will not be repealed,  amended, or have its implementation  delayed.
In  addition,  we are subject to the risk that even if an electric  fuel vehicle
market develops,  a different form of zero emission or low emission vehicle will
dominate the market.  In addition,  we cannot assure you that other solutions to
the problem of containing  emissions created by internal combustion engines will
not be invented,  developed  and  produced.  Any other  solution  could  achieve
greater market acceptance than electric  vehicles.  The failure of a significant
market for electric  vehicles to develop would have a material adverse effect on
our  ability  to  commercialize  this  aspect  of  our  technology.  Even  if  a
significant  market for electric  vehicles  develops,  there can be no assurance
that our technology will be commercially competitive within that market.

     Some of the components of our electric vehicle  technology and our products
pose potential safety risks which could create potential  liability exposure for
us.

         Some of the  components  of our  electric  vehicle  technology  and our
products contain  elements that are known to pose potential safety risks.  Also,
because electric vehicle batteries  contain large amounts of electrical  energy,
they may cause injuries if not handled properly. In addition to these risks, and
there can be no assurance that accidents in our facilities  will not occur.  Any
accident,  whether  occasioned  by the use of all or any part of our products or
technology or by our manufacturing operations, could adversely affect commercial
acceptance of our products and could result in significant  production delays or
claims for damages  resulting  from  injuries.  Any of these  occurrences  would
materially adversely affect our operations and financial condition.

     We may face product liability claims.

         In the event that our products,  including the products manufactured by
MDT, fail to perform as specified, users of these products may assert claims for
substantial amounts.  These claims could have a materially adverse effect on our
financial  condition and results of  operations.  There is no assurance that the
amount of the general  product  liability  insurance  that we  maintain  will be
sufficient to cover potential claims or that the present amount of insurance can
be maintained at the present level of cost, or at all.

     Our fields of business are highly competitive.

         The competition to develop  defense and security  products and electric
vehicle  battery  systems,  and to obtain  funding for the  development of these
products, is, and is expected to remain, intense.

         Our defense and security  products compete with other  manufacturers of
specialized  training systems,  including  Firearms  Training  Systems,  Inc., a
producer of interactive  simulation  systems designed to provide training in the
handling and use of small and  supporting  arms.  In  addition,  we compete with
manufacturers and developers of armor for cars and vans, including O'Gara-Hess &
Eisenhardt, a division of Armor Holdings, Inc.

         Our battery  technology  competes with other battery  technologies,  as
well as  other  Zinc-Air  technologies.  The  competition  in  this  area of our
business consists of development stage companies,  major international companies
and consortia of such companies,  including  battery  manufacturers,  automobile
manufacturers,  energy production and transportation  companies,  consumer goods
companies  and defense  contractors.  Many of our  competitors  have  financial,
technical,  marketing,  sales,  manufacturing,  distribution and other resources
significantly greater than ours.



                                       59
<PAGE>

         Various battery  technologies  are being considered for use in electric
vehicles and defense and safety products by other  manufacturers and developers,
including the following: lead-acid,  nickel-cadmium,  nickel-iron,  nickel-zinc,
nickel-metal  hydride,  sodium-sulfur,   sodium-nickel  chloride,  zinc-bromine,
lithium-ion,    lithium-polymer,    lithium-iron   sulfide,   primary   lithium,
rechargeable alkaline and Zinc-Air.

         If we are  unable  to  compete  successfully  in each of our  operating
areas, especially in the defense and security products area of our business, our
business and results of operations could be materially adversely affected.

     Our business is dependent  on  proprietary  rights that may be difficult to
protect and could affect our ability to compete effectively.

         Our  ability  to  compete  effectively  will  depend on our  ability to
maintain the proprietary  nature of our technology and  manufacturing  processes
through a  combination  of patent and trade  secret  protection,  non-disclosure
agreements and licensing arrangements.

         Litigation,  or participation  in  administrative  proceedings,  may be
necessary to protect our  proprietary  rights.  This type of  litigation  can be
costly and time  consuming and could divert  company  resources  and  management
attention  to defend  our  rights,  and this could harm us even if we were to be
successful in the litigation.  In the absence of patent protection,  and despite
our reliance upon our proprietary confidential information,  our competitors may
be able to use innovations similar to those used by us to design and manufacture
products directly competitive with our products.  In addition,  no assurance can
be given that  others  will not obtain  patents  that we will need to license or
design  around.  To the extent any of our  products  are covered by  third-party
patents,  we could need to acquire a license  under such  patents to develop and
market our products.

         Despite our efforts to safeguard and maintain our  proprietary  rights,
we may not be successful in doing so. In addition,  competition is intense,  and
there can be no assurance that our competitors will not independently develop or
patent  technologies  that  are  substantially  equivalent  or  superior  to our
technology.  Moreover,  in the event of patent litigation,  we cannot assure you
that a court  would  determine  that we were the  first  creator  of  inventions
covered by our issued patents or pending patent applications or that we were the
first to file patent  applications for those  inventions.  If existing or future
third-party  patents  containing broad claims were upheld by the courts or if we
were found to  infringe  third party  patents,  we may not be able to obtain the
required  licenses from the holders of such patents on acceptable  terms,  if at
all.  Failure to obtain these licenses could cause delays in the introduction of
our products or necessitate  costly  attempts to design around such patents,  or
could foreclose the development,  manufacture or sale of our products.  We could
also incur substantial costs in defending ourselves in patent infringement suits
brought  by  others  and  in  prosecuting  patent   infringement  suits  against
infringers.



                                       60
<PAGE>

         We also rely on trade secrets and proprietary  know-how that we seek to
protect, in part, through non-disclosure and confidentiality agreements with our
customers, employees, consultants, and entities with which we maintain strategic
relationships.  We cannot assure you that these agreements will not be breached,
that we would have  adequate  remedies for any breach or that our trade  secrets
will not otherwise become known or be independently developed by competitors.

     We are dependent on key personnel and our business  would suffer if we fail
to retain them.

         We  are  highly  dependent  on  the  presidents  of our  IES  and  FAAC
subsidiaries and the general managers of our MDT and Epsilor  subsidiaries,  and
the loss of the services of one or more of these persons could adversely  affect
us. We are especially  dependent on the services of our Chairman,  President and
Chief Executive Officer, Robert S. Ehrlich. The loss of Mr. Ehrlich could have a
material adverse effect on us. We are party to an employment  agreement with Mr.
Ehrlich, which agreement expires at the end of 2005. We do not have key-man life
insurance on Mr. Ehrlich.

     There are risks involved with the international nature of our business.

         A  significant  portion  of our  sales  are made to  customers  located
outside the U.S.,  primarily in Europe and Asia. In 2003, 2002 and 2001, without
taking account of revenues derived from  discontinued  operations,  42%, 56% and
49%, respectively, of our revenues, were derived from sales to customers located
outside the U.S. We expect that our  international  customers  will  continue to
account for a substantial  portion of our revenues in the near future.  Sales to
international  customers  may  be  subject  to  political  and  economic  risks,
including political instability,  currency controls, exchange rate fluctuations,
foreign taxes,  longer payment cycles and changes in  import/export  regulations
and tariff rates. In addition,  various forms of protectionist trade legislation
have been and in the  future  may be  proposed  in the U.S.  and  certain  other
countries. Any resulting changes in current tariff structures or other trade and
monetary policies could adversely affect our sales to international customers.

     Investors  should not  purchase our common  stock with the  expectation  of
receiving cash dividends.

         We currently  intend to retain any future  earnings for funding  growth
and, as a result,  do not expect to pay any cash  dividends  in the  foreseeable
future.

Market-Related Risks

     The price of our common stock is volatile.

         The market price of our common stock has been  volatile in the past and
may change rapidly in the future. The following factors, among others, may cause
significant volatility in our stock price:

         o        Announcements by us, our competitors or our customers;

         o        The  introduction of new or enhanced  products and services by
                  us or our competitors;



                                       61
<PAGE>

         o        Changes  in  the  perceived   ability  to  commercialize   our
                  technology compared to that of our competitors;

         o        Rumors relating to our competitors or us;

         o        Actual or anticipated  fluctuations in our operating  results;
                  and

         o        General market or economic conditions.

     If our shares were to be delisted,  our stock price might  decline  further
and we might be unable to raise additional capital.

         One of the  continued  listing  standards  for our stock on the  Nasdaq
National  Market is the  maintenance  of a $1.00 bid price.  Our stock price has
periodically  traded below $1.00 in the recent past. If our bid price were to go
and remain below $1.00 for 30 consecutive  business days, Nasdaq could notify us
of our failure to meet the  continued  listing  standards,  after which we would
have 180 calendar  days to correct  such failure or be delisted  from the Nasdaq
National Market.

          Although  we would  have  the  opportunity  to  appeal  any  potential
delisting,  there  can be no  assurances  that  this  appeal  would be  resolved
favorably.  As a result,  there can be no  assurance  that our common stock will
remain  listed on the Nasdaq  National  Market.  If our common  stock were to be
delisted  from the Nasdaq  National  Market,  we might apply to be listed on the
Nasdaq  SmallCap  market;  however,  there can be no assurance  that we would be
approved  for listing on the Nasdaq  SmallCap  market,  which has the same $1.00
minimum bid and other similar  requirements as the Nasdaq National Market. If we
were to move to the Nasdaq SmallCap  market,  current Nasdaq  regulations  would
give us the  opportunity  to obtain an  additional  180-day  grace period and an
additional  90-day  grace  period  after  that if we meet  certain  net  income,
stockholders' equity or market  capitalization  criteria.  While our stock would
continue to trade on the over-the-counter bulletin board following any delisting
from the Nasdaq,  any such  delisting  of our common stock could have an adverse
effect on the market price of, and the efficiency of the trading market for, our
common stock.  Also, if in the future we were to determine  that we need to seek
additional  equity  capital,  it could have an adverse  effect on our ability to
raise capital in the public equity markets.

         In addition,  if we fail to maintain Nasdaq listing for our securities,
and no  other  exclusion  from  the  definition  of a "penny  stock"  under  the
Securities  Exchange  Act of 1934,  as amended,  is  available,  then any broker
engaging in a  transaction  in our  securities  would be required to provide any
customer with a risk disclosure  document,  disclosure of market quotations,  if
any,  disclosure of the compensation of the broker-dealer and its salesperson in
the transaction and monthly account  statements showing the market values of our
securities  held in the  customer's  account.  The bid and offer  quotation  and
compensation information must be provided prior to effecting the transaction and
must be contained on the customer's  confirmation.  If brokers become subject to
the "penny stock" rules when engaging in transactions  in our  securities,  they
would  become less  willing to engage in  transactions,  thereby  making it more
difficult for our stockholders to dispose of their shares.



                                       62
<PAGE>

     A  substantial  number of our shares are  available  for sale in the public
market and sales of those shares could adversely affect our stock price.

         Sales of a substantial number of shares of common stock into the public
market,  or the perception that those sales could occur,  could adversely affect
our stock  price or could  impair  our  ability  to obtain  capital  through  an
offering of equity securities. As of February 29, 2004, we had 59,904,449 shares
of common  stock  issued  and  outstanding.  Of these  shares,  most are  freely
transferable  without  restriction  under  the  Securities  Act of  1933,  and a
substantial  portion of the  remaining  shares may be sold subject to the volume
restrictions,  manner-of-sale  provisions and other conditions of Rule 144 under
the Securities Act of 1933.

         In connection with a stock purchase  agreement dated September 30, 1996
between  Leon S.  Gross  and us,  we also  entered  into a  registration  rights
agreement with Mr. Gross dated September 30, 1996, providing registration rights
with respect to the shares of common  stock  issued to Mr.  Gross in  connection
with the  offering.  These rights  include the right to make two demands for the
registration  of the shares of our common stock owned by Mr. Gross. In addition,
Mr. Gross was granted unlimited rights to "piggyback" on registration statements
that we  file  for the  sale of our  common  stock.  Mr.  Gross  presently  owns
3,482,534 shares, of which 1,538,462 have never been registered.

     Exercise of our  warrants,  options and  convertible  debt could  adversely
affect our stock price and will be dilutive.

         As of February 29, 2004, there were outstanding  warrants to purchase a
total of 19,302,156  shares of our common stock at a weighted  average  exercise
price of $1.85 per share, options to purchase a total of 9,627,212 shares of our
common stock at a weighted  average  exercise price of $1.48 per share, of which
6,477,440 were vested,  at a weighted average exercise price of $1.67 per share,
and outstanding  debentures  convertible into a total of 5,203,149 shares of our
common stock at a weighted average conversion price of $1.39 per share.  Holders
of our options,  warrants and convertible debt will probably exercise or convert
them only at a time  when the price of our  common  stock is higher  than  their
respective  exercise or conversion  prices.  Accordingly,  we may be required to
issue shares of our common stock at a price  substantially lower than the market
price of our stock. This could adversely affect our stock price. In addition, if
and when these  shares  are  issued,  the  percentage  of our common  stock that
existing stockholders own will be diluted.

     Our  certificate  of  incorporation  and bylaws and  Delaware  law  contain
provisions that could discourage a takeover.

     Provisions of our amended and restated  certificate  of  incorporation  may
have the effect of making it more difficult for a third party to acquire,  or of
discouraging  a third party from  attempting  to acquire,  control of us.  These
provisions could limit the price that certain  investors might be willing to pay
in the future for shares of our common stock. These provisions:

         o        divide  our board of  directors  into  three  classes  serving
                  staggered three-year terms;



                                       63
<PAGE>

         o        only permit removal of directors by stockholders  "for cause,"
                  and  require  the  affirmative  vote  of at  least  85% of the
                  outstanding common stock to so remove; and

         o        allow us to issue  preferred stock without any vote or further
                  action by the stockholders.

     The  classification  system of electing directors and the removal provision
may tend to  discourage  a  third-party  from making a tender offer or otherwise
attempting to obtain  control of us and may maintain the incumbency of our board
of  directors,  as the  classification  of the board of directors  increases the
difficulty of replacing a majority of the directors.  These  provisions may have
the effect of deferring  hostile  takeovers,  delaying changes in our control or
management,  or may make it more  difficult  for  stockholders  to take  certain
corporate  actions.  The  amendment  of any of these  provisions  would  require
approval by holders of at least 85% of the outstanding common stock.

Israel-Related Risks

     A significant portion of our operations takes place in Israel, and we could
be adversely affected by the economic, political and military conditions in that
region.

         The offices and facilities of three of our  subsidiaries,  EFL, MDT and
Epsilor, are located in Israel (in Beit Shemesh,  Lod and Dimona,  respectively,
all of  which  are  within  Israel's  pre-1967  borders).  Most  of  our  senior
management is located at EFL's  facilities.  Although we expect that most of our
sales will be made to customers  outside  Israel,  we are  nonetheless  directly
affected  by  economic,  political  and  military  conditions  in that  country.
Accordingly,  any major  hostilities  involving  Israel or the  interruption  or
curtailment of trade between Israel and its present trading  partners could have
a material  adverse effect on our  operations.  Since the  establishment  of the
State of Israel in 1948, a number of armed  conflicts  have taken place  between
Israel and its Arab  neighbors and a state of  hostility,  varying in degree and
intensity, has led to security and economic problems for Israel.

         Historically,  Arab states have  boycotted any direct trade with Israel
and to varying degrees have imposed a secondary  boycott on any company carrying
on trade with or doing business in Israel.  Although in October 1994, the states
comprising the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates,
Kuwait,  Dubai,  Bahrain and Oman) announced that they would no longer adhere to
the  secondary  boycott  against  Israel,  and Israel has entered  into  certain
agreements with Egypt,  Jordan,  the Palestine  Liberation  Organization and the
Palestinian  Authority,  Israel has not entered into any peace  arrangement with
Syria or Lebanon.  Moreover,  since September 2000, there has been a significant
deterioration in Israel's  relationship  with the Palestinian  Authority,  and a
significant increase in terror and violence. Efforts to resolve the problem have
failed to result in an agreeable  solution.  Continued  hostilities  between the
Palestinian community and Israel and any failure to settle the conflict may have
a  material  adverse  effect  on our  business  and us.  Moreover,  the  current
political and security situation in the region has already had an adverse effect
on the economy of Israel, which in turn may have an adverse effect on us.



                                       64
<PAGE>

         Some of our employees are currently obligated to perform annual reserve
duty in the Israel  Defense  Forces and are  subject to being  called for active
military duty at any time. No assessment  can be made of the full impact of such
requirements on us in the future, particularly if emergency circumstances occur,
and no  prediction  can be made as to the effect on us of any expansion of these
obligations.  However, further deterioration of hostilities with the Palestinian
community  into a full-scale  conflict  might require more  widespread  military
reserve  service by some of our employees,  which could have a material  adverse
effect on our business.

     Service of  process  and  enforcement  of civil  liabilities  on us and our
officers may be difficult to obtain.

         We are  organized  under the laws of the State of Delaware  and will be
subject to service of process in the United States.  However,  approximately 35%
of our assets are located  outside the United  States.  In addition,  two of our
directors  and all of our  executive  officers  are  residents  of Israel  and a
portion of the assets of such  directors  and  executive  officers  are  located
outside the United States.

         There is doubt as to the  enforceability of civil liabilities under the
Securities Act of 1933, as amended,  and the Securities Exchange Act of 1934, as
amended,  in original actions  instituted in Israel.  As a result, it may not be
possible  for  investors  to  enforce or effect  service  of process  upon these
directors and executive  officers or to judgments of U.S. courts predicated upon
the civil liability  provisions of U.S. laws against our assets,  as well as the
assets  of these  directors  and  executive  officers.  In  addition,  awards of
punitive   damages  in  actions   brought  in  the  U.S.  or  elsewhere  may  be
unenforceable in Israel.

     Exchange rate fluctuations  between the U.S. dollar and the Israeli NIS may
negatively affect our earnings.

Although a substantial majority of our revenues and a substantial portion of our
expenses are  denominated  in U.S.  dollars,  a portion of our costs,  including
personnel and  facilities-related  expenses,  is incurred in New Israeli Shekels
(NIS). Inflation in Israel will have the effect of increasing the dollar cost of
our operations in Israel, unless it is offset on a timely basis by a devaluation
of the  NIS  relative  to the  dollar.  In  2003,  the  inflation  adjusted  NIS
appreciated  against  the  dollar,  which  raised the dollar cost of our Israeli
operations.

     Some of our agreements are governed by Israeli law.

         Israeli  law  governs  some  of  our  agreements,  such  as  our  lease
agreements on our subsidiaries'  premises in Israel, and the agreements pursuant
to which we purchased IES, MDT and Epsilor. While Israeli law differs in certain
respects from American law, we do not believe that these differences  materially
adversely affect our rights or remedies under these agreements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

         It is our policy not to enter into interest rate  derivative  financial
instruments,  except for hedging of foreign currency exposures  discussed below.
We do not currently have any significant interest rate exposure.



                                       65
<PAGE>

Foreign Currency Exchange Rate Risk

         Since a significant  part of our sales and expenses are  denominated in
U.S. dollars, we have experienced only insignificant  foreign exchange gains and
losses to date, and do not expect to incur significant gains and losses in 2004.
Our research, development and production activities are primarily carried out by
our Israeli subsidiary, EFL, at its facility in Beit Shemesh, and accordingly we
have  sales and  expenses  in New  Israeli  Shekels.  Additionally,  our MDT and
Epsilor  subsidiaries  operate  primarily in New Israeli Shekels.  However,  the
majority of our sales are made outside Israel in U.S. dollars, and a substantial
portion of our costs are incurred in U.S.  dollars.  Therefore,  our  functional
currency  is the U.S.  dollar.  Please see  "Impact of  Inflation  and  Currency
Fluctuations,"  above  and Note 2.b to the Notes to the  Consolidated  Financial
Statements.

         While we conduct our business  primarily in U.S.  dollars,  some of our
agreements are denominated in foreign  currencies.  Specifically,  at the end of
2003 our IES contract with the German National  Police,  which accounted for 16%
of our revenues on a consolidated basis in 2003, was denominated in Euros. Thus,
we are exposed to market risk, primarily related to fluctuations in the value of
the Euro.  Therefore,  due to the  volatility  in the exchange  rate of the Euro
versus the U.S. dollar, we decided to hedge part of the risk of a devaluation of
the U.S dollar, which could have an adverse effect on the revenues that we incur
in IES. During the year 2003 we hedged revenues derived from the German National
Police in order to protect  against a decrease  in value of  forecasted  foreign
currency cash flows resulting from revenues payments  denominated in Euro. We do
not hold or issue  derivative  financial  instruments for trading or speculative
purposes

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                          Index to Financial Statements

<TABLE>
<CAPTION>
                                                                                    Page
                                                                                    ----
 Consolidated Financial Statements
<S>                                                                                    <C>
 Report of Independent Auditors..................................................    F-2
 Consolidated Balance Sheets.....................................................    F-3
 Consolidated Statements of Operations...........................................    F-5
 Statements of Changes in Shareholders' Equity...................................    F-6
 Consolidated Statements of Cash Flows...........................................    F-9
 Notes to Consolidated Financial Statements......................................    F-12
          Supplementary Financial Data

 Quarterly Financial Data (unaudited) for the two years ended December 31, 2003..    F-48
          Financial Statement Schedule

 Schedule II - Valuation and Qualifying Accounts.................................    F-49
</TABLE>


ITEM  9.  CHANGES  IN AND  DISAGREEMENTS  WITH  ACCOUNTANTS  ON  ACCOUNTING  AND
          FINANCIAL DISCLOSURE

         None.



                                       66
<PAGE>

ITEM 9A. CONTROLS AND PROCEDURES

         During  the fourth  quarter  of 2003,  our  management,  including  the
principal  executive  officer and  principal  financial  officer,  evaluated our
disclosure  controls  and  procedures  related  to  the  recording,  processing,
summarization, and reporting of information in our periodic reports that we file
with the SEC. These  disclosure  controls and  procedures  have been designed to
ensure that material information relating to us, including our subsidiaries,  is
made  known  to our  management,  including  these  officers,  by  other  of our
employees,  and  that  this  information  is  recorded,  processed,  summarized,
evaluated, and reported, as applicable, within the time periods specified in the
SEC's rules and forms. Due to the inherent  limitations of control systems,  not
all  misstatements  may be  detected.  These  inherent  limitations  include the
realities that judgments in  decision-making  can be faulty and that  breakdowns
can occur  because of simple  error or mistake.  Additionally,  controls  can be
circumvented by the individual acts of some persons, by collusion of two or more
people,  or by management  override of the control.  Our controls and procedures
can only provide reasonable,  not absolute,  assurance that the above objectives
have been met.

         As of December 31, 2003,  these  officers  concluded that the design of
the disclosure controls and procedures  provides reasonable  assurance that they
can accomplish their objectives.  We intend to continually strive to improve our
disclosure  controls  and  procedures  to enhance the  quality of our  financial
reporting.

         There have been no  changes  in our  internal  control  over  financial
reporting  that  occurred  during our last  fiscal  quarter to which this Annual
Report on Form 10-K relates that have  materially  affected,  or are  reasonably
likely to materially affect, our internal control over financial reporting.



                                       67
<PAGE>

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Executive Officers, Directors and Significant Employees

     Executive Officers and Directors

         Our executive  officers and directors and their ages as of February 29,
2004 were as follows:

<TABLE>
<CAPTION>
               Name               Age                                    Position
               ----               ---                                    --------
<S>                                <C>
   Robert S. Ehrlich...........    65  Chairman of the Board, President and Chief Executive Officer
   Steven Esses..................  40  Executive Vice President, Chief Operating Officer and Director
   Avihai Shen.................    36  Vice President - Finance and Chief Financial Officer
   Dr. Jay M. Eastman..........    57  Director
   Jack E. Rosenfeld...........    64  Director
   Lawrence M. Miller..........    57  Director
   Bert W. Wasserman...........    71  Director
   Edward J. Borey                 53  Director
</TABLE>


         Our by-laws  provide for a board of directors of one or more directors.
There are  currently  seven  directors.  Under the terms of our  certificate  of
incorporation,  the board of directors  is composed of three  classes of similar
size,  each elected in a different  year, so that only one-third of the board of
directors  is  elected  in any  single  year.  Dr.  Eastman  and Mr.  Esses  are
designated  Class I directors  and have been elected for a term expiring in 2006
and until their  successors  are elected and  qualified;  Messrs.  Rosenfeld and
Miller are designated Class II directors elected for a term expiring in 2005 and
until their successors are elected and qualified;  and Mr. Ehrlich is designated
a Class  III  director  elected  for a term that  expires  in 2004 and until his
successor is elected and  qualified.  Mr. Bert W.  Wasserman  and Mr.  Edward J.
Borey have been  appointed  to the Board (in February  2003 and  December  2003,
respectively)  and proposed for election to the Board as Class III  directors at
the next  annual  meeting  of the  shareholders  in June  2004,  along  with Mr.
Ehrlich. A majority of the Board is "independent"  under relevant SEC and Nasdaq
regulations.

         Robert S. Ehrlich has been our Chairman of the Board since January 1993
and our President and Chief Executive  Officer since October 2002. From May 1991
until January 1993, Mr. Ehrlich was our Vice Chairman of the Board, and from May
1991 until October 2002 he was our Chief  Financial  Officer.  Mr. Ehrlich was a
director of Eldat,  Ltd., an Israeli  manufacturer  of electronic  shelf labels,
from June 1999 to July 2003.  From 1987 to June 2003,  Mr.  Ehrlich  served as a
director of PSC Inc.  ("PSCX"),  a manufacturer  and marketer of laser diode bar
code  scanners,  and,  between  April 1997 and June 2003,  Mr.  Ehrlich  was the
chairman of the board of PSCX. PSCX filed a voluntary  petition for relief under
Chapter 11 of the Bankruptcy Code in November 2002; its  pre-negotiated  plan of
reorganization  was confirmed by the Bankruptcy  Court in June 2003. Mr. Ehrlich
received a B.S. and J.D. from Columbia University in New York, New York.



                                       68
<PAGE>

         Steven Esses has been a director since July 2002 and our Executive Vice
President  since January 2003 and Chief  Operating  Officer since February 2003.
From 2000 till 2002, Mr. Esses was a principal with Stillwater Capital Partners,
Inc., a New  York-based  investment  research and advisory  company (hedge fund)
specializing in alternative investment  strategies.  During this time, Mr. Esses
also acted as an  independent  consultant to new and existing  businesses in the
areas of finance and business development.  From 1995 to 2000, Mr. Esses founded
Dunkin'  Donuts in Israel and held the  position of Managing  Director  and CEO.
Prior  thereto,  he was  Director of Retail  Jewelry  Franchises  with  Hamilton
Jewelry,  and before that he served as Executive  Director of Operations for the
Conway Organization, a major off-price retailer with 17 locations.

         Avihai Shen has been our Vice President - Finance since  September 1999
and our Chief Financial  Officer since October 2002, and served as our corporate
Secretary  from  September  1999  to  December  2000.  Mr.  Shen  was the CFO of
Commtouch  Software Ltd., an internet  company based in California that develops
e-mail  solutions,  from 1996 to early 1999, and worked  previously at Ernst and
Young in Israel.  Mr. Shen is a certified  public  accountant  and has a B.A. in
Economics  from  Bar-Ilan  University  in Israel  and an M.B.A.  from the Hebrew
University of Jerusalem.

         Dr. Jay M. Eastman has been one of our  directors  since  October 1993.
Since November  1991,  Dr.  Eastman has served as President and Chief  Executive
Officer of Lucid,  Inc., which is developing  laser technology  applications for
medical  diagnosis and  treatment.  Dr. Eastman has served as a director of PSCX
since April 1996 and served as Senior Vice President of Strategic  Planning from
December 1995 through October 1997.  PSCX filed a voluntary  petition for relief
under Chapter 11 of the Bankruptcy  Code in November  2002;  its  pre-negotiated
plan of  reorganization  was confirmed by the Bankruptcy Court in June 2003. Dr.
Eastman is also a director of  Dimension  Technologies,  Inc.,  a developer  and
manufacturer  of 3D displays  for computer and video  displays,  and  Centennial
Technologies Inc., a manufacturer of PCMCIA cards. From 1981 until January 1983,
Dr. Eastman was Director of the  University of Rochester's  Laboratory for Laser
Energetics,  where he was a member of the staff from September 1975 to 1981. Dr.
Eastman holds a B.S. and a Ph.D.  in Optics from the  University of Rochester in
New York.

         Jack E. Rosenfeld has been one of our directors since October 1993. Mr.
Rosenfeld is also a director of Maurice Corporation and a director of PSCX. PSCX
filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in
November 2002; its  pre-negotiated  plan of reorganization  was confirmed by the
Bankruptcy  Court  in June  2003.  Since  April  1998,  Mr.  Rosenfeld  has been
President and Chief Executive Officer of Potpourri  Collection Inc., a specialty
catalog direct marketer. Mr. Rosenfeld was President and Chief Executive Officer
of Hanover  Direct,  Inc.,  formerly Horn & Hardart Co., which operates a direct
mail marketing  business,  from September 1990 until December 1995, and had been
President and Chief Executive Officer of its direct marketing subsidiary,  since
May 1988. Mr. Rosenfeld holds a B.A. from Cornell University in Ithaca, New York
and an LL.B. from Harvard University in Cambridge, Massachusetts.

         Lawrence M. Miller was  elected to the board of  directors  in November
1996. Mr. Miller has been a senior  partner in the  Washington  D.C. law firm of
Schwartz,  Woods and Miller  since 1990.  He served from August 1993 through May
1996 as a member of the board of  directors of The Phoenix  Resource  Companies,
Inc., a publicly  traded energy  exploration  and production  company,  and as a
member of the Audit and Compensation  Committee of that board.  That company was
merged  into  Apache  Corporation  in May 1996.  Mr.  Miller  holds a B.A.  from
Dickinson  College in Carlisle,  Pennsylvania and a J.D. with honors from George
Washington  University  in  Washington,  D.C. He is a member of the  District of
Columbia bar.



                                       69
<PAGE>

         Bert W.  Wasserman  was  added  to the  board  in  February  2003.  Mr.
Wasserman served as Executive Vice President and Chief Financial Officer of Time
Warner,  Inc. from 1990 until his  retirement in 1995 and served on the Board of
Directors  of  Time   Warner,   Inc.  and  its   predecessor   company,   Warner
Communications, Inc. from 1981 to 1995. He joined Warner Communications, Inc. in
1966 and had been an  officer of that  company  since  1970.  Mr.  Wasserman  is
director of several  investment  companies in the Dreyfus Family of Funds. He is
also a director  of Malibu  Entertainment,  Inc.,  Lillian  Vernon  Corporation,
InforMedix,  Inc.  and PSCX.  PSCX filed a voluntary  petition  for relief under
Chapter 11 of the Bankruptcy Code in November 2002; its  pre-negotiated  plan of
reorganization was confirmed by the Bankruptcy Court in June 2003. Mr. Wasserman
is a certified  public  accountant;  he holds a B.A. from Baruch  College in New
York  City,  of whose  Board of  Trustees  he has served as Vice  President  and
President, and an LL.B from Brooklyn Law School.

         Edward J. Borey was added to the board in December 2003.  From December
2000 to September 2003, Mr. Borey served as President,  Chief Executive  Officer
and a director of PSCX. PSCX filed a voluntary petition for relief under Chapter
11 of  the  Bankruptcy  Code  in  November  2002;  its  pre-negotiated  plan  of
reorganization  was  confirmed by the  Bankruptcy  Court in June 2003.  Prior to
joining the Company,  Mr. Borey was President and CEO of TranSenda  (May 2000 to
December  2000).  Previously,  Mr. Borey held senior  positions in the automated
data collection industry. At Intermec Technologies Corporation  (1995-1999),  he
was Executive  Vice President and Chief  Operating  Officer and also Senior Vice
President/General Manager of the Intermec Media subsidiary. Currently, Mr. Borey
serves as a Board member at Centura Software, recently renamed MBrane, and he is
on the Advisory Board of TranSenda  Software and NextRx.  Mr. Borey holds a B.S.
in Economics from the State University of New York,  College of Oswego;  an M.A.
in Public  Administration  from the  University  of Oklahoma;  and an M.B.A.  in
Finance from Santa Clara University.

     Committees of the Board of Directors

         Our  board  of  directors  has  an  Audit  Committee,   a  Compensation
Committee, a Nominating Committee and an Executive Committee.

         Created in  December  1993,  the purpose of the Audit  Committee  is to
review with management and our independent auditors the scope and results of the
annual  audit,  the nature of any other  services  provided  by the  independent
auditors,  changes in the accounting  principles  applied to the presentation of
our financial  statements,  and any comments by the independent  auditors on our
policies  and  procedures  with  respect to internal  accounting,  auditing  and
financial  controls.  The Audit  Committee was  established  in accordance  with
Section  3(a)(58)(A)  of the  Securities  Exchange Act of 1934,  as amended.  In
addition,  the Audit  Committee  is charged with the  responsibility  for making
decisions on the  engagement of  independent  auditors.  As required by law, the
Audit Committee operates pursuant to a charter.  The Audit Committee consists of
Messrs.  Wasserman  (Chair),  Miller and Rosenfeld.  We have determined that Mr.
Wasserman  qualifies as an "audit committee  financial  expert" under applicable
SEC and Nasdaq regulations.  Mr. Wasserman,  as well as all the other members of
the Audit  Committee,  is  "independent,"  as  independence  is  defined in Rule
4200(a)(15) of the National Association of Securities Dealers' listing standards
and under Item 7(d)(3)(iv) of Schedule 14A of the proxy rules under the Exchange
Act.



                                       70
<PAGE>

         The Compensation  Committee,  also created in December 1993, recommends
annual  compensation  arrangements  for the Chief  Executive  Officer  and Chief
Financial Officer and reviews annual compensation  arrangements for all officers
and significant  employees.  The Compensation  Committee consists of Dr. Eastman
(Chair)  and  Messrs.  Wasserman  and  Rosenfeld,  all of whom  are  independent
non-employee directors.

         The Executive Committee,  created in July 2001, exercises the powers of
the Board during the intervals  between meetings of the Board, in the management
of the  property,  business  and affairs of the Company  (except with respect to
certain extraordinary transactions). The Executive Committee consists of Messrs.
Ehrlich (Chair), Miller and Esses.

         The  Nominating  Committee,  created  in  March  2003,  identifies  and
proposes  candidates  to serve as  members of the Board of  Directors.  Proposed
nominees  for  membership  on the Board of  Directors  submitted  in  writing by
stockholders to the Secretary of the Company will be brought to the attention of
the  Nominating  Committee.  The  Nominating  Committee  consists of Mr.  Miller
(Chair), Dr. Eastman and Mr. Rosenfeld, all of whom are independent non-employee
directors.

     Code of Ethics

         We have  adopted  a Code of  Ethics,  as  required  by  Nasdaq  listing
standards  and the rules of the SEC,  that  applies to our  principal  executive
officer,  our principal financial officer, and our principal accounting officer,
as well as a more general  code of conduct that applies to our other  employees.
The Code of Ethics is  publicly  available  through a  hyperlink  located on the
investor        relations       page       of       our       website,        at
http://www.arotech.com/compro/investor.html.  If we make substantive  amendments
to the Code of Ethics or grant any waiver,  including any implicit waiver,  that
applies to anyone subject to the Code of Ethics,  we will disclose the nature of
such amendment or waiver on the website or in a report on Form 8-K in accordance
with applicable Nasdaq and SEC rules

     Voting Agreements

         Messrs. Gross, Ehrlich and Yehuda Harats are parties to a Voting Rights
Agreement  dated  September 30, 1996, as amended,  pursuant to which each of the
parties  agrees to vote the  shares of our common  stock held by that  person in
favor of the election of Messrs. Ehrlich, Harats and Miller until the earlier of
December 28, 2004 or our fifth annual meeting of stockholders after December 28,
1999. Mr. Harats  resigned as a director in 2002;  however,  we believe that Mr.
Harats must continue to comply with the terms of this agreement.

     Director Compensation



                                       71
<PAGE>

         Non-employee  members of our board of  directors  are paid $2,500 (plus
expenses) for each board of directors meeting  attended,  $2,000 (plus expenses)
for each meeting of the audit committee of the board of directors attended,  and
$1,000 (plus expenses) for each meeting of all other  committees of the board of
directors attended.  In addition,  we have adopted a Non-Employee Director Stock
Option Plan pursuant to which non-employee directors receive an initial grant of
options to purchase 25,000 shares of our common stock upon the effective date of
such plan or upon the date of his or her  election  as a  director.  Thereafter,
non-employee  directors  will receive  options to purchase  10,000 shares of our
common stock for each year of service on the board. All such options are granted
at fair  market  value and vest  ratably  over three  years from the date of the
grant.  At our next annual meeting of shareholders in June 2004, we will propose
increasing  these stock option  grants to 40,000 shares of our common stock upon
the effective  date of such plan or upon the date of a director's  election as a
director  and 25,000  shares of our common stock for each year of service on the
board.

     Significant Employees

         Our significant employees as of February 29, 2004, and their ages as of
December 31, 2003, are as follows:

<TABLE>
<CAPTION>
                       Name                  Age                            Position
                       ----                  ---                            --------
<S>                                          <C>
        Jonathan Whartman.................   49  Senior Vice President
        Dr. Neal Naimer...................   45  Vice President and Chief Technology Officer
        Yoel Gilon........................   51  Vice President - Electric Vehicle Technologies
        Yaakov Har-Oz.....................   46  Vice President, General Counsel and Secretary
        Danny Waldner.....................   32  Controller
        Greg Otte.........................   44  President, IES Interactive Training, Inc.
        Alan G. Jordan....................   50  President and CEO, FAAC Incorporated
        Yosef Bar.........................   61  General Manager, MDT Protective Industries
        Hezy Aspis........................   53  General Manager, Epsilor Electronics Industries, Ltd.
        Arik Arad.........................   51  Chairman, IES Interactive Training, Inc. and President,  Arocon
                                                 Security Corporation
</TABLE>


         Jonathan  Whartman has been Senior Vice President  since December 2000,
and Vice  President of  Marketing  from 1994 to December  2000.  From 1991 until
1994, Mr. Whartman was our Director of Special  Projects.  Mr. Whartman was also
Director of Marketing of Amtec from its  inception in 1989 through the merger of
Amtec into Arotech.  Before joining Amtec,  Mr.  Whartman was Manager of Program
Management at Luz,  Program  Manager for desk-top  publishing at ITT Qume in San
Jose,  California  from 1986 to 1987,  and Marketing  Director at Kidron Digital
Systems, an Israeli computer developer,  from 1982 to 1986. Mr. Whartman holds a
B.A. in Economics and an M.B.A. from the Hebrew University, Jerusalem, Israel.

         Dr. Neal Naimer has been a Vice President since June 1997 and our Chief
Technology  Officer since December  2002. Dr. Naimer was previously  Director of
Electrode  Engineering of our Air Electrode  development  program.  From 1987 to
1989, he was the Manager of the Chemical Vapor  Deposition (Thin Films) Group at
Intel Electronics in Jerusalem,  and was Project Manager of the photo voltaic IR
detector development program at Tadiran  Semiconductor Devices in Jerusalem from
1984 to 1987. Dr. Naimer was educated at University College of London,  England,
where he received  his B.Sc.  in Chemical  Engineering  and a Ph.D.  in Chemical
Engineering.



                                       72
<PAGE>

         Yoel Gilon has been our Vice President - Electric Vehicle  Technologies
since  2001;   prior  to  that,  he  served  as  Director  of  Electric  Vehicle
Technologies at our Beit Shemesh facility since joining us in 1994. From 1991 to
1994, Mr. Gilon was Project Development Manager at Ormat Industries. Previously,
Mr.  Gilon  was  Vice  President  of  System  Engineering   Development  at  Luz
Industries.  Mr. Gilon holds a B.Sc. in  Mathematics  and Physics and a M.Sc. in
Mathematics  from the Hebrew  University of  Jerusalem.  He also holds a B.A. in
Fine Arts from the Bezalel Academy in Jerusalem.

         Yaakov  Har-Oz has served as our Vice  President  and  General  Counsel
since October 2000 and as our corporate Secretary since December 2000. From 1994
until  October  2000,  Mr.  Har-Oz  was a partner in the  Jerusalem  law firm of
Ben-Ze'ev,  Hacohen  & Co.  Prior  to  moving  to  Israel  in  1993,  he  was an
administrative  law judge and in private law  practice in New York.  Mr.  Har-Oz
holds a B.A. from Brandeis University in Waltham,  Massachusetts and a J.D. from
Vanderbilt  Law School  (where he was an editor of the law review) in Nashville,
Tennessee.  He is a  member  of the  New  York  bar and the  Israel  Chamber  of
Advocates.

         Danny Waldner has served as our Controller  since March 2000 and as our
chief accounting  officer since October 2002. Prior thereto,  Mr. Waldner was an
accountant  at KPMG in Israel  from 1996 to 2000.  Mr.  Waldner  is a  Certified
Public Accountant and holds a B.A. in Accounting and Business Administration and
an M.B.A. from the Rishon Lezion College of Administration in Israel.

         Greg Otte has served as IES's  President  since January 2001. From 1994
to 2001, Mr. Otte was in charge of IES's North American marketing efforts. Prior
to this, he was responsible for sales,  product placement and national contracts
with  Tuxall  Uniform  &  Equipment,  a  national  supplier  of law  enforcement
equipment.  Mr. Otte holds a bachelor's  degree in Marketing from the University
of Colorado.

         Alan G. Jordan started at First Ann Arbor Corporation,  the predecessor
of FAAC, in 1978 as a junior  engineer.  He subsequently was promoted to section
head, program manager, group head, director of operations,  vice president,  and
finally president, which position he has held for more than the past five years.
Prior to  joining  FAAC,  Mr.  Jordan  was an  engineer  in the U.S.  Navy civil
service.  Mr. Jordan  maintains  Department of Defense "secret"  clearance.  Mr.
Jordan  holds a  bachelor's  degree  in  Systems  Science  from  Michigan  State
University.

         Yosef Bar established  MDT Protective  Industries in 1989 as one of the
first  bulletproofing  companies in Israel.  Under the direction of Mr. Bar, MDT
moved from its initial emphasis on vandalism  protection to  bulletproofing  not
just  windshields  but the  entire  vehicle,  as a result  of which  MDT  became
Israel's  leader in the  state-of-the  art  lightweight  armoring  of  vehicles,
ranging from light tactical  vehicles to passenger  vehicles.  Mr. Bar served in
the  Israel  Defense  Forces,  reaching  the rank of  Lieutenant  Colonel of the
paratroop  regiment with over 1,000 jumps to his credit. He also participated in
several anti-terrorism courses.



                                       73
<PAGE>

         Hezy Aspis has headed Epsilor Electronic  Industries,  Ltd. since 1991.
Prior to this, he was an engineer with Tadiran Batteries Ltd.,  Israel's leading
lithium battery  manufacturer.  Mr. Aspis holds a B.Sc. in electric  engineering
from the Technion Israel Institute of Technology in Haifa, Israel, and an M.B.A.
from Tel-Aviv University in Israel.

         Arik  Arad  has  served  as IES's  Chairman  since  August  2003 and as
Chairman of Arocon Security Consulting since September 2003. Mr. Arad has served
in the military, law enforcement and private-sector security business, servicing
clientele from among the Fortune 500(TM) companies.  In that capacity,  Mr. Arad
has participated in the process of reassessing security  requirements,  security
design,  security  implementation,  security  training  programs  and  proactive
security  follow-up.  Mr. Arad has been exposed to issues pertinent to companies
whose worldwide  operations pose potential for terrorist  activity.  He has also
gained  worldwide  experience in securing major airports,  shopping  centers and
other high profile  facilities.  Mr. Arad served as a Lieutenant  Colonel in the
Israel  Defense  Forces.  Mr.  Arad is a graduate of the  International  Seminar
Management  Program (ISMP) of the Harvard  Business  School and holds a B.Sc. in
psychology and political sciences from the Haifa University in Israel.

     Section 16(a) Beneficial Ownership Reporting Compliance

         Under the securities laws of the United States, our directors,  certain
of our  officers  and any  persons  holding  more than ten percent of our common
stock are required to report their ownership of our common stock and any changes
in that ownership to the Securities and Exchange Commission.  Specific due dates
for these  reports  have been  established  and we are  required  to report  any
failure to file by these dates  during 2003.  We are not aware of any  instances
during 2003,  not  previously  disclosed by us, where such  "reporting  persons"
failed to file the required reports on or before the specified dates,  except as
follows:

         (i)      Mr.   Borey  was  required  to  report  his  holdings  of  our
                  securities in a Form 3 that should have been filed on or prior
                  to  December  15,  2003 in  connection  with  his  becoming  a
                  director  on  December 4, 2003.  Additionally,  Mr.  Borey was
                  required  to file a Form 4 on or prior to  January  2, 2004 in
                  connection  with  his  receipt  of  35,000  stock  options  on
                  December  30,   2003.   He  reported  his  holdings  and  this
                  transaction in a Form 5 filed on February 17, 2004.

         (ii)     Mr.  Eastman  was  required  to file a Form 4 on or  prior  to
                  January 2, 2004 in connection with his receipt of 10,000 stock
                  options on December 30, 2003. He reported this  transaction in
                  a Form 5 filed on February 17, 2004.

         (iii)    Mr. Ehrlich was required to file a Form 4 on or prior to March
                  17, 2003 in  connection  with his receipt of  1,500,000  stock
                  options on March 14, 2003. He reported this  transaction  in a
                  Form 4 filed on August 11, 2003.

         (iv)     Mr.  Ehrlich was required to file a Form 4 on or prior to June
                  30,  2003 in  connection  with his  receipt of  500,000  stock
                  options on June 26, 2003.  He reported this  transaction  in a
                  Form 4 filed on August 11, 2003.



                                       74
<PAGE>

         (v)      Mr.  Ehrlich  was  required  to file a Form 4 on or  prior  to
                  January  27,  2004 in  connection  with his  receipt of 35,000
                  stock   options  on  January  25,  2004.   He  reported   this
                  transaction in a Form 5 filed on February 17, 2004.

         (vi)     Mr.  Esses  was  required  to  file a Form  4 on or  prior  to
                  February  26, 2003 in  connection  with his receipt of 600,000
                  stock   options  on  February  24,  2003.   He  reported  this
                  transaction in a Form 4 filed on August 8, 2003.

         (vii)    Mr.  Esses was  required  to file a Form 4 on or prior to July
                  11,  2003 in  connection  with his  receipt of  100,000  stock
                  options on July 9,  2003,  and a Form 4 on or prior to October
                  15,  2003 in  connection  with his  receipt of  335,000  stock
                  options on October 13, 2003. He reported these transactions in
                  a Form 5 filed on  February  17,  2004 (as amended on February
                  24, 2004).

         (viii)   Mr.  Miller  was  required  to  file a Form 4 on or  prior  to
                  January 2, 2004 in connection with his receipt of 10,000 stock
                  options on December 30, 2003. He reported this  transaction in
                  a Form 5 filed on February 17, 2004.

         (ix)     Mr.  Rosenfeld  was  required  to file a Form 4 on or prior to
                  January 2, 2004 in connection with his receipt of 10,000 stock
                  options on December 30, 2003. He reported this  transaction in
                  a Form 5 filed on February 18, 2004 (after the required filing
                  date of February 17, 2004, due to a technical  delay in filing
                  with the EDGAR system).

         (x)      Mr. Shen was required to file a Form 4 on or prior to February
                  26,  2003 in  connection  with his  receipt of  120,000  stock
                  options on February 24, 2003. He reported this  transaction in
                  a Form 4 filed on August 11, 2003.

         (xi)     Mr. Shen was required to file a Form 4 on or prior to July 11,
                  2003 in  connection  with his receipt of 120,000 stock options
                  on July 9, 2003,  and a Form 4 on or prior to October 15, 2003
                  in  connection  with his receipt of 333,750  stock  options on
                  October 13, 2003. He reported these  transactions  in a Form 5
                  filed on February 17, 2004 (as amended on February 24, 2004).

         (xii)    Mr.  Wasserman  was  required  to report his  holdings  of our
                  securities in a Form 3 that should have been filed on or prior
                  to March 6, 2003 in connection with his becoming a director on
                  February 24, 2003. Additionally, Mr. Wasserman was required to
                  file a Form 4 on or prior to  January  2,  2004 in  connection
                  with his receipt of 10,000 stock options on December 30, 2003.
                  He reported  his  holdings  and this  transaction  in a Form 5
                  filed on February 19, 2004 (after the required  filing date of
                  February 17, 2004, due to a technical delay in filing with the
                  EDGAR system).



                                       75
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

Cash and Other Compensation

     General

         Our Chief  Executive  Officer  and the  other  highest  paid  executive
officers (of which there were two) who were  compensated  at a rate of more than
$100,000  in  salary  and  bonuses  during  the year  ended  December  31,  2003
(collectively,  the "Named Executive Officers") are Israeli residents,  and thus
certain  elements  of the  compensation  that we pay  them is  structured  as is
customary in Israel.

         During  2002,  2001  and  2000,  compensation  to our  Named  Executive
Officers took several forms:

         >>       cash salary;

         >>       bonus,  some of which was paid in cash in the year in which it
                  was earned and some of which was  accrued in the year in which
                  it was earned but paid in cash in a subsequent year;

         >>       cash  reimbursement  for  taxes  paid by the  Named  Executive
                  Officer and  reimbursed by us in  accordance  with Israeli tax
                  regulations;

         >>       accruals  (but not cash  payments)  in respect of  contractual
                  termination  compensation  in excess of the Israeli  statutory
                  minimum;

         >>       accruals (but not cash  payments) in respect of pension plans,
                  which consist of a savings plan,  life insurance and statutory
                  severance pay benefits, and a continuing education fund (as is
                  customary in Israel);

         >>       stock  options,  including  options  issued in exchange  for a
                  waiver  of  salary  under  the  "options-for-salary"   program
                  discussed in more detail below; and

         >>       other  benefits,  primarily  consisting  of  annual  statutory
                  holiday pay.

         The specific  amounts of each form of  compensation  paid to each Named
Executive Officer appear in the summary compensation table and the notes thereto
appearing under "Summary Compensation Table," below.

     Summary Compensation Table

         The  following  table,  which  should be read in  conjunction  with the
explanations  provided above,  shows the compensation that we paid (or accrued),
in  connection  with  services  rendered for 2003,  2002 and 2001,  to our Named
Executive Officers.



                                       76
<PAGE>

                         SUMMARY COMPENSATION TABLE(1)

<TABLE>
<CAPTION>
                                                                       Long Term
                                        Annual Compensation           Compensation                       Compensation
                                   ----------------------------------   ----------      --------------------------------------
                                                                                         Changes in
                                                                                        Accruals for
                                                                                          Sick Days,
                                                                                          Vacation        Payment to
                                                              Tax       Securities       Days, and       Pension and
Name and Principal                                         Reimburse-   Underlying      Termination       Education
    Position                Year    Salary     Bonus          ment       Options        Compensation        Funds      Others
-------------------------   ----   --------   -------      ----------   ----------      ------------     ----------   --------
<S>                         <C>     <C>       <C>          <C>           <C>            <C>              <C>          <C>
Robert S. Ehrlich           2003    259,989   $99,750(2)   $   27,211    2,035,000      $   80,713(3)    $   48,228   $    678
Chairman of the Board,      2002   $202,962   $99,750      $   15,232      262,500(4)   $  170,691(5)    $   22,256   $    654
  President, Chief          2001   $211,644   $84,000      $   17,201      521,000(6)   $  229,800(7)    $   52,841   $ 87,113(8)
  Executive Officer and
  director

Steven Esses
Executive Vice President,   2003   $      0   $     0      $        0   $1,035,000      $        0       $        0   $      0
  Chief Operating Officer   2002   $      0   $     0      $        0            0      $        0       $        0   $120,480(9)
  and director*             2001   $      0   $     0      $        0            0      $        0       $        0   $      0



Avihai Shen
Vice President - Finance    2003   $123,988   $     0      $    8,653      608,750      $    6,471(10)   $   23,133   $    463
  and Chief Financial       2002   $ 93,641   $     0      $   18,857       48,935      $    9,847(11)   $   20,394   $  6,894(12)
  Officer                   2001   $ 82,019   $     0      $    8,804       43,749      $    1,629(13)   $   15,956   $    674
</TABLE>

-------------------------------------
  *  Mr. Esses became an officer in January 2003. His compensation as an officer
     during 2003 consisted  solely of stock options.  Prior to January 2003, Mr.
     Esses was a director  (from  July  2002),  in which  position  he  received
     certain compensation as a consultant,  in addition to the stock options and
     per-meeting  fees payable to directors  generally  (which is not  reflected
     above).

 (1) We paid the  amounts  reported  for each  named  executive  officer in U.S.
     dollars and/or New Israeli Shekels (NIS).  We have translated  amounts paid
     in NIS into U.S.  dollars at the exchange rate of NIS into U.S.  dollars at
     the time of payment or accrual.

 (2) We paid Mr. Ehrlich $67,370 during 2003 in satisfaction of the remainder of
     bonuses  from  2002 to which he was  entitled  according  to his  contract.
     Additionally,  we accrued  $99,750 for Mr. Ehrlich in  satisfaction  of the
     2003 bonus to which he was entitled according to his contract.

 (3) Of this amount, $92,075 represents our accrual for severance pay that would
     be payable to Mr. Ehrlich upon a "change of control" or upon the occurrence
     of certain other events;  $3,451 represents the increase of the accrual for
     sick leave and vacation redeemable by Mr. Ehrlich; and $(14,813) represents
     the decrease of our accrual for  severance pay that would be payable to Mr.
     Ehrlich  under the laws of the State of Israel if we were to terminate  his
     employment.

 (4) Of this amount, 262,500 options were in exchange for a total of $105,000 in
     salary waived by Mr. Ehrlich during 2002 pursuant to the options-for-salary
     program  instituted  by us beginning in May 2001.  See  "Options-for-Salary
     Program," below.

 (5) Of this amount,  $109,935  represents  our accrual for  severance  pay that
     would be payable to Mr.  Ehrlich  upon a "change  of  control"  or upon the
     occurrence of certain other events;  $17,571 represents the increase of the
     accrual for sick leave and vacation redeemable by Mr. Ehrlich;  and $43,725
     represents  the  increase of our accrual  for  severance  pay that would be
     payable to Mr.  Ehrlich under the laws of the State of Israel if we were to
     terminate his employment.

 (6) Of this amount,  80,000  options were in exchange for a total of $32,000 in
     salary waived by Mr. Ehrlich during 2001 pursuant to the options-for-salary
     program  instituted  by us beginning in May 2001.  See  "Options-for-Salary
     Program," below.

 (7) Of this amount,  $172,360  represents  our accrual for  severance  pay that
     would be payable to Mr.  Ehrlich  upon a "change  of  control"  or upon the
     occurrence of certain other events;  $50,548 represents the increase of the
     accrual for sick leave and vacation  redeemable by Mr. Ehrlich;  and $6,892
     represents  the  increase of our accrual  for  severance  pay that would be
     payable to Mr.  Ehrlich under the laws of the State of Israel if we were to
     terminate his employment.

 (8) Of this amount,  $86,434 represents benefit imputed to Mr. Ehrlich upon the
     purchase by us of certain of his shares for treasury,  and $679  represents
     other  benefits that we paid to Mr.  Ehrlich in 2001. See "Item 13. Certain
     Relationships and Related Transactions - Officer Loans," below.



                                       77
<PAGE>

 (9) Represents consulting fees paid in 2002.

(10) Of this amount,  $8,369 represents the increase of the accrual for vacation
     redeemable by Mr. Shen; and $(1,628) represents the decrease of our accrual
     for  severance  pay that would be payable to Mr. Shen under the laws of the
     State of Israel if we were to terminate his employment.

(11) Of this amount,  $1,062 represents the increase of the accrual for vacation
     redeemable by Mr. Shen;  and $8,785  represents the increase of our accrual
     for  severance  pay that would be payable to Mr. Shen under the laws of the
     State of Israel if we were to terminate his employment.

(12) Of this amount, $6,500 represents the value of shares issued to Mr. Shen as
     a stock bonus and $394  represents  other benefits that we paid to Mr. Shen
     in 2002.

(13) Of this  amount,  $(1.099)  represents  the  decrease  of the  accrual  for
     vacation  redeemable by Mr. Shen; and $2,728 represents the increase of our
     accrual for  severance pay that would be payable to Mr. Shen under the laws
     of the State of Israel if we were to terminate his employment.

     Executive Loans

         In  1999,  2000 and  2002,  we  extended  certain  loans  to our  Named
Executive  Officers.  These loans are summarized in the following table, and are
further described under "Item 13. Certain Relationships and Related Transactions
- Officer Loans," below.

<TABLE>
<CAPTION>
                                           Original        Amount
                                           Principal    Outstanding
    Name of Borrower      Date of Loan  Amount of Loan as of 12/31/03                Terms of Loan
    ----------------      ------------  -------------- --------------                -------------
<S>                     <C>             <C>             <C>             <C>
                                                                      Ten-year non-recourse loan to purchase our
                                                                        stock, secured by the shares of stock
Robert S. Ehrlich.......   12/28/99     $    167,975    $    201,570    purchased.

                                                                      Twenty-five-year non-recourse loan to
                                                                        purchase our stock, secured by the
Robert S. Ehrlich.......   02/09/00     $    789,991    $    657,146    shares of stock purchased.

                                                                      Twenty-five-year non-recourse loan to
                                                                        purchase our stock, secured by the
Robert S. Ehrlich.......   10/06/02     $     36,500    $     37,810    shares of stock purchased.
</TABLE>


     Options-for-Salary Program

         Between May 2001 and December 2002, we conducted an  options-for-salary
program  designed to conserve our cash and to offer  incentives  to employees to
remain with us despite lower cash compensation.  Under this program, most of our
salaried  employees  permanently  waived a portion of their salaries in exchange
for options to  purchase  shares of our common  stock,  at a ratio of options to
purchase  2.5  shares  of our stock for each  dollar  in salary  waived.  Social
benefits (such as pension) and contractual  bonuses for such employees continued
to  be   calculated   based  on  their   salaries   prior  to   reduction.   The
options-for-salary program was ended on December 31, 2002.

         During 2001,  options were accrued  quarterly in advance,  but since no
employees  requested the grant of their options  during the third  quarter,  all
grants were deferred to the beginning of the fourth quarter, during the month of
October.  During 2002,  options were accrued  quarterly in advance for the Named
Executive Officers, and annually in advance for other employees.

         During  2001,  in  exchange  for  waiver of  $265,597  in  salary,  our
employees  other than the Named Executive  Officers  received a total of 663,992
options,  which  options were granted  based on the lowest  closing price of our
common stock during the month of October 2001 ($1.30). Named Executive Officers,
in exchange for waiver of $40,699 in salary, received a total of 101,747 options
during 2001,  which options were granted based on the lowest  closing  prices of
our common stock during the month of October 2001  ($1.30),  as set forth in the
table below.



                                       78
<PAGE>

         During  2002,  in  exchange  for  waiver of  $364,209  in  salary,  our
employees  other than the Named Executive  Officers  received a total of 910,522
options,  which  options were granted  based on the lowest  closing price of our
common  stock  during  the  month of  December  2002  ($0.61).  Named  Executive
Officers,  in exchange  for waiver of  $119,774  in salary,  received a total of
299,435  options  during 2002,  which  options were granted  based on the lowest
closing  prices of our common stock during each quarter of 2002, as set forth in
the table below.

         Following is a table setting forth the number of options that we issued
to each of our Named  Executive  Officers under the  options-for-salary  program
during each fiscal quarter in which the program was in effect,  and the range of
trading prices for our common stock during each such fiscal quarter:

<TABLE>
<CAPTION>
                                                                                             Low Trading  High Trading     Closing
                            Fiscal      Amount of      Number of    Number of      Average      Price     Price During      Price
                           Quarter        Salary        Options      Options      Exercise      During       Quarter     on Last Day
Named Executive Officer     Ended         Waived        Accrued       Issued        Price      Quarter                   of Quarter
------------------------ ---------------------------- -------------------------- ---------------------------------------------------
<S>                        <C>          <C>               <C>               <C>                 <C>           <C>           <C>
Robert S. Ehrlich......    06/30/01     $    8,000        20,000            0           -       $2.18         $4.20         $2.54
                           09/30/01     $   12,000        30,000            0           -       $1.10         $3.05         $1.48
                           12/31/01     $   12,000        30,000       80,000       $1.30       $1.30         $2.48         $1.66
                           03/31/02     $   26,250        65,625       65,625       $1.42       $1.35         $2.41         $1.55
                           06/30/02     $   26,250        65,625       65,625       $0.73       $0.73         $1.79         $0.91
                           09/30/02     $   26,250        65,625       65,625       $0.85       $0.79         $1.70         $1.05
                           12/31/02     $   26,250        65,625       65,625       $0.61       $0.61         $1.17         $0.64

Avihai Shen............    06/30/01     $    2,174         5,435            0           -       $2.18         $4.20         $2.54
                           09/30/01     $    3,262         8,153            0           -       $1.10         $3.05         $1.48
                           12/31/01     $    3,262         8,153       21,741       $1.30       $1.30         $2.48         $1.66
                           03/31/02     $    3,262         8,153        8,153       $1.42       $1.35         $2.41         $1.55
                           06/30/02     $    3,262         8,153        8,153       $0.73       $0.73         $1.79         $0.91
                           09/30/02     $    3,262        12,476       12,476       $0.85       $0.79         $1.70         $1.05
                           12/31/02     $    3,262         8,153        8,153       $0.61       $0.61         $1.17         $0.64
</TABLE>


Stock Options

         The table below sets forth  information  with respect to stock  options
granted to the Named Executive Officers for the fiscal year 2003.



                                       79
<PAGE>


                        OPTION GRANTS IN LAST FISCAL YEAR


<TABLE>
<CAPTION>
                             INDIVIDUAL GRANTS
                         ----------------------------
                                        % OF TOTAL                                     POTENTIAL REALIZABLE VALUE
                          NUMBER OF        OPTIONS                                      OF ASSUMED ANNUAL RATES
                          SECURITIES      GRANTED TO      EXERCISE                     OF STOCK PRICE APPRECIATION
                          UNDERLYING     EMPLOYEES         OR BASE                        FOR OPTION TERM(1)
                          OPTIONS        IN FISCAL         PRICE        EXPIRATION    ------------------------------
          NAME            GRANTED          YEAR           ($/SH)          DATE           5% ($)          10% ($)
      ---------------    -----------    -------------    -----------    ----------    -------------    -------------
<S>                           <C>             <C>          <C>           <C> <C>        <C>               <C>
Robert S. Ehrlich.....      1,500,000         27%          $0.46        03/14/08       $   190,634      $   421,252
                              500,000          9%          $0.85        06/26/08       $   111,894      $   247,257
                               35,000          6%          $0.42        01/25/13       $     9,245      $    23,428
Steven Esses..........        600,000         11%          $0.43        02/24/08       $    71,281      $   157,512
                              100,000          2%          $0.85        07/09/13       $    53,456      $   135,468
                              300,000          5%          $1.28        12/31/08       $   106,092      $   234,436
                               35,000          1%          $1.28        01/31/13       $    28,174      $    71,400
Avihai Shen...........        120,000          2%          $0.43        02/24/08       $    14,256     $     31,503
                              120,000          2%          $0.85        07/09/13       $    64,147      $   162,562
                              333,750          6%          $1.28        07/09/13       $   268,664      $   680,847
                               35,000          1%          $0.42        01/25/13       $     9,245      $    23,429
</TABLE>


---------------------------------

(1)      The potential realizable value illustrates value that might be realized
         upon  exercise of the options  immediately  prior to the  expiration of
         their terms, assuming the specified compounded rates of appreciation of
         the  market  price per  share  from the date of grant to the end of the
         option  term.  Actual  gains,  if any,  on stock  option  exercise  are
         dependent upon a number of factors, including the future performance of
         the  common  stock and the timing of option  exercises,  as well as the
         executive  officer's  continued  employment through the vesting period.
         The  gains  shown  are net of the  option  exercise  price,  but do not
         include  deductions  for  taxes  and other  expenses  payable  upon the
         exercise  of the  option  or for sale of  underlying  shares  of common
         stock.  The 5% and 10% rates of appreciation  are mandated by the rules
         of the  Securities  and Exchange  Commission  and do not  represent our
         estimate or projection  of future  increases in the price of our stock.
         There can be no assurance that the amounts reflected in this table will
         be  achieved,   and  unless  the  market  price  of  our  common  stock
         appreciates  over the option term,  no value will be realized  from the
         option grants made to the executive officers.

         The table below sets forth information for the Named Executive Officers
with respect to aggregated  option  exercises during fiscal 2003 and fiscal 2003
year-end option values.

          Aggregated Option Exercises and Fiscal Year-End Option Values

<TABLE>
<CAPTION>
                        Shares                            Number of Securities             Value of Unexercised
                      cquired on         Value           Underlying Unexercised            In-the-Money Options
        Name         A Exercise        Realized        Options at Fiscal Year End          at Fiscal-Year-End(1)
 --------------------------------- ------------------ ------------------------------ ----------------------------------
                                                       Exercisable   Unexercisable     Exercisable     Unexercisable
                                                      -------------- --------------- ---------------- -----------------
<S>                                 <C>                  <C>           <C>            <C>              <C>
Robert S. Ehrlich....         -     $            -       1,905,667     1,000,000      $    1,826,171   $    1,185,000
Steven Esses.........    99,860     $      183,215         416,807       518,333      $      317,362   $      655,733
Avihai Shen..........    75,000     $      143,500         217,304       421,100      $      119,283   $      286,046
</TABLE>


-----------------------------------

(1)  Options that are "in-the-money" are options for which the fair market value
     of the  underlying  securities  on December  31, 2003  ($1.82)  exceeds the
     exercise or base price of the option.

Employment Contracts

         Mr. Ehrlich is party to an employment agreement with us effective as of
January 1, 2000. The term of this employment agreement, as extended,  expires on
December 31, 2005, and is extended  automatically  for  additional  terms of two
years each unless either Mr. Ehrlich or we terminate the agreement sooner.



                                       80
<PAGE>

         The  employment  agreement  provides  for a base  salary of $20,000 per
month, as adjusted annually for Israeli inflation and devaluation of the Israeli
shekel  against  the U.S.  dollar,  if any.  Additionally,  the board may at its
discretion  raise Mr.  Ehrlich's base salary.  In January 2002, the board raised
Mr.  Ehrlich's base salary to $23,750 per month  effective  January 1, 2002; Mr.
Ehrlich has elected to waive this increase in his salary and to receive  options
instead, under our salary for options program.

         The  employment  agreement  provides  that if the  results we  actually
attain  in a given  year are at  least  80% of the  amount  we  budgeted  at the
beginning of the year,  we will pay a bonus,  on a sliding  scale,  in an amount
equal to a minimum of 35% of Mr. Ehrlich's annual base salary then in effect, up
to a maximum of 90% of his annual  base  salary then in effect if the results we
actually  attain  for the year in  question  are 120% or more of the  amount  we
budgeted at the beginning of the year.

         The employment  agreement also contains various  benefits  customary in
Israel for senior executives (please see "Item 1. Business - Employees," above),
tax  and   financial   planning   expenses  and  an   automobile,   and  contain
confidentiality  and  non-competition  covenants.  Pursuant  to  the  employment
agreements,  we granted Mr. Ehrlich demand and "piggyback"  registration  rights
covering shares of our common stock held by him.

         We can terminate  Mr.  Ehrlich's  employment  agreement in the event of
death or  disability or for "Cause"  (defined as  conviction of certain  crimes,
willful  failure  to carry out  directives  of our board of  directors  or gross
negligence or willful  misconduct).  Mr.  Ehrlich has the right to terminate his
employment  upon a change in our control or for "Good  Reason," which is defined
to include adverse changes in employment status or compensation, our insolvency,
material breaches and certain other events. Additionally, Mr. Ehrlich may retire
(after age 68) or terminate  his agreement for any reason upon 150 days' notice.
Upon termination of employment, the employment agreement provides for payment of
all  accrued  and  unpaid  compensation,  and  (unless  we have  terminated  the
agreement for Cause or Mr.  Ehrlich has  terminated  the agreement  without Good
Reason and without  giving us 150 days' notice of  termination)  bonuses due for
the year in which  employment is  terminated  and severance pay in the amount of
three years' base salary (or, in the case of  termination  by Mr. Ehrlich on 150
days' notice,  a lump sum payment of $520,000).  Furthermore,  certain  benefits
will continue and all outstanding options will be fully vested.

         Mr. Esses is not a party to an employment  agreement  with us. Mr. Shen
has signed our standard employee employment agreement, described below.

         Other  employees  (including  Mr. Shen) have  entered  into  individual
employment  agreements with us. These  agreements  govern the basic terms of the
individual's  employment,  such as salary,  vacation,  overtime  pay,  severance
arrangements  and  pension  plans.  Subject to Israeli  law,  which  restricts a
company's  right to  relocate  an  employee  to a work site  farther  than sixty
kilometers  from his or her regular  work site,  we have  retained  the right to
transfer certain  employees to other locations  and/or  positions  provided that
such  transfers do not result in a decrease in salary or benefits.  All of these
agreements also contain provisions  governing the confidentiality of information
and ownership of intellectual  property  learned or created during the course of
the employee's  tenure with us. Under the terms of these  provisions,  employees
must keep  confidential  all  information  regarding our operations  (other than
information  which is already  publicly  available)  received  or learned by the
employee  during the course of employment.  This provision  remains in force for
five  years  after the  employee  has left our  service.  Further,  intellectual
property created during the course of the employment relationship belongs to us.



                                       81
<PAGE>

         A number of the individual employment agreements,  but not all, contain
non-competition  provisions  which  restrict  the  employee's  rights to compete
against us or work for an enterprise  which competes against us. Such provisions
remain  in force  for a period of two  years  after  the  employee  has left our
service.

         Under the laws of Israel,  an employee  of ours who has been  dismissed
from service,  died in service,  retired from service upon attaining  retirement
age, or left due to poor health, maternity or certain other reasons, is entitled
to severance pay at the rate of one month's salary for each year of service.  We
currently fund this  obligation by making monthly  payments to approved  private
provident  funds  and by  its  accrual  for  severance  pay in the  consolidated
financial  statements.  See Note 2.r of the Notes to the Consolidated  Financial
Statements.

Compensation Committee Interlocks and Insider Participation

         The  Compensation  Committee  of our  board of  directors  for the 2003
fiscal year consisted until May 8, 2003 of Dr. Jay M. Eastman, Jack E. Rosenfeld
and Lawrence M. Miller;  thereafter, the Compensation Committee consisted of Dr.
Jay M. Eastman, Jack E. Rosenfeld and Bert W. Wasserman. None of the members has
served as our officers or employees.

         Robert S. Ehrlich, our Chairman and Chief Financial Officer,  serves as
Chairman and a director of PSCX,  for which Dr.  Eastman  serves as director and
member of the Executive  and Strategic  Planning  Committees  and Mr.  Rosenfeld
serves as director and member of the Executive Compensation Committees.

ITEM 12.  SECURITY  OWNERSHIP OF CERTAIN  BENEFICIAL  OWNERS AND  MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

Security Ownership of Certain Beneficial Owners and Management

         The  following  table sets forth  information  regarding  the  security
ownership,  as of March 23, 2004, of those persons  owning of record or known by
us to own beneficially more than 5% of our common stock and of each of our Named
Executive Officers and directors,  and the shares of common stock held by all of
our directors and executive officers as a group.

<TABLE>
<CAPTION>
                                                                                            Percentage of Total
        Name and Address of Beneficial Owner(1)          Shares Beneficially Owned(2)(3)   Shares Outstanding(3)
        ---------------------------------------          -------------------------------   ---------------------
<S>                                                               <C>                             <C>
Leon S. Gross...........................................          3,482,534(4)(13)                5.6%
Robert S. Ehrlich.......................................          2,284,213(5)(13)                3.6%
Steven Esses............................................            663,475(6)                    1.1%
Avihai Shen.............................................            267,804(7)                     *
Dr. Jay M. Eastman......................................             85,001(8)                     *
Jack E. Rosenfeld.......................................             87,001(9)                     *
Lawrence M. Miller......................................            539,080(10)                    *
Bert W. Wasserman.......................................              8,334(11)                    *
Edward J. Borey.........................................             40,334(12)                    *
All of our directors and executive officers as a group
(10 persons**)..........................................          7,519,535(14)                  11.5%
</TABLE>




                                       82
<PAGE>

------------------------------------

*        Less than one percent.

**       Includes  3,482,534  shares owned by Mr. Leon Gross that are subject to
         the Voting  Rights  Agreement  described  in footnote  9,  below.  Also
         includes  508,924  shares held of record by Mr.  Yehuda Harats that are
         subject to the Voting Rights Agreement described in footnote 9, below.

(1)      The address of each named  beneficial owner other than Leon Gross is in
         care of Arotech Corporation, 632 Broadway, New York, New York 10012.

(2)      Unless otherwise  indicated in these footnotes,  each of the persons or
         entities named in the table has sole voting and sole  investment  power
         with respect to all shares shown as beneficially  owned by that person,
         subject to applicable community property laws.

(3)      For purposes of determining  beneficial  ownership of our common stock,
         owners of options  exercisable  within sixty days are  considered to be
         the  beneficial  owners of the  shares of common  stock for which  such
         securities are exercisable. The percentage ownership of the outstanding
         common  stock  reported  herein is based on the  assumption  (expressly
         required  by the  applicable  rules  of  the  Securities  and  Exchange
         Commission)  that only the person whose ownership is being reported has
         converted his options into shares of common stock.

(4)      Includes 447,165 shares held by Leon S. Gross and Lawrence M. Miller as
         co-trustees  of the  Rose  Gross  Charitable  Foundation.  Mr.  Gross's
         address is c/o Enterprises  Inc., River Park House,  3600  Conshohocken
         Avenue, Philadelphia, Pennsylvania 19131.

(5)      Includes 50,000 shares held by Mr.  Ehrlich's wife (in which shares Mr.
         Ehrlich  disclaims  beneficial  ownership),  161,381 shares held in Mr.
         Ehrlich's  pension plan, 3,000 shares held by children sharing the same
         household (in which shares Mr. Ehrlich disclaims beneficial ownership),
         and 1,905,667  shares  issuable  upon  exercise of options  exercisable
         within 60 days.

(6)      Consists  of  663,475   shares   issuable   upon  exercise  of  options
         exercisable within 60 days.

(7)      Includes  257,304 shares issuable upon exercise of options  exercisable
         within 60 days.

(8)      Consists of 85,001 shares issuable upon exercise of options exercisable
         within 60 days.

(9)      Includes  85,001 shares  issuable upon exercise of options  exercisable
         within 60 days.

(10)     Includes 447,165 shares held by Leon S. Gross and Lawrence M. Miller as
         co-trustees of the Rose Gross Charitable Foundation,  and 80,001 shares
         issuable upon exercise of options exercisable within 60 days.

(11)     Consists of 8,334 shares issuable upon exercise of options  exercisable
         within 60 days.

(12)     Includes  8,334 shares  issuable upon  exercise of options  exercisable
         within 60 days.

(13)     Messrs.  Ehrlich,  Leon Gross and Yehuda Harats are parties to a Voting
         Rights  Agreement  pursuant to which each of the parties agrees to vote
         the  shares of our  common  stock  held by that  person in favor of the
         election  of Messrs.  Ehrlich,  Harats and Miller  until the earlier of
         December 28, 2004 or our fifth  annual  meeting of  stockholders  after
         December 28, 1999. Mr. Harats resigned as a director in 2002;  however,
         we believe  that Mr.  Harats must  continue to comply with the terms of
         this agreement. As of February 19, 2004, 4,370,004 shares of our common
         stock were subject to this Voting Rights Agreement.

(14)     Includes 3,093,117 shares issuable upon exercise of options exercisable
         within 60 days.



                                       83
<PAGE>

Securities Authorized for Issuance Under Equity Compensation Plans

         The following table sets forth certain information,  as of December 31,
2003, with respect to our 1991,  1993, 1995 and 1998 stock option plans, as well
as any other  stock  options and  warrants  previously  issued by us  (including
individual compensation arrangements) as compensation for goods and services:

                      Equity Compensation Plan Information

<TABLE>
<CAPTION>
                                                                                       Number of securities
                                                                                       remaining available
                                                                                       for future issuance
                              Number of securities                                         under equity
                                to be issued upon            Weighted-average           compensation plans
                                   exercise of              exercise price of         (excluding securities
                              outstanding options,         outstanding options,        reflected in column
                               warrants and rights         warrants and rights                 (a))
       Plan Category                    (a)(1)                     (b)                          (c)(1)
---------------------------- ------------------------     -----------------------     -----------------------
<S>                                   <C>                          <C>                         <C>
Equity compensation
  plans approved by
  security holders.....               6,150,677                    $1.38                       (352,708)
Equity compensation
  plans not approved
  by security
  holders(2)(3)........               3,481,236                    $1.65                       (299,374)
</TABLE>


-------------------------------------

(1)      Numbers in  parenthesis in column (c), which are included in the number
         in column (a),  indicate options that have been  conditionally  granted
         pending  expansion  of  certain of our stock  option  plans at our next
         annual meeting of stockholders.

(2)      In October 1998, the Board of Directors adopted the 1998  Non-Executive
         Stock Option and Restricted  Stock Purchase Plan,  which under Delaware
         law did not require shareholder  approval since directors and executive
         officers were  ineligible to  participate in it.  Participation  in the
         1998 Plan is limited to those of our employees and  consultants who are
         neither  executive  officers nor otherwise subject to Section 16 of the
         Securities  Exchange Act of 1934, as amended,  or Section 162(m) of the
         Internal   Revenue  Code  of  1986,  as  amended.   The  1998  Plan  is
         administered by the  Compensation  Committee of our Board of Directors,
         which determined the conditions of grant. Options issued under the 1998
         Plan  generally  expire no more than ten years  from the date of grant,
         and incentive options issued under the 1998 Plan may be granted only at
         exercise  prices  equal to the fair market value of our common stock on
         the date the  option is  granted.  A total of  4,750,000  shares of our
         common  stock  were  originally  subject  to the  1998  Plan,  of which
         3,181,862   options  are  outstanding,   1,568,138  options  have  been
         exercised,  and 299,374 options have been conditionally granted pending
         expansion  of this  stock  option  plan at our next  annual  meeting of
         stockholders.

(3)      For a  description  of the  material  features of grants of options and
         warrants  other than options  granted  under our employee  stock option
         plans,  please  see  Note  11.g.2  of the  Notes  to  the  Consolidated
         Financial Statements.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Voting Agreements



                                       84
<PAGE>

         Pursuant to a securities  purchase  agreement  dated  December 28, 1999
between a group of  purchasers,  including Mr.  Gross,  and us, Mr. Gross agreed
that for a period of five years,  neither he nor his  "affiliates" (as such term
is defined in the Securities Act) directly or indirectly or in conjunction  with
or  through  any  "associate"  (as such  term is  defined  in Rule  12b-2 of the
Exchange  Act),  will (i) solicit  proxies with respect to any capital  stock or
other  voting  securities  of  ours  under  any   circumstances,   or  become  a
"participant"  in  any  "election  contest"  relating  to  the  election  of our
directors  (as such  terms  are used in Rule  14a-11  of  Regulation  14A of the
Exchange Act);  (ii) make an offer for the acquisition of  substantially  all of
our assets or capital stock or induce or assist any other person to make such an
offer; or (iii) form or join any "group" within the meaning of Section  13(d)(3)
of the  Exchange  Act with  respect to any of our capital  stock or other voting
securities for the purpose of  accomplishing  the actions referred to in clauses
(i) and (ii) above, other than pursuant to the voting rights agreement described
below.

         Pursuant to a voting rights  agreement  dated September 30, 1996 and as
amended  December 10, 1997 and December 28, 1999,  between Mr. Gross,  Robert S.
Ehrlich,  Yehuda Harats and us,  Lawrence M. Miller,  Mr.  Gross's  advisor,  is
entitled  to be  nominated  to serve on our  board of  directors  so long as Mr.
Gross, his heirs or assigns retain at least 1,375,000 shares of common stock. In
addition,  under the voting rights agreement,  Mr. Gross and Messrs. Ehrlich and
Harats  agreed to vote and take all  necessary  action so that Messrs.  Ehrlich,
Harats and Miller  shall  serve as members of the board of  directors  until the
earlier of December 28, 2004 or our fifth annual meeting of  stockholders  after
December  28,  1999.  Mr.  Harats  resigned as a director in 2002;  however,  we
believe  that  Mr.  Harats  must  continue  to  comply  with  the  terms of this
agreement.  As of February 19, 2004,  4,370,004  shares of our common stock were
subject to this Voting Rights Agreement.

Officer Loans

         On December 3, 1999,  Robert S. Ehrlich purchased 125,000 shares of our
common  stock out of our  treasury at the closing  price of the common  stock on
December  2,  1999.  Payment  was  rendered  by  Mr.  Ehrlich  in  the  form  of
non-recourse  promissory  notes  due in 2009 in the  amount  of  $167,975  each,
secured by the shares of common stock purchased and other shares of common stock
previously  held  by  him.  As  of  December  31,  2003,  the  aggregate  amount
outstanding pursuant to this promissory note was $201,570.

         On February 9, 2000, Mr. Ehrlich exercised  131,665 stock options.  Mr.
Ehrlich  and Harats  paid the  exercise  price of the stock  options and certain
taxes that we paid on his behalf by giving us a non-recourse promissory note due
in 2025 in the amount of  $789,991,  secured  by the shares of our common  stock
acquired through the exercise of the options and certain compensation due to Mr.
Ehrlich  upon  termination.  As of  December  31,  2003,  the  aggregate  amount
outstanding pursuant to this promissory note was $657,146.

         On June 10, 2002,  Mr.  Ehrlich  exercised  50,000 stock  options.  Mr.
Ehrlich paid the exercise price of the stock options by giving us a non-recourse
promissory  note due in 2012 in the amount of $36,500,  secured by the shares of
our common stock  acquired  through the exercise of the options.  As of December
31, 2003, the aggregate amount outstanding  pursuant to this promissory note was
$37,810.



                                       85
<PAGE>

Director Consulting Agreements

         Beginning in February  2002,  Mr. Steven  Esses,  who became one of our
directors in July 2002,  entered into an oral  consulting  arrangement  with us,
whereby he performed periodic financial and other consulting for us. We paid Mr.
Esses a total of $120,480 in  consulting  fees in 2002.  Beginning in July 2002,
when Mr. Esses became a director, this consulting arrangement ceased.

         Beginning in January 2004,  Mr. Edward J. Borey,  who became one of our
directors in December 2003, entered into a consulting agreement with us pursuant
to which he agreed to aid us in identifying potential acquisition  candidates in
exchange for  transaction  fees in respect of  acquisitions  in which he plays a
"critical  role" (as  determined by us in our sole and absolute  discretion)  in
identifying  and/or initiating and/or  negotiating the transaction in the amount
of (i) 1.5% of the value of the transaction up to $10,000,000, plus (ii) 1.0% of
the value of the  transaction  in excess of $10,000,000  and up to  $50,000,000,
plus (iii) 0.5% of the value of the  transaction  in excess of  $50,000,000.  We
also agreed to issue to Mr. Borey, at par value, a total of 32,000 shares of our
common  stock,  the value of which is to be deducted from any  transaction  fees
paid.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

         In accordance with the requirements of the  Sarbanes-Oxley  Act of 2002
and the Audit  Committee's  charter,  all audit and  audit-related  work and all
non-audit work performed by our independent  accountants,  Kost, Forer, Gabbay &
Kassierer, is approved in advance by the Audit Committee, including the proposed
fees for such work.  The Audit  Committee is informed of each  service  actually
rendered.

         >>       Audit  Fees.  Audit fees billed or expected to be billed to us
                  by  Kost,  Forer,  Gabbay  &  Kassierer  for the  audit of the
                  financial  statements  included  in our Annual  Report on Form
                  10-K, and reviews of the financial  statements included in our
                  Quarterly  Reports on Form 10-Q,  for the years ended December
                  31, 2002 and 2003 totaled approximately $151,375 and $177,000,
                  respectively.

         >>       Audit-Related  Fees. Kost, Forer, Gabbay & Kassierer billed us
                  $383 and $34,500 for the fiscal years ended  December 31, 2002
                  and 2003,  respectively,  for assurance  and related  services
                  that are reasonably related to the performance of the audit or
                  review of our financial  statements and are not reported under
                  the caption "Audit Fees," above.

         >>       Tax  Fees.  Kost,  Forer,  Gabbay  &  Kassierer  billed  us an
                  aggregate  of $12,000 and  $24,320 for the fiscal  years ended
                  December 31, 2002 and 2003,  respectively,  for tax  services,
                  principally  advice  regarding the  preparation  of income tax
                  returns.

         >>       Other Matters.  The Audit  Committee of the Board of Directors
                  has  considered  whether the  provision  of the  Audit-Related
                  Fees,  Tax  Fees  and  all  other  fees  are  compatible  with
                  maintaining the independence of our principal accountant.



                                       86
<PAGE>

         Applicable  law and  regulations  provide  an  exemption  that  permits
certain  services to be provided  by our outside  auditors  even if they are not
pre-approved.  We have  not  relied  on this  exemption  at any time  since  the
Sarbanes-Oxley Act was enacted.



                                       87
<PAGE>

                                     PART IV

ITEM 15.       EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)  The following documents are filed as part of this report:

     (1)  Financial  Statements - See Index to Financial  Statements  on page 66
          above.

     (2)  Financial   Statements   Schedules  -  Schedule  II  -  Valuation  and
          Qualifying  Accounts.  All schedules other than those listed above are
          omitted  because of the  absence of  conditions  under  which they are
          required or because  the  required  information  is  presented  in the
          financial statements or related notes thereto.

     (3)  Exhibits - The  following  Exhibits are either filed  herewith or have
          previously been filed with the Securities and Exchange  Commission and
          are referred to and incorporated herein by reference to such filings:

  Exhibit No.                         Description
  -----------                         -----------

   (8)3.1        Amended and Restated Certificate of Incorporation

  (15)3.1.1      Amendment to our Amended and Restated Certificate of
                 Incorporation

  (24)3.1.2      Amendment to our Amended and Restated Certificate of
                 Incorporation

    **3.1.3      Amendment to our Amended and Restated Certificate of
                 Incorporation

   (2)3.2        Amended and Restated By-Laws

   (1)4          Specimen Certificate for shares of common stock, $.01 par
                 value

 + (6)10.6       Amended and Restated 1993 Stock Option and Restricted Stock
                 Purchase Plan dated  November 11, 1996

 + (1)10.7.1     Form of Management Employment Agreements

+ *   10.7.2     General Employee Agreements
   (1)

 * (1)10.8       Office of Chief Scientist documents

   (2)10.8.1     Letter from the Office of Chief Scientist to us dated January
                 4, 1995

 + (3)10.12      Amended and Restated 1995 Non-Employee Director Stock Option
                 Plan

   (4)10.14      Stock Purchase Agreement between us and Leon S. Gross ("Gross")
                 dated September 30, 1996

   (4)10.15      Registration  Rights  Agreement  between  us  and  Gross  dated
                 September 30, 1996

   (4)10.16      Voting Rights  Agreement  between us, Gross,  Robert S. Ehrlich
                 and Yehuda Harats dated September 30, 1996

 + (5)10.20      Amended and Restated  Employment  Agreement dated as of October
                 1, 1996 between us, EFL and Robert S. Ehrlich

+ (15)10.20.1    Second Amended and Restated Employment Agreement,  effective as
                 of January 1, 2000 between us, EFL and Robert S. Ehrlich

+ (15)10.20.2    Letter dated January 12, 2001  amending the Second  Amended and
                 Restated Employment Agreement,  effective as of January 1, 2000
                 between us, EFL and Robert S. Ehrlich

   (6)10.25      Amendment  No. 1 to the Voting  Rights  Agreement  between  us,
                 Gross, Robert S. Ehrlich,  and Yehuda Harats dated December 10,
                 1997


                                      -88-
<PAGE>

  Exhibit No.                         Description
  -----------                         -----------

   (6)10.26      Amendment No. 2 to the Registration  Rights  Agreement  between
                 us, Gross,  Robert S. Ehrlich and Yehuda Harats dated  December
                 10, 1997

   (7)10.27      1998  Non-Executive  Stock Option and Restricted Stock Purchase
                 Plan

  (10)10.31      Form of Warrant dated December 28, 1999

  (10)10.32      Amendment No. 1 to Voting Rights  Agreement  dated December 28,
                 1999,  by and between us,  Leon S.  Gross,  Robert S.  Ehrlich,
                 Yehuda  Harats  and the  Purchasers  listed on Exhibit A to the
                 Securities Purchase Agreement dated December 28, 1999

  (12)10.35.1    Promissory  Note dated January 3, 1993,  from Robert S. Ehrlich
                 to us

  (12)10.35.2    Amendment dated April 1, 1998, to Promissory Note dated January
                 3, 1993 between Robert S. Ehrlich and us

  (12)10.37      Promissory  Note dated December 3, 1999, from Robert S. Ehrlich
                 to us

  (12)10.39      Promissory  Note dated February 9, 2000, from Robert S. Ehrlich
                 to us

  (14)10.48      Series A Stock  Purchase  Warrant  issued to  Capital  Ventures
                 International dated November 17, 2000

  (14)10.49      Series B Stock  Purchase  Warrant  issued to  Capital  Ventures
                 International dated November 17, 2000

  (14)10.50      Stock  Purchase  Warrant issued to Josephthal & Co., Inc. dated
                 November 17, 2000

  (15)10.52      Promissory  Note dated January 12, 2001, from Robert S. Ehrlich
                 to us

  (15)10.54      Agreement of Lease dated  December 5, 2000 between us as tenant
                 and Renaissance 632 Broadway LLC as landlord

  (16)10.55      Series C Stock  Purchase  Warrant  issued to  Capital  Ventures
                 International dated May 3, 2001

  (17)10.56      Form of Common Stock Purchase Warrant dated May 8, 2001

  (23)10.63      Securities  Purchase  Agreement dated December 31, 2002 between
                 us and the Investors

  (23)10.64      Form of 9% Secured Convertible Debenture due June 30, 2005

  (23)10.65      Form of Warrant dated December 31, 2002

  (23)10.66      Form of Security Agreement dated December 31, 2002

  (23)10.67      Form of Intellectual Property Security Agreement dated December
                 31, 2002

 +(24)10.68      Settlement  Agreement and Release  between us and Yehuda Harats
                 dated December 31, 2002

  (24)10.69.1    Commercial lease agreement  between Commerce Square  Associates
                 L.L.C. and I.E.S.  Electronics  Industries  U.S.A.,  Inc. dated
                 September 24, 1997

  (24)10.69.2    Amendment to Commercial lease agreement between Commerce Square
                 Associates  L.L.C. and I.E.S.  Electronics  Industries  U.S.A.,
                 Inc. dated as of May 1, 2000

  (24)10.70      Agreement of Lease dated  December 6, 2000 between Janet Nissim
                 et al. and M.D.T.  Protection  (2000) Ltd.  [English summary of
                 Hebrew original]

  (24)10.71      Agreement of Lease dated August 22, 2001 between Aviod Building
                 and  Earthworks  Company  Ltd.  et al.  and  M.D.T.  Protective
                 Industries Ltd. [English summary of Hebrew original]


                                      -89-
<PAGE>

  Exhibit No.                         Description
  -----------                         -----------

    **10.72      Promissory Note dated July 1, 2002 from Robert S. Ehrlich to us

  (25)10.73      Securities  Purchase Agreement dated September 30, 2003 between
                 us and the Investors named therein

  (25)10.74      Form of 8% Secured Convertible Debenture due September 30, 2006

  (25)10.75      Form of Warrant dated September 30, 2003

  (25)10.76      Form of Security Agreement dated September 30, 2003

  (25)10.77      Form  of  Intellectual   Property   Security   Agreement  dated
                 September 30, 2003

  (26)1010.78    Form of Amendment  and Exercise  Agreement  dated  December 10,
                 2003

  (26)10.79      Form of Supplemental Warrant dated December 18, 2003

  (27)10.80      Stock Purchase and Sale Agreement dated January 7, 2004 between
                 us and the shareholders of FAAC Incorporated

  (27)10.81      Securities  Purchase Agreement dated January 7, 2004 between us
                 and the Investors named therein

  (27)10.82      Registration  Rights Agreement dated January 7, 2004 between us
                 and the Investors named therein

  (27)10.83      Form of Warrant dated January __, 2004

  (28)10.84      Share Purchase  Agreement dated January __, 2004 between us and
                 the shareholders of Epsilor Electronics Industries, Ltd.

  (28)10.85      Management  Agreement  dated  January __, 2004 among us, Office
                 Line Ltd. and Hezy Aspis

 *(29)10.86      Settlement   Agreement   between  us  and  I.E.S.   Electronics
                 Industries, Ltd. dated February 4, 2004

   +**10.86      Consulting  agreement  dated  January  1, 2004  between  us and
                 Edward J. Borey

    **10.87      Lease dated April 8, 1997,  between AMR  Holdings,  L.L.C.  and
                 FAAC Incorporated

    **10.88      Lease dated as of March 22, 2004  between us and Fisk  Building
                 Associates L.L.C.

    **14         Code of Ethics

    **21         List of Subsidiaries of the Registrant

    **23         Consent of Kost, Forer, Gabbay & Kassierer

    **31.1       Certification  of  Principal   Executive  Officer  pursuant  to
                 Section 302 of the Sarbanes-Oxley Act of 2002

    **31.2       Certification  of  Principal   Financial  Officer  pursuant  to
                 Section 302 of the Sarbanes-Oxley Act of 2002

    **32.1       Certification  of Principal  Executive  Officer  pursuant to 18
                 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the
                 Sarbanes-Oxley Act of 2002

    **32.2       Certification  of Principal  Financial  Officer  pursuant to 18
                 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the
                 Sarbanes-Oxley Act of 2002

----------
 * English translation or summary from original Hebrew
** Filed herewith
 + Includes management contracts and compensation plans and arrangements


                                      -90-
<PAGE>

(1)      Incorporated  by  reference to our  Registration  Statement on Form S-1
         (Registration  No.  33-73256),  which became  effective on February 23,
         1994

(2)      Incorporated  by  reference to our  Registration  Statement on Form S-1
         (Registration No. 33-97944), which became effective on February 5, 1996

(3)      Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 1995

(4)      Incorporated  by  reference  to our  Current  Report  on Form 8-K dated
         October 4, 1996

(5)      Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 1996, as amended

(6)      Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 1997, as amended

(7)      Incorporated  by  reference to our  Registration  Statement on Form S-8
         (Registration No. 333- 74197), which became effective on March 10, 1998

(8)      Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 1998

(9)      [Intentionally omitted]

(10)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         January 7, 2000

(11)     [Intentionally omitted]

(12)     Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 1999

(13)     [Intentionally omitted]

(14)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         November 17, 2000

(15)     Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 2000

(16)     Incorporated  by reference to our Current  Report on Form 8-K filed May
         7, 2001 (EDGAR Film No. 1623996)

(17)     Incorporated  by reference to our Current  Report on Form 8-K filed May
         7, 2001 (EDGAR Film No. 1623989)

(18)     [Intentionally omitted]

(19)     [Intentionally omitted]

(20)     [Intentionally omitted]

(21)     [Intentionally omitted]

(22)     [Intentionally omitted]

(23)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         January 6, 2003

(24)     Incorporated  by  reference  to our Annual  Report on Form 10-K for the
         year ended December 31, 2002

(25)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         October 3, 2003

(26)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         December 23, 2003

(27)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         January 9, 2004

(28)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         February 4, 2004

(29)     Incorporated  by  reference  to our  Current  Report  on Form 8-K filed
         February 5, 2004 (b) Reports on Form 8-K.

The following  reports on Form 8-K were filed during the fourth  quarter of 2003
and thereafter:

<TABLE>
<CAPTION>
        Date Filed                                             Item Reported
        ----------                                             -------------

<S>                       <C>
                            Item 5 - Other Events and Regulation FD Disclosure;  and Item 7 - Financial Statements,
October 3, 2003...........  Pro Forma Financial Information and Exhibits

                            Item 7 - Financial Statements,  Pro Forma Financial Information and Exhibits;  and Item
November 3, 2003..........  12 - Results of Operations and Financial Condition

                            Item 5 - Other Events and Regulation FD Disclosure;  and Item 7 - Financial Statements,
December 23, 2003.........  Pro Forma Financial Information and Exhibits

                            Item 2 -  Acquisition  or  Disposition  of Assets;  5 - Other Events and  Regulation FD
                            Disclosure;  and Item 7 - Financial  Statements,  Pro Forma Financial Information and
January 9, 2004...........  Exhibits

                            Item 7 - Financial Statements,  Pro Forma Financial Information and Exhibits;  and Item
January 15, 2004..........  12 - Results of Operations and Financial Condition
</TABLE>


                                       91
<PAGE>


<TABLE>
<S>                       <C>
                            Item 5 - Other Events and Regulation FD Disclosure;  and Item 7 - Financial Statements,
January 21, 2004..........  Pro Forma Financial Information and Exhibits

                            Item 2 - Acquisition or Disposition of Assets; and Item 7 - Financial  Statements,  Pro
February 4, 2004..........  Forma Financial Information and Exhibits

                            Item 5 - Other Events and Regulation FD Disclosure;  and Item 7 - Financial Statements,
February 5, 2004..........  Pro Forma Financial Information and Exhibits

March 9, 2004.............  Item 7 -Financial Statements, Pro Forma Financial Information and Exhibits (amendment)

                            Item 5 - Other Events and Regulation FD Disclosure;  and Item 7 - Financial Statements,
March 9, 2004.............  Pro Forma Financial Information and Exhibits
</TABLE>




                                       92
<PAGE>


                                   SIGNATURES

         Pursuant to the  requirements  of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 30 , 2004.

                                        AROTECH CORPORATION

                                        By: /s/  Robert S. Ehrlich
                                            Name: Robert S. Ehrlich
                                            Title: Chairman, President and Chief
                                                   Executive Officer

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

<TABLE>
<CAPTION>
               Signature                                       Title                                   Date
               ---------                                       -----                                   ----
<S>                                     <C>                                                     <C>
                                           Chairman, President, Chief Executive Officer and
          /s/ Robert S. Ehrlich                               Director
          -----------------------------
          Robert S. Ehrlich                         (Principal Executive Officer)                March   30  , 2004

          /s/ Avihai Shen                             Vice President - Finance
          ------------------------------
              Avihai Shen                           (Principal Financial Officer)                March   30  , 2004

           /s/ Danny Waldner                         Controller
          ------------------------------
          Danny Waldner                             (Principal Accounting Officer)               March   30  , 2004

           /s/ Steven                   Esses Executive Vice President, Chief Operating Officer
          ------------------------------
           Steven Esses                                   and Director                           March   30  , 2004

           /s/ Jay M. Eastman
          ------------------------------
           Dr. Jay M. Eastman                                Director                            March   30  , 2004

           /s/ Lawrence M. Miller
          ------------------------------
           Lawrence M. Miller                                Director                            March   30  , 2004

           /s/ Jack E. Rosenfeld
          ------------------------------
           Jack E. Rosenfeld                                 Director                            March   30  , 2004

          /s/ Bert W. Wasserman
          ------------------------------
          Bert W. Wasserman                                  Director                            March   30  , 2004

          /s/ Edward J. Borey
          ------------------------------
          Edward J. Borey                                    Director                            March   21  , 2004
</TABLE>



<PAGE>



                 ELECTRIC FUEL CORPORATION AND ITS SUBSIDIARIES


                    AROTECH CORPORATION AND ITS SUBSIDIARIES
                        CONSOLIDATED FINANCIAL STATEMENTS
                             AS OF DECEMBER 31, 2003
                                 IN U.S. DOLLARS
                                      INDEX

                                                               Page
                                                           -------------
Report of Independent Auditors                                      2
Consolidated Balance Sheets                                     3 - 4
Consolidated Statements of Operations                               5
Statements of Changes in Shareholders' Equity                   6 - 8
Consolidated Statements of Cash Flows                          9 - 11
Notes to Consolidated Financial Statements                    12 - 47



<PAGE>

                         REPORT OF INDEPENDENT AUDITORS

                             To the Shareholders of

                               AROTECH CORPORATION

     We have audited the  accompanying  consolidated  balance  sheets of Arotech
Corporation  (formerly known as Electric Fuel  Corporation)  (the "Company") and
its subsidiaries as of December 31, 2003 and 2002, and the related  consolidated
statements of  operations,  changes in  shareholders'  equity and cash flows for
each of the three years in the period ended  December 31, 2003.  Our audits also
included  the  financial  statement  schedule  listed  in Item  15(a)(2)  of the
Company's 10-K. These financial  statements and schedule are the  responsibility
of the  Company's  management.  Our  responsibility  is to express an opinion on
these financial statements and schedule based on our audits.

     We conducted our audits in accordance  with  auditing  standards  generally
accepted in the United States.  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  referred to above
present fairly, in all material respects, the consolidated financial position of
the  Company and its  subsidiaries  as of  December  31, 2003 and 2002,  and the
consolidated  results of their  operations  and cash flows for each of the three
years in the period ended  December  31, 2003,  in  conformity  with  accounting
principles generally accepted in the United States. Additionally, in our opinion
the related  financial  statement  schedule,  when considered in relation to the
basic financial  statements and schedule taken as a whole, present fairly in all
material respects the information set forth therein.

Tel Aviv, Israel                            KOST, FORER, GABBAY & KASSIERER
March 9, 2004                               A Member of Ernst & Young Global



                                      F-2
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------
In U.S. dollars


<TABLE>
                                                                                              December 31,
                                                                                -----------------------------------------
                                                                                      2003                   2002
                                                                                ------------------     ------------------
         ASSETS
CURRENT ASSETS:
<S>                                                                              <C>                    <C>
     Cash and cash equivalents                                                   $    13,685,125        $    1,457,526
      Restricted collateral deposit and other restricted cash                            706,180               633,339
      Trade receivables (net of allowance for doubtful accounts in the
        amounts of $61,282 and $40,636 as of December 31, 2003 and 2002,
        respectively)                                                                  4,706,423             3,776,195
     Other accounts receivable and prepaid expenses                                    1,187,371             1,032,311
     Inventories                                                                       1,914,748             1,711,479
     Assets of discontinued operations                                                    66,068               349,774
                                                                                ------------------     ------------------

Total current assets                                                                  22,265,915             8,960,624
                                                                                ------------------     ------------------

SEVERANCE PAY FUND                                                                     1,023,342             1,025,071

PROPERTY AND EQUIPMENT, NET                                                            2,292,741             2,555,249

GOODWILL                                                                               5,064,555             4,954,981

OTHER Intangible Assets, NET                                                           2,375,195             2,567,457
                                                                                ------------------     ------------------

                                                                                 $    33,021,748        $   20,063,382
                                                                                ==================     ==================
</TABLE>


        The accompanying notes are an integral part of the consolidated
                             financial statements.


                                      F-3
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------
In U.S. dollars

<TABLE>
<CAPTION>
                                                                                              December 31,

                                                                                ------------------------------------------
                                                                                       2003                   2002
                                                                                -------------------     ------------------
         LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
<S>                                                                              <C>                     <C>
     Short term bank loans                                                       $        40,849         $      108,659
     Trade payables                                                                    1,967,448              2,900,117
     Other accounts payable and accrued expenses                                       4,321,347              2,009,109
     Current portion of promissory note                                                  150,000              1,200,000
     Liabilities of discontinued operations                                              380,108              1,053,798
                                                                                -------------------     ------------------

Total current liabilities                                                              6,859,752              7,271,683

LONG TERM LIABILITIES
     Accrued severance pay                                                             2,814,492              2,994,233
     Convertible debenture                                                               881,944                      -
     Deferred warranty revenue                                                           220,143                      -
     Promissory note                                                                     150,000                516,793
                                                                                -------------------     ------------------

Total long-term liabilities                                                            4,066,579              3,511,026

COMMITMENTS AND CONTINGENT LIABILITIES

MINORITY INTEREST                                                                         51,290                243,172

SHAREHOLDERS' EQUITY:
     Share capital -

     Common stock - $0.01 par value each;
         Authorized: 100,000,000 shares as of December 31, 2002 and 2001;
           Issued: 47,972,407 shares and 35,701,594 shares as of December 31,
           2003 and 2002, respectively; Outstanding - 47,417,074 shares and
           35,146,261 shares as of December 31, 2003 and 2002, respectively              479,726                357,017
     Preferred shares - $0.01 par value each;
         Authorized: 1,000,000 shares as of December 31, 2003 and 2002; No
           shares issued and outstanding as of December 31, 2003 and 2002                                             -
     Additional paid-in capital                                                      135,891,316            114,082,584
     Accumulated deficit                                                            (109,681,893)          (100,673,619)
     Deferred stock compensation                                                          (8,464)               (12,000)
     Treasury stock, at cost (common stock - 555,333 shares as of December 31,
       2003 and 2002)                                                                 (3,537,106)            (3,537,106)
     Notes receivable from shareholders                                               (1,203,881)            (1,177,589)
     Accumulated other comprehensive loss                                                104,429                 (1,786)
                                                                                -------------------     ------------------
Total shareholders' equity                                                            22,044,127              9,037,501
                                                                                -------------------     ------------------

                                                                                 $    33,021,748         $   20,063,382
                                                                                ===================     ==================
</TABLE>

        The accompanying notes are an integral part of the consolidated
                             financial statements.

                                      F-4
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
--------------------------------------------------------------------------------
In U.S. dollars

<TABLE>
<CAPTION>
                                                                            Year ended December 31,
                                                         ---------------------------------------------------------------
                                                                2003                  2002                  2001
                                                         -------------------   -------------------   -------------------

Revenues:
<S>                                                         <C>                   <C>                   <C>
   Products                                                 $   16,918,480        $    5,944,370        $    1,670,634
   Services                                                        408,161               462,369               422,998
                                                         -------------------   -------------------   -------------------

Total revenues                                                  17,326,641             6,406,739             2,093,632

Cost of revenues                                                11,087,840             4,421,748             1,992,636
                                                         -------------------   -------------------   -------------------

Gross profit                                                     6,238,801             1,984,991               100,996
                                                         -------------------   -------------------   -------------------

Operating expenses:

   Research and development, net                                 1,053,408               685,919               455,845
   Selling and marketing expenses                                3,532,636             1,309,669               105,977
   General and administrative expenses                           6,196,779             4,023,103             3,827,544
   Amortization of intangible assets                               864,910               623,543                     -
   In-process research and development write-off                         -                26,000                     -
                                                         -------------------   -------------------   -------------------

Total operating costs and expenses                              11,647,733             6,668,234             4,389,366
                                                         -------------------   -------------------   -------------------

Operating loss                                                  (5,408,932)           (4,683,243)           (4,288,370)
Financial income (expenses), net                                (3,470,459)              100,451               262,581
                                                         -------------------   -------------------   -------------------

Loss before minority interest in loss (earnings) of a
   subsidiary and tax expenses                                  (8,879,391)           (4,582,792)           (4,025,789)
Tax expenses                                                      (396,193)                    -                     -
Minority interest in loss (earnings) of a subsidiary               156,900              (355,360)                    -
                                                         -------------------   -------------------   -------------------
Loss from continuing operations                                 (9,118,684)           (4,938,152)           (4,025,789)

Income (loss) from discontinued operations (including
   loss on disposal of $4,446,684 during 2002)                     110,410           (13,566,206)          (13,260,999)
                                                         -------------------   -------------------   -------------------
Net loss                                                    $   (9,008,274)       $  (18,504,358)       $  (17,286,788)
                                                         ===================   ===================   ===================

Deemed dividend to certain shareholders of common stock     $            -        $            -        $   (1,196,667)
                                                         -------------------   -------------------   -------------------

Net loss attributable to shareholders of common stock       $   (9,008,274)       $  (18,504,358)       $  (18,483,455)
                                                         ===================   ===================   ===================

Basic and diluted net loss per share from continuing
  operations                                                $      (0.23)         $      (0.15)         $       (0.21)
                                                         ===================   ===================   ===================
Basic and diluted net loss per share from discontinued
  operations                                                $       0.00          $      (0.42)         $       (0.55)
                                                         ===================   ===================   ===================
Basic and diluted net loss per share                        $      (0.23)         $      (0.57)         $       (0.76)
                                                         ===================   ===================   ===================

Weighted average number of shares used in computing
  basic and diluted net loss per share                          38,890,174            32,381,502            24,200,184
                                                         ===================   ===================   ===================
</TABLE>


        The accompanying notes are an integral part of the consolidated
                             financial statements.



                                      F-5
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
In U.S. dollars

<TABLE>
<CAPTION>

                                                          ADDITIONAL                      DEFERRED
                                      COMMON STOCK          PAID-IN       ACCUMULATED      STOCK        TREASURY
                                   SHARES      AMOUNT       CAPITAL        DEFICIT      COMPENSATION      STOCK
                                 -------------------------------------------------------------------------------------
<S>                               <C>           <C>         <C>          <C>               <C>             <C>
Balance as of January 1, 2001     21,422,691    $ 214,227   $89,091,790  $ 64,882,473)     $  (17,240)     $  (37,731)

Repurchase of common shares
  from shareholders and
  repayment of the related
  interest and principal of
  notes from shareholders                  -            -       228,674              -               -     (3,499,375)
Issuance of shares to investors,
  net                              6,740,359       67,405    14,325,941              -               -               -
Retirement of shares                 (3,000)         (30)      (17,970)              -               -               -
Issuance of shares to service
  providers                          346,121        3,461       536,916              -               -               -
Exercise of options                  219,965        2,200       512,089              -               -               -
Exercise of warrants                 333,333        3,333       836,667              -               -               -
Deferred stock compensation                -            -        18,000              -        (18,000)               -
Amortization of deferred stock
  compensation                             -            -       (6,193)              -          17,240               -
Stock compensation related to
  options issued to
  consultants                              -            -       139,291              -               -               -
Stock compensation related to
  options to consultants
  repriced                                 -            -        21,704              -               -               -
Comprehensive loss:
Net loss                                   -            -             -   (17,286,788)               -               -
                                  ----------- ------------  ------------ --------------  --------------  -------------

Total comprehensive loss

Balance as of December 31, 2001   29,059,469    $ 290,596   $105,686,909 $(82,169,261)     $  (18,000)   $ (3,537,106)
                                  =========== ============  ============ ==============  ==============  =============

<CAPTION>
                                                         NOTES
                                     TOTAL             RECEIVABLE           TOTAL
                                 COMPREHENSIVE            FROM           SHAREHOLDERS
                                      LOSS             SHAREHOLDERS          EQUITY
                                 ----------------------------------------------------------
<S>                                                   <C>                <C>
Balance as of January 1, 2001                         $  (4,290,204)     $  20,078,369

Repurchase of common shares
  from shareholders and
  repayment of the related
  interest and principal of
  notes from shareholders                                  3,470,431           199,730
Issuance of shares to investors,
  net                                                              -        14,393,346
Retirement of shares                                          18,000                 -
Issuance of shares to service
  providers                                                        -           540,377
Exercise of options                                         (43,308)           470,981
Exercise of warrants                           -                   -           840,000
Deferred stock compensation                                        -                 -
Amortization of deferred stock
  compensation                                                     -            11,047
Stock compensation related to
  options issued to
  consultants                                                      -           139,291
Stock compensation related to
  options to consultants
  repriced                                                         -            21,704
Comprehensive loss:
Net loss                            (17,286,788)                   -      (17,286,788)
                                   --------------  ------------------ -----------------

Total comprehensive loss           $(17,286,788)
                                   ==============
Balance as of December 31, 2001                        $   (845,081)     $  19,408,057
                                                   ================== =================
</TABLE>


        The accompanying notes are an integral part of the consolidated
                             financial statements.


                                      F-6
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
In U.S. dollars


<PAGE>



<TABLE>
<CAPTION>

                                                                ADDITIONAL                      DEFERRED
                                         COMMON STOCK            PAID-IN       ACCUMULATED       STOCK        TREASURY
                                      SHARES      AMOUNT         CAPITAL        DEFICIT       COMPENSATION     STOCK
                                 -------------------------------------------------------------------------------------
<S>                               <C>           <C>         <C>          <C>               <C>             <C>
Balance as of January 1, 2002       29,059,469      $290,596   $105,686,909  $(82,169,261)      $(18,000)  $(3,537,106)
  Adjustment of notes from
    shareholders
  Repayment of notes from
    employees                                -             -              -              -              -             -
  Issuance of shares to investors    2,041,176        20,412      3,209,588
  Issuance of shares to service
    providers                          368,468         3,685        539,068
  Issuance of shares to lender
    in respect of prepaid
    interest expenses                  387,301         3,873        232,377              -              -             -
  Exercise of options by
    employees                          191,542         1,915        184,435
  Amortization of deferred stock
    compensation                                                                                    6,000
  Stock compensation related to
    options issued to employees         13,000           130         12,870
  Issuance of shares in respect
    of acquisition                   3,640,638        36,406      4,056,600
  Accrued interest on notes
    receivable                                                      160,737
  Other comprehensive loss
    Foreign currency translation
    adjustment
  Net loss                                                                    (18,504,358)
                                  ------------- -------------  ------------- -------------- -------------- -------------
  Total comprehensive loss

  Balance as of December 31, 2002   35,701,594     $ 357,017   $114,082,584  $(100,673,619)   $  (12,000)  $(3,537,106)
                                  ============= =============  ============= ============== ============== =============


<CAPTION>
                                                         NOTES
                                     TOTAL             RECEIVABLE                  TOTAL
                                 COMPREHENSIVE            FROM                 SHAREHOLDERS
                                      LOSS             SHAREHOLDERS               EQUITY
                                 ----------------------------------------------------------
<S>                                                   <C>                <C>
Balance as of January 1, 2002                       $(845,081)               -   $19,408,057
  Adjustment of notes from
    shareholders                                     (178,579)                     (178,579)
  Repayment of notes from
    employees                                           43,308                        43,308
  Issuance of shares to investors                                                  3,230,000
  Issuance of shares to service
    providers                                                                        542,753
  Issuance of shares to lender
    in respect of prepaid
    interest expenses                                        -                       236,250
  Exercise of options by
    employees                                         (36,500)                       149,850
  Amortization of deferred stock
    compensation                                                                       6,000
  Stock compensation related to
    options issued to employees                                                       13,000
  Issuance of shares in respect
    of acquisition                                                                 4,093,006
  Accrued interest on notes
    receivable                                       (160,737)                             -
  Other comprehensive loss
    Foreign currency translation
    adjustment                           (1,786)                      (1,786)        (1,786)
  Net loss                          (18,504,358)                                (18,504,358)
                                  --------------- ------------- -------------- --------------
  Total comprehensive loss        $ (18,506,144)
                                  ===============
  Balance as of December 31, 2002                 $(1,177,589)     $  (1,786)    $ 9,037,501
                                                  ============= ============== ==============
</TABLE>



        The accompanying notes are an integral part of the consolidated
                             financial statements.


                                      F-7
<PAGE>



AROTECH CORPORATION AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
In U.S. dollars


<TABLE>
<CAPTION>

                                       COMMON STOCK           ADDITIONAL                    DEFERRED
                                  ------------------------      PAID-IN     ACCUMULATED       STOCK          TREASURY
                                    SHARES      AMOUNT          CAPITAL       DEFICIT      COMPENSATION        STOCK
                                  --------------------------------------------------------------------------------------
<S>                               <C>           <C>         <C>          <C>               <C>             <C>
Balance as of January 1, 2003       35,701,594     $ 357,017   $114,082,584  $(100,673,619)   $  (12,000)  $(3,537,106)
  Compensation related to
    warrants issued to the
    holders of convertible
    debentures                                                    5,157,500
  Compensation related to
    beneficial conversion
    feature of convertible
    debentures                                                    5,695,543
  Issuance of shares on
    conversion of convertible
    debentures                       6,969,605        69,696      6,064,981
  Issuance of shares on exercise
    of warrants                      3,682,997        36,831      3,259,422
  Issuance of shares to
    consultants                        223,600         2,236        159,711
  Compensation related to
    warrants and options issued
    to consultants and investors                                    418,162
  Compensation related to
    non-recourse loan granted to
    shareholder                                                      38,500
  Deferred stock compensation                                         4,750                       (4,750)
  Amortization of deferred stock
    compensation                                                                                    8,286
  Exercise of options by
    employees                          689,640         6,896        426,668
  Exercise of options by
    consultants                         15,000           150          7,200
  Conversion of convertible
    promissory note                    563,971         5,640        438,720
  Increase in investment in
    subsidiary against common
    stock issuance                     126,000         1,260        120,960
  Accrued interest on notes
    receivable from shareholders                                     16,615
  Other comprehensive loss -
    foreign currency translation
    adjustment
  Net loss                                                                     (9,008,274)
                                  ------------- -------------  ------------- -------------- -------------- -------------


  Balance as of December 31, 2003   47,972,407     $ 479,726   $135,891,316  $(109,681,893)  $    (8,464)  $(3,537,106)
                                  ============= =============  ============= ============== ============== =============

<CAPTION>


                                                                    ACCUMULATED
                                      TOTAL      NOTES RECEIVABLE   OTHER COM-       TOTAL
                                  COMPREHENSIVE        FROM         PREHENSIVE   SHAREHOLDERS'
                                      LOSS         SHAREHOLDERS      LOSS           EQUITY
                                 -------------------------------------------------------------

<S>                               <C>           <C>                 <C>           <C>
Balance as of January 1, 2003       $(1,177,589)     $  (1,786)                    $ 9,037,501
  Compensation related to
    warrants issued to the
    holders of convertible
    debentures                                                                       5,157,500
  Compensation related to
    beneficial conversion
    feature of convertible
    debentures                                                                       5,695,543
  Issuance of shares on
    conversion of convertible
    debentures                          (9,677)                                      6,125,000
  Issuance of shares on exercise
    of warrants                                                                      3,296,253
  Issuance of shares to
    consultants                                                                        161,947
  Compensation related to
    warrants and options issued
    to consultants and investors                                                       418,162
  Compensation related to
    non-recourse loan granted to
    shareholder                                                                         38,500
  Deferred stock compensation                                                                -
  Amortization of deferred stock
    compensation                                                                         8,286
  Exercise of options by
    employees                                                                          433,564
  Exercise of options by
    consultants                                                                          7,350
  Conversion of convertible
    promissory note                                                                    444,360
  Increase in investment in
    subsidiary against common
    stock issuance                                                                     122,220
  Accrued interest on notes
    receivable from shareholders       (16,615)                                              -
  Other comprehensive loss -
    foreign currency translation
    adjustment                                         106,215          106,215        106,215
  Net loss                                                           (9,008,274)    (9,008,274)
                                    ------------  -------------- ---------------- --------------
                                                                     (8,902,059)
                                                                 ================
  Balance as of December 31, 2003   $(1,203,881)     $ 104,429                    $ 22,044,127
                                    ============  ==============                  ==============
</TABLE>


        The accompanying notes are an integral part of the consolidated
                             financial statements.


                                      F-8
<PAGE>



AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------
In U.S. dollars

<TABLE>
<CAPTION>
                                                                                 Year ended December 31,
                                                                -----------------------------------------------------------
                                                                      2003                 2002                 2001
                                                                ------------------   ------------------   -----------------
Cash flows from operating activities:
<S>                                                                  <C>                 <C>                  <C>
     Net loss                                                        (9,008,274)         (18,504,358)         (17,286,788)
       Less loss (profit) for the period from discontinued
         operations                                                    (110,410)          13,566,206           13,260,999
     Adjustments  required to  reconcile  net loss to net cash used in operating
       activities:
     Minority interest in earnings (loss) of subsidiary                (156,900)             355,360                    -
     Depreciation                                                       730,159              473,739              530,013
     Amortization of intangible assets                                  864,910              623,543                    -
     In-process research and development write-off                            -               26,000                    -
     Accrued severance pay, net                                           3,693             (357,808)             530,777
     Amortization of deferred stock compensation                          8,286                6,000               17,240
     Impairment and write-off of loans to shareholders                  (12,519)             542,317              206,005
     Compensation expenses related to repurchase of treasury
       stock                                                                                       -              228,674
     Write-off of inventories                                            96,350              116,008                    -
     Impairment of fixed assets                                          68,945                    -                    -
     Amortization of compensation related to beneficial
       conversion feature and warrants issued to holders of
       convertible debentures                                         3,359,987                    -                    -
     Amortization of deferred expenses related to convertible
       debenture issuance                                               483,713                    -                    -
     Amortization of prepaid financial expenses                         236,250                    -                    -
     Amortization of capitalized research and development
       projects                                                          14,401                    -                    -
     Stock-based compensation related to repricing of warrants
       granted to investors and the grant of new warrants               388,403                    -                    -
     Stock-based compensation related to repricing of warrants
       granted to consultants                                            29,759                    -                    -
     Stock-based compensation related to shares issued to
       consultants                                                      161,947                    -                    -
     Stock-based compensation related to non-recourse note
       granted to stockholder                                            38,500                    -                    -
     Compensation expenses related to shares issued to
       employees                                                              -               13,000                    -
     Accrued interest on notes receivable from shareholders                   -                    -               36,940
     Interest accrued on promissory notes due to acquisition            (66,793)              29,829                    -
     Interest accrued on restricted collateral deposit                        -               (3,213)                   -
     Capital (gain) loss from sale of property and equipment            (11,504)              (4,444)                 815
     Decrease (increase) in trade receivables                          (820,137)             389,516             (452,425)
     Decrease in other accounts receivable and prepaid expenses          40,520              257,218              616,040
     Increase in inventories                                           (193,222)            (520,408)            (128,897)
     Decrease in trade payables                                        (986,022)             (62,536)            (301,075)
     Increase (decrease) in other accounts payable and accrued
       expenses                                                       1,827,668             (423,664)             286,511
                                                                ------------------   ------------------   -----------------
     Net cash used in operating activities from continuing           (3,012,290)          (3,477,695)          (2,455,171)
       operations (reconciled from continuing operations)

     Net cash used in operating activities from discontinued
        operations (reconciled from discontinued operations)           (313,454)          (5,456,912)         (10,894,660)
                                                                ------------------   ------------------   -----------------

Net cash used in operating activities                                (3,325,744)          (8,934,607)         (13,349,831)
                                                                ------------------   ------------------   -----------------
</TABLE>

        The accompanying notes are an integral part of the consolidated
                             financial statements.


                                      F-9
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------
In U.S. dollars

<TABLE>
<CAPTION>
                                                                                 Year ended December 31,
                                                                 ---------------------------------------------------------
                                                                       2003                2002                2001
                                                                 -----------------   -----------------   -----------------
Cash flows from investing activities:
<S>                                                                     <C>                 <C>                 <C>
     Purchase of property and equipment                                 (580,949)           (275,540)           (513,746)
     Increase in capitalized research and development projects          (209,616)                  -                   -
     Payment to suppliers for purchase of property and
       equipment from previous year                                            -             (39,336)            (43,883)
     Loans granted to shareholders                                       (13,737)             (4,529)                  -
     Repayment of loans granted to shareholders                            9,280                   -                   -
     Proceeds from sale of property and equipment                         16,753               8,199              40,217
     Acquisition of IES (1)                                                    -          (2,958,083)                  -
     Acquisition of MDT (2)                                                    -          (1,201,843)                  -
     Repayment of promissory note related to acquisition of
       subsidiary                                                       (750,000)                  -                   -
     Purchase of intangible assets and inventory                        (196,331)                  -                   -
     Increase in restricted cash                                         (72,840)           (595,341)                  -
     Net cash used in discontinued operations (purchase of
       property and equipment)                                                 -            (290,650)           (761,555)
                                                                 -----------------   -----------------   -----------------
Net cash used in investing activities                                 (1,797,440)         (5,357,123)         (1,278,967)
                                                                 -----------------   -----------------   -----------------
Cash flows from financing activities:

     Proceeds from issuance of shares, net                                (6,900)          3,230,000          14,393,346
     Proceeds from exercise of options to employees and
       consultants                                                       440,914             113,350             470,981
     Proceeds from exercise of warrants                                3,296,254                   -             840,000
     Proceeds from the sale of convertible debentures, net            13,708,662                   -                   -
     Payment of interest and principal on notes receivable from
       shareholders                                                            -              43,308                   -
     Profit distribution to minority                                           -            (412,231)                  -
     Increase (decrease) in short term bank credit                       (74,158)            108,659                   -
     Payment on capital lease obligation                                  (4,427)             (5,584)                  -
                                                                 -----------------   -----------------   -----------------
Net cash provided by financing activities                             17,360,345           3,077,502          15,704,327
                                                                 -----------------   -----------------   -----------------
Increase (decrease) in cash and cash equivalents                      12,237,161         (11,214,228)          1,075,529
Cash erosion due to exchange rate differences                             (9,562)                  -                   -
Cash and cash equivalents at the beginning of the year                 1,457,526          12,671,754          11,596,225
                                                                 -----------------   -----------------   -----------------
Cash and cash equivalents at the end of the year                  $   13,685,125      $    1,457,526      $   12,671,754
                                                                 =================   =================   =================
Supplementary information on non-cash transactions:

Purchase of property and equipment against trade payables         $            -      $            -      $       39,336
                                                                 =================   =================   =================
Purchase of treasury stock in respect of notes receivable from
  shareholders                                                    $            -      $            -      $    3,499,375
                                                                 =================   =================   =================
Retirement of shares issued under notes receivables               $            -      $            -      $       18,000
                                                                 =================   =================   =================
Issuance of shares to consultants in respect of prepaid
   interest expenses                                              $            -      $      236,250      $            -
                                                                 =================   =================   =================
Exercise of options against notes receivable                      $            -      $       36,500      $       43,308
                                                                 =================   =================   =================
 Purchase of intangible assets against note receivable            $      300,000      $            -      $            -
                                                                 =================   =================   =================
 Increase of investment in subsidiary against issuance of
   shares of common stock                                         $      123,480      $            -      $            -
                                                                 =================   =================   =================
 Conversion of promissory note to shares of common stock          $      450,000      $            -      $            -
                                                                 =================   =================   =================
 Conversion of convertible debenture to shares of common stock    $    6,125,000      $            -      $            -
                                                                 =================   =================   =================
 Benefit due to convertible debentures and warrants               $   10,853,043      $            -      $            -
                                                                 =================   =================   =================
Supplemental disclosure of cash flows activities:
  Cash paid during the year for:
         Interest                                                 $       39,412      $       10,640      $       19,106
                                                                  ================    ================    ================
</TABLE>

        The accompanying notes are an integral part of the consolidated
                             financial statements.

                                      F-10
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)
--------------------------------------------------------------------------------
In U.S. dollars

(1)      In July 2002, the Company acquired  substantially  all of the assets of
         I.E.S.  Electronics Industries U.S.A., Inc. ("IES"). The net fair value
         of the assets  acquired  and the  liabilities  assumed,  at the date of
         acquisition, was as follows:

Working capital, excluding cash and                                 $ 1,233,000
   cash equivalents
 Property and equipment, net                                            396,776
 Capital lease obligation                                               (15,526)
 Technology                                                           1,515,000
 Existing contracts                                                      46,000
 Covenants not to compete                                                99,000
 In process research and development                                     26,000
 Customer list                                                          527,000
 Trademarks                                                             439,000
 Goodwill                                                             4,032,726
                                                                    -----------

                                                                      8,298,976

Issuance of shares                                                   (3,653,929)
Issuance of promissory note                                          (1,686,964)
                                                                    -----------

                                                                    $ 2,958,083
                                                                    ===========


(2)      In July 2002,  the Company  acquired  51% of the  outstanding  ordinary
         shares of MDT Protective Industries Ltd. ("MDT"). The fair value of the
         assets acquired and liabilities assumed was as follows:

Working capital, excluding cash and                                 $   350,085
   cash and cash equivalents
Property, and equipment, net                                            139,623
Minority rights                                                        (300,043)
Technology                                                              280,000
Customer base                                                           285,000
Goodwill                                                                886,255
                                                                    -----------
                                                                      1,640,920

Issuance of shares                                                     (439,077)
                                                                    -----------
                                                                    $ 1,201,843
                                                                    ===========



        The accompanying notes are an integral part of the consolidated
                             financial statements.

                                      F-11
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: -  GENERAL

a. Arotech  Corporation,  f/k/a  Electric  Fuel  Corporation  ("Arotech"  or the
"Company") and its subsidiaries are engaged in the development,  manufacture and
marketing  of  defense  and  security   products,   including  advanced  hi-tech
multimedia  and  interactive  digital  solutions  for training of military,  law
enforcement and security personnel and sophisticated  lightweight  materials and
advanced engineering processes to armor vehicles, and in the design, development
and  commercialization  of  its  proprietary  zinc-air  battery  technology  for
electric vehicles and defense  applications.  The Company is primarily operating
through  Electric  Fuel Ltd.  ("EFL") a  wholly-owned  Israeli  subsidiary;  IES
Interactive  Training,  Inc.  ("IES"),  a wholly-owned U.S.  subsidiary;  Arocon
Security  Corporation,  a wholly-owned  U.S.  subsidiary;  Electric Fuel Battery
Corporation,  a wholly-owned U.S. subsidiary; MDT Protective Industries ("MDT"),
an Israeli  subsidiary in which the Company has a 75.5% interest;  and MDT Armor
Corporation,  a U.S.  subsidiary in which the Company has an 88%  interest.  The
Company's  production  and research and  development  operations  are  primarily
located in Israel and in the United States.

b. Acquisition of IES:

In August 2, 2002, the Company  entered into an asset purchase  agreement  among
I.E.S.  Electronics  Industries U.S.A., Inc. ("IES"),  its direct and certain of
its  indirect  shareholders,  and  its  wholly-owned  Israeli  subsidiary,  EFL,
pursuant to the terms of which it acquired substantially all the assets, subject
to  substantially  all the  liabilities,  of IES, a developer,  manufacturer and
marketer of advanced hi-tech  multimedia and interactive  digital  solutions for
training of  military,  law  enforcement  and  security  personnel.  The Company
intends to continue to use the assets  purchased  in the conduct of the business
formerly  conducted by IES (the "Business").  The acquisition has been accounted
under the purchase method of accounting. Accordingly, all assets and liabilities
were acquired as at the values on such date, and the Company  consolidated IES's
results with its own commencing at such date.

The assets  purchased  consisted of the current assets,  property and equipment,
and other  intangible  assets  used by IES in the conduct of the  Business.  The
consideration for the assets and liabilities purchased consisted of (i) cash and
promissory  notes in an aggregate  amount of $4,800,000  ($3,000,000 in cash and
$1,800,000  in  promissory  notes,  which was  recorded at its fair value in the
amount of  $1,686,964)  (see Note 9), and (ii) the issuance,  with  registration
rights,  of a total of 3,250,000 shares of our common stock,  $.01 par value per
share, having a value of approximately $3,653,929,  which shares are the subject
of a  voting  agreement  on  the  part  of IES  and  certain  of its  affiliated
companies.  The value of 3,250,000  shares  issued was  determined  based on the
average  market price of Arotech's  Common stock over the period  including  two
days before and after the terms of the acquisition were agreed to and announced.
The total  consideration of $8,354,893  (including $14,000 of transaction costs)
was determined based upon arm's-length  negotiations between the Company and IES
and IES's shareholders.



                                      F-12
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: - GENERAL (Cont.)

Based upon a valuation of tangible and intangible  assets acquired,  Arotech has
allocated the total cost of the acquisition to IES's assets as follows:


Tangible assets acquired                                $  2,856,951

Intangible assets

     Technology (four year useful life)                    1,515,000
     Existing contracts (one year useful life)                46,000
     Covenants not to compete (five year useful
       life)                                                  99,000
     In process research and development                      26,000
     Customer list (seven year useful life)                  527,000
     Trademarks (indefinite useful life)                     439,000
     Goodwill                                              4,032,726
Liabilities assumed                                       (1,186,784)
                                                    ----------------------

Total consideration                                     $  8,354,893
                                                    ======================

In  accordance  with  SFAS No.  142,  "Goodwill  and Other  Intangible  Assets,"
goodwill  arising  from  acquisitions   will  not  be  amortized.   In  lieu  of
amortization,  Arotech is required to perform an annual  impairment  review.  If
Arotech  determines,  through the impairment  review process,  that goodwill has
been  impaired,  it will  record  the  impairment  charge  in its  statement  of
operations.  Arotech will also assess the impairment of goodwill whenever events
or  changes  in  circumstances  indicate  that  the  carrying  value  may not be
recoverable.

The value  assigned to the  tangible,  intangibles  assets and  liabilities  was
determined as follows:

1.       To determine the value of the Company's  net current  assets,  property
         and equipment,  and net liabilities;  the Cost Approach was used, which
         requires  that the assets and  liabilities  in  question be restated to
         their market values.  Per estimation made by the independent  appraisal
         the book values for the current assets and liabilities  were reasonable
         proxies for their market values.

2.       The amount of the excess cost attributable to technology of Range 2000,
         3000 and A2Z Systems is $1,515,000 and was determined  using the Income
         Approach.

3.       The value assigned to purchased  in-process  technology  relates to two
         projects  "Black Box" and A2Z trainer.  The estimated fair value of the
         acquired in-process research and development platforms that had not yet
         reached  technological  feasibility  and had no alternative  future use
         amounted to $26,000.  Technological feasibility or commercial viability
         of these  projects  was  established  at the  acquisition  date.  These
         products were  considered to have no alternative  future use other than
         the  technological  indications  for which  they  were in  development.
         Accordingly,   these   amounts   were   immediately   expensed  in  the
         consolidated  statement  of  operations  on  the  acquisition  date  in
         accordance  with  FASB  Interpretation  No. 4,  "Applicability  of FASB
         Statement No. 2 to Business Combinations  Accounted for by the Purchase
         Method." The estimated fair values of these  platforms were  determined
         using  discounted  cash flow models.  Projects were  estimated to be 4%
         complete;  estimated  costs  to  completion  of  these  platforms  were
         approximately $200,000 and $25,000,  respectively, and discount rate of
         25% was used.



                                      F-13
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: - GENERAL (Cont.)

4.       The value  assigned  to the  customer  list is  amounted  to  $527,000.
         Management  states that its customers have generally been very loyal to
         IES's products; most present customers are expected to purchase add-ons
         or up-grades  to their IES  simulator  systems in the future,  and some
         will  purchase  additional  warranties  for the systems  they  possess.
         Independent  appraisal has therefore valued the Company's customer list
         using the Income Approach.

5.       The value  assigned to the  trademarks  amounted  to  $439,000  and was
         determined based on the Cost Approach.  In doing so, it is assumed that
         historical  expenditures for advertising are a reasonable proxy for the
         future benefits expected from the Trademarks and Trade names.

6.       Value of IES's  Covenant Not to Compete  (CNC) was valued at the amount
         of  $99,000.  One of IES's  intangible  assets is its  covenant  not to
         compete.  Asset Purchase Agreement precludes the former parent company,
         and its  principals  and key employees from competing with IES for five
         years from the  Valuation  Date.  According  to  management,  among the
         individuals covered by the CNC are the original developers of the Range
         2000 and A2Z systems.  Estimated  CNC's value was determined  using the
         Income  Approach.  The  estimated  value  of the  CNC is the sum of the
         present  value of the cash  flows that would be lost if the CNC was not
         in  place.  Specifically,  the  value of the CNC is  calculated  as the
         difference  between  the  projected  cash  flows if the  former  parent
         company or its principals were to start  competing  immediately and the
         projected cash flows if those parties start competing after five years,
         when the CNC expires.

In September  2003, the Company's IES subsidiary  purchased  selected  assets of
Bristlecone Corporation. The assets purchased consisted of inventories, customer
lists,  and  certain  other  assets   (including   intangible   assets  such  as
intellectual  property  and customer  lists),  including  the name  "Bristlecone
Training  Products"  and the patents for the Heads Up Display (HUD) and a remote
trigger  device,  used by  Bristlecone  in  connection  with its  designing  and
manufacturing  firearms training devices,  for a total consideration of $183,688
in cash and  $300,000 in  promissory  notes,  payable in four equal  semi-annual
payments of $75,000 each, to become due and payable on March 1, 2004, August 31,
2004,  February 28, 2005 and August 31, 2005.  The acquired  patents are used in
the IES's Range FDU (firearm diagnostics unit).

The purchase consideration was estimated as follows:



                                      F-14
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: - GENERAL (Cont.)

                                                                    U.S. Dollars
                                                                        --------
Cash consideration                                                      $ 33,668
                                                                        $183,688

Present value of promissory notes                                        289,333
Transaction expenses                                                      12,643
                                                                        --------
Total consideration                                                     $485,664
                                                                        ========

Based upon a valuation of tangible and intangible  assets acquired,  the Company
has  allocated  the total cost of the  acquisition  of  Bristlecone's  assets as
follows:

                                                                    U.S. Dollars
                                                                    ------------
Tangible assets acquired                                                $ 33,668
                                                                        $ 33,668

Intangible assets

         Technology and patents                                          436,746
         Customer list                                                    15,250
                                                                        --------
Total consideration                                                     $485,664
                                                                        ========

The Company  believes that the acquisition of Bristlecone is not material to its
business.

c. Acquisition of MDT:

On July 1, 2002, the Company entered into a stock purchase agreement with all of
the shareholders of M.D.T.  Protective Industries Ltd. ("MDT"),  pursuant to the
terms of which the Company purchased 51% of the issued and outstanding shares of
MDT, a privately-held  Israeli company that  specializes in using  sophisticated
lightweight materials and advanced engineering processes to armor vehicles.  The
Company also entered into certain other  ancillary  agreements  with MDT and its
shareholders and other affiliated companies. The Acquisition was accounted under
the  purchase  method  accounting  and  results  of MDT's  operations  have been
included in the  consolidated  financial  statements  since that date. The total
consideration  of $1,767,877 for the shares  purchased  consisted of (i) cash in
the aggregate amount of 5,814,000 New Israeli Shekels ($1,231,780), and (ii) the
issuance,  with  registration  rights,  of an aggregate of 390,638 shares of our
common  stock,  $0.01  par  value  per  share,  having a value of  approximately
$439,077. The value of 390,638 shares issued was determined based on the average
market price of Arotech's Common stock over the period including two days before
and after the terms of the acquisition were agreed to and announced.

Based upon a valuation of tangible and intangible  assets acquired,  Arotech has
allocated the total cost of the acquisition to MDT's assets as follows:

             Tangible assets acquired                       $  1,337,048
             Intangible assets
                Technology (five year weighted
                 average useful life)                            280,000
                Customer base (five year weighted
                 average useful life)                            285,000
                Goodwill                                         886,255
             Liabilities assumed                              (1,020,426)
                                                        -----------------------
             Total consideration                            $  1,767,877
                                                        =======================



                                      F-15
<PAGE>
AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: - GENERAL (Cont.)

In  accordance  with  SFAS No.  142,  "Goodwill  and Other  Intangible  Assets,"
goodwill  arising  from  acquisitions   will  not  be  amortized.   In  lieu  of
amortization,  Arotech is required to perform an annual  impairment  review.  If
Arotech  determines,  through the impairment  review process,  that goodwill has
been  impaired,  it will  record  the  impairment  charge  in its  statement  of
operations.  Arotech will also assess the impairment of goodwill whenever events
or  changes  in  circumstances  indicate  that  the  carrying  value  may not be
recoverable.

The value  assigned to the  tangible,  intangibles  assets and  liabilities  was
determined as follows:

1.       To  determine  the  value of the  Company's  net  current  assets,  net
         property,  and  equipment  and net  liabilities;  the Cost Approach was
         used,  which  requires that the assets and  liabilities  in question be
         restated to their market values. Per estimation made by the independent
         appraisal the book values for the current assets and  liabilities  were
         reasonable proxies for their market values.

2.       The amount of the excess cost  attributable  to  technology  of optimal
         bulletproofing  material and power mechanism for bulletproofed  windows
         is $280,000 and was determined using the Income Approach.

3.       The value  assigned  to the  customer  base is  amounted  to  $285,000.
         Independent  appraisal has valued the Company's customer base using the
         Income  Approach.  The valuation of the customers'  base derives mostly
         from relations with customers with no contracts.  Most of the customers
         of  MDT  are  from  defense   sector  and  usually  have   longstanding
         relationships and tend to reorder from the Company.

In September  2003,  the Company  increased  its holdings in both of its vehicle
armoring  subsidiaries.  The  Company  now holds  88% of MDT  Armor  Corporation
(compared to 76% before this transaction) and 75.5% of MDT Protective Industries
Ltd.  (compared  to 51% before  this  transaction).  The  Company  acquired  the
additional  stake in MDT from AGA  Means of  Protection  and  Commerce  Ltd.  in
exchange for the issuance to AGA of 126,000  shares of its common stock,  valued
at $0.98 per share based on the closing price of the  Company's  common stock on
the closing date of September 4, 2003, or a total of $123,480. Of this amount, a
total of $75,941 was allocated to intangible  assets. The Company did not obtain
a valuation due to the immaterial nature of this acquisition.

d. Pro forma results:

The following unaudited proforma  information does not purport to represent what
the  Company's  results  of  operations  would  have  been had the  acquisitions
occurred  on January 1, 2001 and 2002,  nor does it  purport  to  represent  the
results of operations of the Company for any future period.



                                      F-16
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: - GENERAL (Cont.)

<TABLE>
<CAPTION>
                                                                       Year ended December 31,
                                                                 -----------------------------------
                                                                      2002                2001
                                                                 ---------------    ----------------
<S>                                                              <C>                <C>
 Revenues                                                           $12,997,289        $12,369,749
                                                                 ===============    ================

 Net loss from continuing operations                                $(6,103,771)      $(5,757,675)
                                                                 ===============    ================

 Basic and diluted net loss per share for continuing operations     $     (0.18)       $    (0.21)
                                                                 ===============    ================

 Weighted average number of shares of common stock in
   computation of basic and diluted net loss per share               34,495,185         27,840,822
                                                                 ===============    ================
</TABLE>

The  amount  of  the  excess  cost  attributable  to  in-process   research  and
development of IES and MDT in the amount of $26,000 has not been included in the
pro forma information, as it does not represent a continuing expense.

e. Discontinued operations:

In September 2002, the Company committed to a plan to discontinue the operations
of its  retail  sales of  consumer  battery  products.  The  Company  ceased the
operation and disposed of all assets related to this segment by an  abandonment.
The operations and cash flows of consumer  battery business have been eliminated
from the operations of the entity as a result of the disposal transactions.  The
Company  has no  intent of  continuing  its  activity  in the  consumer  battery
business.  The Company's plan of discontinuance  involved (i) termination of all
employees whose time was substantially  devoted to the consumer battery line and
who could not be used elsewhere in the Company's  operations,  including payment
of all  statutory  and  contractual  severance  sums,  by the end of the  fourth
quarter of 2002, and (ii) disposal of the raw materials, equipment and inventory
used  exclusively  in the consumer  battery  business,  since the Company has no
reasonable  expectation of being able to sell such raw  materials,  equipment or
inventory  for any sum  substantially  greater  than  the  cost of  disposal  or
shipping,  by the end of the first quarter of 2003.  The Company had  previously
reported  its  consumer  battery  business  as  a  separate  segment   (Consumer
Batteries)  as  called  for  by  Statement  of  Financial   Standards  No.  131,
"Disclosures About Segments of an Enterprise and Related Information" ("SFAS No.
131").

The results of operations  including revenue,  operating expenses,  other income
and expense of the retail sales of consumer battery  products  business unit for
2002  and  2001  have  been  reclassified  in  the  accompanying  statements  of
operations as a discontinued operation. The Company's balance sheets at December
31, 2002 and 2001  reflect the net  liabilities  of the retail sales of consumer
battery  products  business as net  liabilities  and net assets of  discontinued
operation within current liabilities and current assets.

At December 31, 2002, the estimated net losses  associated  with the disposition
of the retail sales of consumer  battery  products  business were  approximately
$13,566,206 for 2002. These losses included  approximately  $6,508,222 in losses
from operations for the period from January 1, 2002 through the measurement date
of December 31, 2002 and  $7,057,684,  reflecting a write-down  of inventory and
net property and  equipment  of the retail  sales of consumer  battery  products
business, as follows:



                                      F-17
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 1: - GENERAL (Cont.)


                                              December 31, 2002
                                          --------------------------
Write-off of inventories                        $   2,611,000
Impairment of property and equipment                4,446,684
                                               ----------------
                                                $   7,057,684
                                               ================

As a result of the  discontinuance  of  consumer  battery  segment,  the Company
ceased to use property and equipment related to this segment. In accordance with
Statement  of  Financial   Accounting  Standard  No.  144  "Accounting  for  the
Impairment or Disposal of Long- Lived  Assets"  ("SFAS No. 144") such assets was
considered to be impaired,  the  impairment to be recognized was measured by the
amount by which the carrying  amount of the assets exceeds the fair value of the
assets.

Obligations  to employees for severance and other  benefits  resulting  from the
discontinuation  have been  reflected in the financial  statements on an accrual
basis.

Summary  operating  results from the discontinued  operation for the years ended
December 31, 2003, 2002 and 2001 are as follows:

<TABLE>
<CAPTION>
                                                            Year Ended December 31,
                                          -------------------------------------------------------------
                                                2003                  2002                  2001
                                          -----------------      ----------------     -----------------
<S>                                        <C>                    <C>                  <C>
             Revenues                      $    117,267           $   1,100,442        $   1,939,256
             Cost of sales (1)                        -              (5,293,120)          (5,060,966)
                                          -----------------      ----------------     -----------------

             Gross profit (loss)                117,267              (4,192,678)          (3,121,710)
             Operating expenses, net              6,857               4,926,844           10,139,289
             Impairment of fixed assets               -               4,446,684                    -
                                          -----------------      ----------------     -----------------
             Operating profit (loss)       $    110,410           $ (13,566,206)       $ (13,260,999)
                                          =================      ================     =================
</TABLE>


(1)      Including  write-off of inventory in the amount of $0,  $2,611,000  and
         $441,000 for the years ended December 31, 2003, 2002 and 2001.


<PAGE>



AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES

The  consolidated  financial  statements  have been prepared in accordance  with
generally accepted accounting principles in the United States ("U.S. GAAP").

a. 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 amounts reported in the financial  statements and accompanying notes.
Actual results could differ from those estimates.

b. Financial statements in U.S. dollars:

A majority  of the  revenues  of the  Company  and most of its  subsidiaries  is
generated in U.S. dollars.  In addition,  a substantial portion of the Company's
and most of its  subsidiaries  costs are  incurred in U.S.  dollars  ("dollar").
Management  believes  that the dollar is the primary  currency  of the  economic
environment in which the Company and most of its subsidiaries operate. Thus, the
functional and reporting currency of the Company and most of its subsidiaries is
the dollar.  Accordingly,  monetary accounts maintained in currencies other than
the U.S. dollar are remeasured into U.S. dollars in accordance with Statement of
Financial Accounting Standards No. 52 "Foreign Currency  Translation" ("SFAS No.
52"). All  transaction,  gains and losses from the remeasured  monetary  balance
sheet items are  reflected  in the  consolidated  statements  of  operations  as
financial income or expenses, as appropriate.

The majority of financial  transactions  of MDT is in New Israel Shekel  ("NIS")
and a substantial portion of MDT's costs is incurred in NIS. Management believes
that the NIS is the  functional  currency  of MDT.  Accordingly,  the  financial
statements  of MDT have been  translated  into U.S.  dollars.  All balance sheet
accounts have been translated  using the exchange rates in effect at the balance
sheet  date.  Statement  of  operations  amounts has been  translated  using the
weighted  average  exchange  rate  for the  period.  The  resulting  translation
adjustments are reported as a component of accumulated other  comprehensive loss
in shareholders' equity

c. Principles of consolidation:

The consolidated  financial  statements  include the accounts of the Company and
its  wholly  and  majority  owned   subsidiaries.   Intercompany   balances  and
transactions have been eliminated upon consolidation.

d. Cash equivalents:

Cash  equivalents  are  short-term  highly liquid  investments  that are readily
convertible to cash with maturities of three months or less when acquired.

e. Inventories:

Inventories  are  stated  at the  lower  of  cost  or  market  value.  Inventory
write-offs  and  write-down  provisions are provided to cover risks arising from
slow-moving items or technological obsolescence and for market prices lower than
cost.  The Company  periodically  evaluates  the  quantities on hand relative to
current and historical selling prices and historical and projected sales volume.
Based on this  evaluation,  provisions  are made to write  inventory down to its
market  value.  In 2003,  the Company  wrote off $96,350 of obsolete  inventory,
which has been included in the cost of revenues.



                                      F-18
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)


Cost is determined as follows:

Raw and packaging materials - by the average cost method.

Work in progress -  represents  the cost of  manufacturing  with the addition of
allocable indirect manufacturing cost.

Finished products - on the basis of direct manufacturing costs with the addition
of allocable indirect manufacturing costs.

f. Property and equipment:

Property and equipment are stated at cost net of  accumulated  depreciation  and
investment  grants (no  investment  grants were received  during 2003,  2002 and
2001).

Depreciation is calculated by the straight-line method over the estimated useful
lives of the assets, at the following annual rates:

                                                                  %
                                                     --------------------------

      Computers and related equipment                            33
      Motor vehicles                                             15
      Office furniture and equipment                           6 - 10
      Machinery, equipment and installation              10 - 25 (mainly 10)
      Leasehold improvements                         Over the term of the lease

g. Goodwill:

Goodwill  represents the excess of cost over the fair value of the net assets of
businesses  acquired.  Under Statement of Financial Accounting Standard No. 142,
"Goodwill and Other Intangible  Assets" ("SFAS No, 142") goodwill  acquired in a
business combination on or after July 1, 2001, is not amortized.

SFAS No. 142 requires  goodwill to be tested for  impairment  on adoption of the
Statement and at least  annually  thereafter or between  annual tests in certain
circumstances,  and written down when impaired,  rather than being  amortized as
previous  accounting  standards  required.  Goodwill is tested for impairment by
comparing the fair value of the Company's  reportable  units with their carrying
value.  Fair value is determined using  discounted cash flows,  market multiples
and  market  capitalization.  Significant  estimates  used in the  methodologies
include  estimates of future cash flows,  future short-term and long-term growth
rates,  weighted  average cost of capital and estimates of market  multiples for
the reportable units.

h. Other intangible assets:

Intangible  assets  acquired  in a  business  combination  that are  subject  to
amortization are amortized over their useful life using a method of amortization
that  reflects  the pattern in which the  economic  benefits  of the  intangible
assets are  consumed  or  otherwise  used up, in  accordance  with SFAS No. 142.
Intangible assets are amortized over their useful life (See Note 1b. and c).



                                      F-19
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)

i. Impairment of indefinite-lived intangible asset

The acquired IES trademark is deemed to have an  indefinite  useful life because
it is  expected  to  contribute  to  cash  flows  indefinitely.  Therefore,  the
trademark will not be amortized  until its useful life is no longer  indefinite.
The trademark is tested annually for impairment in accordance FAS 142.

j. Impairment of long-lived assets:

The Company and its  subsidiaries'  long-lived  assets and certain  identifiable
intangibles  are  reviewed  for  impairment  in  accordance  with  Statement  of
Financial Accounting Standard No. 144 "Accounting for the Impairment or Disposal
of  Long-Lived   Assets"  ("SFAS  No.  144")  whenever   events  or  changes  in
circumstances  indicate  that  the  carrying  amount  of an  asset  may  not  be
recoverable. Recoverability of the carrying amount of assets to be held and used
is measured by a comparison  of the carrying  amount of the assets to the future
undiscounted  cash flows expected to be generated by the assets.  If such assets
are  considered to be impaired,  the  impairment to be recognized is measured by
the amount by which the carrying  amount of the assets exceeds the fair value of
the assets. As of December 31, 2003 no impairment losses have been identified.

k. Revenue recognition:

The  Company  generates   revenues   primarily  from  sales  of  multimedia  and
interactive  digital training systems and use-of-force  simulators  specifically
targeted for law  enforcement and firearms  training and from service  contracts
related  to such  sales  (through  IES),  from  providing  lightweight  armoring
services of vehicles  (through MDT), and from sale of zinc-air  battery products
for defense  applications.  To a lesser  extent,  revenues  are  generated  from
development  services  and  long-term  arrangements  subcontracted  by  the  U.S
Government.

Revenues  from  products,  training and  simulation  systems are  recognized  in
accordance with SEC Staff  Accounting  Bulletin No. 104,  "Revenue  Recognition"
("SAB No. 104") when persuasive  evidence of an agreement  exists,  delivery has
occurred,  the fee is fixed or determinable,  collectability is probably, and no
further obligation remains.

The Company does not grant a right of return to its customers.

Revenues from long-term  agreements,  subcontracted by the U.S. government,  are
recorded on a  cost-sharing  basis,  when  services  are  rendered  and products
delivered,  as prescribed in the related  agreements.  Provisions  for estimated
losses are  recognized  in the period in which the  likelihood of such losses is
determined. As of December 31, 2003, no such estimated losses were identified.



                                      F-20
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)

Deferred  warranty  revenues  includes unearned amounts received from customers,
but not recognized as revenues.

Revenues from development services are recognized based on Statement of Position
No.  81-1  "Accounting  for  Performance  of  Construction  - Type  and  Certain
Production - Type  Contracts"  ("SOP  81-1"),  using  contract  accounting  on a
percentage of completion method,  based on completion of agreed-upon  milestones
and in  accordance  with the "Output  Method" or based on the time and  material
basis.  Provisions for estimated losses on uncompleted  contracts are recognized
in the  period in which the  likelihood  of such  losses  is  determined.  As of
December 31, 2003, no such estimated losses were identified.



                                      F-21
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)

Revenues  from  lightweight  armoring  services of vehicles  are  recorded  when
services are rendered and vehicle is  delivered  and no  additional  obligations
exists.

Revenues  from  products not delivered  upon  customers'  request due to lack of
storage space at the customers' facilities during the integration are recognized
when the  criteria  of Staff  Accounting  Bulletin  No. 104 ("SAB No.  104") for
bill-and-hold transactions are met.

l. Research and development cost:

Research  and  development  costs,  net of grants  received,  are charged to the
statements of operations as incurred.

Significant  software  development costs incurred by the Company's  subsidiaries
between  completion  of the working  model and the point at which the product is
ready for general release, are capitalized.

Capitalized  software costs are amortized by using the straight-line method over
the  estimated  useful life of the product  (three to five  years).  The Company
assesses  the  recoverability  of this  intangible  asset on a regular  basis by
determining whether the amortization of the asset over its remaining life can be
recovered through future gross revenues from the specific software product sold.
Based on its most recent  analyses,  management  believes  that no impairment of
capitalized software development costs exists as of December 31, 2003.

m. Royalty-bearing grants:

Royalty-bearing  grants  from the Office of the Chief  Scientist  ("OCS") of the
Israeli  Ministry of  Industry  and Trade and from the  Israel-U.S.  Bi-national
Industrial Research and Development  Foundation  ("BIRD-F") for funding approved
research  and  development  projects are  recognized  at the time the Company is
entitled to such grants on the basis of the costs  incurred,  and  included as a
deduction of research and development costs.

n. Income taxes:

The Company and its  subsidiaries  account for income taxes in  accordance  with
Statement of Financial  Accounting  Standards  No. 109,  "Accounting  for Income
Taxes"  ("SFAS No. 109").  This  Statement  prescribes  the use of the liability
method,   whereby  deferred  tax  assets  and  liability  account  balances  are
determined  based on differences  between  financial  reporting and tax bases of
assets and  liabilities  and are  measured  using the enacted tax rates and laws
that will be in effect when the differences are expected to reverse. The Company
and its  subsidiaries  provide a valuation  allowance,  if necessary,  to reduce
deferred tax assets to their estimated realizable value.

o. Concentrations of credit risk:

Financial  instruments that potentially subject the Company and its subsidiaries
to  concentrations  of  credit  risk  consist   principally  of  cash  and  cash
equivalents,  restricted  collateral deposit and other restricted cash and trade
receivables. Cash and cash equivalents are invested in U.S. dollar deposits with
major  Israeli and U.S.  banks.  Such  deposits in the U.S.  may be in excess of
insured limits and are not insured in other  jurisdictions.  Management believes
that  the  financial  institutions  that  hold  the  Company's  investments  are
financially sound and,  accordingly,  minimal credit risk exists with respect to
these investments.



                                      F-22
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)

The trade  receivables  of the Company and its  subsidiaries  are mainly derived
from sales to  customers  located  primarily  in the United  States,  Europe and
Israel.  Management believes that credit risks are moderated by the diversity of
its end customers and  geographical  sales areas.  The Company  performs ongoing
credit  evaluations  of its  customers'  financial  condition.  An allowance for
doubtful  accounts is determined with respect to those accounts that the Company
has determined to be doubtful of collection.

The Company  and its  subsidiaries  had no  off-balance-sheet  concentration  of
credit  risk such as  foreign  exchange  contracts,  option  contracts  or other
foreign hedging arrangements.

p. Basic and diluted net loss per share:

Basic net loss per share is computed  based on the  weighted  average  number of
shares of common stock outstanding  during each year. Diluted net loss per share
is  computed  based on the  weighted  average  number of shares of common  stock
outstanding  during each year,  plus dilutive  potential  shares of common stock
considered  outstanding  during  the  year,  in  accordance  with  Statement  of
Financial Standards No. 128, "Earnings Per Share" ("SFAS No. 128").

All  outstanding  stock  options  and  warrants  have  been  excluded  from  the
calculation of the diluted net loss per common share because all such securities
are anti-dilutive for all periods  presented.  The total weighted average number
of shares  related to the  outstanding  options and warrants  excluded  from the
calculations  of diluted net loss per share was  22,194,211  and  4,394,803  and
3,170,334 for the years ended December 31, 2003, 2002 and 2001, respectively.

q. Accounting for stock-based compensation:

The Company has elected to follow  Accounting  Principles  Board  Opinion No. 25
"Accounting for Stock Issued to Employees" ("APB No. 25") and Interpretation No.
44 "Accounting for Certain Transactions  Involving Stock Compensation" ("FIN No.
44") in accounting for its employee  stock option plans.  Under APB No. 25, when
the exercise price of the Company's  share options is less than the market price
of  the  underlying  shares  on the  date  of  grant,  compensation  expense  is
recognized.   Under  Statement  of  Financial   Accounting   Standard  No.  123,
"Accounting  for   Stock-Based   Compensation"   ("SFAS  No.  123"),   pro-forma
information  regarding net income and net income per share is required,  and has
been  determined as if the Company had accounted for its employee  stock options
under the fair value method of SFAS No. 123.

The  Company  applies  SFAS No. 123 and  Emerging  Issue  Task  Force No.  96-18
"Accounting for Equity  Instruments  that are Issued to Other than Employees for
Acquiring,  or in Conjunction  with Selling,  Goods or Services"  ("EITF 96-18")
with respect to options issued to non-employees. SFAS No. 123 requires use of an
option  valuation  model to measure  the fair value of the  options at the grant
date.

The fair value for the options to employees  was estimated at the date of grant,
using  the   Black-Scholes   Option   Valuation   Model,   with  the   following
weighted-average  assumptions:  risk-free  interest  rates  of  2.54%,  3.5% and
3.5-4.5% for 2003,  2002 and 2001,  respectively;  a dividend  yield of 0.0% for
each of those  years;  a volatility  factor of the expected  market price of the
common  stock  of 0.67 for  2003,  0.64  for  2002  and  0.82  for  2001;  and a
weighted-average expected life of the option of 5 years for 2003, 2002 and 2001.



                                      F-23
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)


         The following  table  illustrates the effect on net income and earnings
per share,  assuming  that the Company  had  applied the fair value  recognition
provision of SFAS No. 123 on its stock-based employee compensation:

<TABLE>
<CAPTION>
                                                                              Year ended December 31,
                                                                  2003                  2002                  2001
                                                             ------------          ------------          ------------
<S>                                                          <C>                   <C>                   <C>
Net loss as reported                                         $ (9,008,274)         $(18,504,358)         $(18,483,455)
Add: Stock-based compensation expenses included in
   reported net loss                                                8,286                 6,000                17,240
Deduct:  Stock-based compensation expenses
   determined under fair value method for all awards           (1,237,558)           (2,072,903)           (2,906,386)
                                                             $(10,237,546)         $(20,571,261)         $ 21,372,601
                                                             ============          ============          ============
Loss per share:
   Basic and diluted, as reported                            $      (0.23)         $      (0.57)         $      (0.76)
                                                             ============          ============          ============
   Diluted, pro forma                                        $      (0.26)         $      (0.64)         $      (0.88)
                                                             ============          ============          ============
</TABLE>


r. Fair value of financial instruments:

The  following  methods  and  assumptions  were  used  by the  Company  and  its
subsidiaries   in  estimating   their  fair  value   disclosures  for  financial
instruments:

The carrying amounts of cash and cash equivalents, restricted collateral deposit
and other restricted cash, trade receivables,  short-term bank credit, and trade
payables  approximate  their fair value due to the  short-term  maturity of such
instruments.

Long-terms  liabilities are estimated by discounting the future cash flows using
current  interest rates for loans or similar terms and maturities.  The carrying
amount of the long-term liabilities approximates their fair value.

s. Severance pay:

The Company's  liability  for  severance  pay is calculated  pursuant to Israeli
severance pay law based on the most recent salary of the employees multiplied by
the number of years of employment  as of the balance  sheet date.  Employees are
entitled  to one  month's  salary  for each  year of  employment,  or a  portion
thereof.  The Company's  liability for all of its employees is fully provided by
monthly deposits with severance pay funds, insurance policies and by an accrual.
The value of these  policies is recorded  as an asset in the  Company's  balance
sheet.

In addition  and  according  to certain  employment  agreements,  the Company is
obligated to provide for a special  severance  pay in addition to amounts due to
certain employees  pursuant to Israeli severance pay law. The Company has made a
provision  for this  special  severance  pay in  accordance  with  Statement  of
Financial  Accounting  Standard  No.  106,   "Employer's   Accounting  for  Post
Retirement  Benefits Other than Pensions"  ("SFAS No. 106").  As of December 31,
2003 and 2002,  the  accumulated  severance  pay in that  regard  amounted  to $
1,699,260 and $1,630,366, respectively.



                                      F-24
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 2: - SIGNIFICANT ACCOUNTING POLICIES (Cont.)

The deposited  funds include  profits  accumulated up to the balance sheet date.
The deposited funds may be withdrawn only upon the fulfillment of the obligation
pursuant  to Israeli  severance  pay law or labor  agreements.  The value of the
deposited  funds is based on the cash  surrendered  value of these  policies and
includes immaterial profits.

Severance expenses for the year ended December 31, 2003 amounted to $ 219,857 as
compared to severance  income and expenses for the years ended December 31, 2002
and 2001, which amounted to $338,574 and $653,885, respectively.

t. Advertising costs:

The  Company  and  its  subsidiaries  expense  advertising  costs  as  incurred.
Advertising  expense for the years ended  December 31,  2003,  2002 and 2001 was
approximately $34,732, $294,599 and $1,676,280 respectively.

NOTE 3:- RESTRICTED COLLATERAL DEPOSIT AND OTHER RESTRICTED CASH

The  restricted  collateral  deposit is  invested in a $706,180  certificate  of
deposit that is used to secure certain real property lease  arrangements,  and a
currency  hedging  arrangement to protect the Company against change in the euro
versus the dollar in  connection  with IES's  contract  with the German  police,
which is  denominated in euros; a portion was also on deposit with an arbitrator
in connection with the Company's litigation with IES Electronic Industries, Ltd.

                                   December 31, 2003

IES Deposit                         $    450,000
Forward Deal                             205,489
Property Lease                            41,412
Other                                      9,279
                                   -----------------
                                    $    706,180
                                   =================



NOTE 4: - OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

                                              December 31,
                                   ------------------------------------
                                        2003                2002
                                   ----------------    ----------------
Government authorities              $       65,402      $      348,660
Employees                                  246,004              23,959
Prepaid expenses                           551,010             591,008
Other                                      324,955              68,684
                                   ----------------    ----------------

                                    $    1,187,371      $    1,032,311
                                   ================    ================




                                      F-25
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 5:- INVENTORIES

                                              December 31,
                                  --------------------------------------
                                        2003                 2002
                                  -----------------    -----------------
Raw and packaging materials        $      657,677       $      893,666
Work in progress                          634,221              296,692
Finished products                         622,850              521,121
                                  -----------------    -----------------
                                   $    1,914,748       $    1,711,479
                                  =================    =================


NOTE 6:- PROPERTY AND EQUIPMENT, NET

a. Composition of property and equipment is as follows:

<TABLE>
<CAPTION>
                                                                           December 31,
                                                               -------------------------------------
                                                                     2003                2002
                                                               -----------------   -----------------
              Cost:
<S>                                                              <C>                 <C>
                       Computers and related equipment           $   1,015,836       $      815,759
                       Motor vehicles                                  288,852              335,286
                       Office furniture and equipment                  402,726              519,092
                       Machinery, equipment and

                         installations                               4,866,904            4,715,182
                       Leasehold improvements                          882,047              442,482
                       Demo inventory                                  150,996              154,689
                                                                ----------------    ----------------

                                                                     7,607,361            6,982,490
                                                                ----------------    ----------------
              Accumulated depreciation:

                       Computers and related equipment                 753,593              669,258
                       Motor vehicles                                   95,434               39,281
                       Office furniture and equipment                  173,301              255,829
                       Machinery, equipment and installations        3,637,111            3,106,389
                       Leasehold improvements                          655,181              356,484
                                                                ----------------    ----------------

                                                                     5,314,620            4,427,241
                                                                ----------------    ----------------

              Depreciated cost                                   $   2,292,741       $    2,555,249
                                                                ================    ================
</TABLE>


b.  Depreciation  expense amounted to $730,159,  $473,739 and $530,013,  for the
years ended December 31, 2003, 2002 and 2001, respectively.

As for liens, see Note 10.d.



                                      F-26
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 7: - OTHER INTANGIBLE ASSETS, NET

a.

                                             Year ended December 31,
                                        --------------------------------
                                            2003                 2002
                                        -----------          -----------
Cost:
  Technology                            $ 2,231,746          $ 1,795,000
  Capitalized research and
    development                             209,615                   --
  Existing contracts                         46,000               46,000
  Covenants not to compete                   99,000               99,000
  Customer list                             827,250              812,000
                                        -----------          -----------

                                          3,413,611            2,752,000
Exchange differences                         25,438                   --
Less - accumulated amortization          (1,502,854)             623,543
                                        -----------          -----------

Amortized cost                            1,936,195            2,128,457
Trademarks                                  439,000              439,000
                                        -----------          -----------

                                        $ 2,375,195          $ 2,567,457
                                        ===========          ===========


b.  Amortization  expenses  amounted to $879,311 for the year ended December 31,
2003.

c. Estimated amortization expenses for the years ended:

       Year ended December 31,
------------------------------------
2004                  $      552,443
2005                         541,466
2006                         366,421
2007                         244,734
2008 and forward             231,131
                     ---------------
                      $    1,936,195
                     ===============

NOTE 8: - PROMISSORY NOTES

In  connection  with the  acquisition  discussed in Note 1b, the Company  issued
promissory notes in the face amount of an aggregate of $1,800,000,  one of which
was a note for $400,000 that was convertible into an aggregate of 200,000 shares
of the  Company's  common  stock.  The Company has  accounted for these notes in
accordance  with  Accounting  Principles  Board  Opinion  No. 21,  "Interest  on
Receivables  and  Payables,"  and recorded the notes at its present value in the
amount of $1,686,964. In December 2002, the terms of these promissory notes were
amended to (i)  extinguish  the  $1,000,000  note due at the end of June 2003 in
exchange for prepayment of $750,000, (ii) amend the $400,000 note due at the end
of December 2003 to be a $450,000 note, and (iii) amend the convertible $400,000
note due at the end of June 2004 to be a $450,000 note  convertible  at $0.75 as
to $150,000, at $0.80 as to $150,000, and at $0.85 as to $150,000. In accordance
with EITF 96-19,  "Debtor's  Accounting for a  Modification  or Exchange of Debt
Instruments,"  the terms of the  promissory  notes are not treated as changed or
modified when the cash flow effect on a present value basis is less than 10% and
therefore the Company did not record any compensation  related to these changes.
The $450,000 note due at the end of June 2004 was converted into an aggregate of
563,971  shares of common stock in August 2003.  With  reference to the $450,000
note due at the end of December 2003, see Note 17.f.



                                      F-27
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 9: - OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES

                                                 December 31,
                                      ------------------------------------
                                           2003                2002
                                      ----------------   -----------------

 Employees and payroll accruals         $   1,232,608      $      615,292
 Accrued vacation pay                         216,768             137,179
 Accrued expenses                             842,760             342,793
 Minority balance                             149,441             289,451
 Government authorities                       357,095             497,428
 Deferred warranty revenues                    40,936              95,831
 Litigation settlement accrual(1)           1,313,642                   -
 Other                                        168,097              31,135
                                       ---------------    -----------------
                                        $   4,321,347      $    2,009,109
                                       ===============    =================

(1) See Note 17.f.

NOTE 10: - COMMITMENTS AND CONTINGENT LIABILITIES

a. Royalty commitments:

1. Under EFL's research and development  agreements with the Office of the Chief
Scientist  ("OCS"),  and  pursuant to  applicable  laws,  EFL is required to pay
royalties at the rate of 3%-3.5% of net sales of products  developed  with funds
provided by the OCS, up to an amount equal to 100% of research  and  development
grants received from the OCS (linked to the U.S. dollars. Amounts due in respect
of projects  approved after year 1999 also bear interest of the Libor rate). EFL
is obligated to pay royalties  only on sales of products in respect of which OCS
participated  in their  development.  Should the project  fail,  EFL will not be
obligated to pay any royalties.

Royalties paid or accrued for the years ended December 31, 2003,  2002 and 2001,
to the OCS amounted to $435, $32,801 and $75,791, respectively.

As of  December  31,  2003,  the  total  contingent  liability  to the  OCS  was
approximately   $10,057,000.   The  Company  regards  the  probability  of  this
contingency coming to pass in any material amount to be low.

2. EFL, in cooperation with a U.S.  participant,  has received approval from the
BIRD-F for 50% funding of a project for the  development of a hybrid  propulsion
system  for  transit  buses.  The  maximum  approved  cost  of  the  project  is
approximately  $1.8  million,  and the  Company's  share in the project costs is
anticipated to amount to approximately $1.1 million, which will be reimbursed by
BIRD-F at the aforementioned rate of 50%. Royalties at rates of 2.5%-5% of sales
are  payable up to a maximum of 150% of the grant  received,  linked to the U.S.
Consumer Price Index. Accelerated royalties are due under certain circumstances.

EFL is obligated to pay royalties  only on sales of products in respect of which
BIRD-F participated in their development.  Should the project fail, EFL will not
be obligated to pay any royalties.

No  royalties  were paid or accrued to the BIRD-F in each of the three  years in
the period ended December 31, 2003.



                                      F-28
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 10: - COMMITMENTS AND CONTINGENT LIABILITIES(Cont.)

As of December 31, 2003, the total contingent liability to pay BIRD-F (150%) was
approximately  $772,000. The Company regards the probability of this contingency
coming to pass in any material amount to be low.

b. Lease commitments:

The Company and its subsidiaries  rent their facilities under various  operating
lease agreements, which expire on various dates, the latest of which is in 2005.
The  minimum  rental  payments  under  non-cancelable  operating  leases  are as
follows:

      Year ended December 31,
 -----------------------------------

 2004              $      393,512
 2005                     197,266
                  ------------------
                   $      590,778
                  ==================

Total rent expenses for the years ended December 31, 2003,  2002 and 2001,  were
approximately $484,361, $629,101 and $456,701, respectively.

c. Guarantees:

The Company obtained bank guarantees in the amount of $51,082 in connection with
(i) a  lease  agreement  of one  of the  Company's  subsidiaries,  (ii) a  sales
obligation  to a  customer  of one  of the  Company's  subsidiaries,  and  (iii)
obligations  of  one of  the  Company's  subsidiaries  to  the  Israeli  customs
authorities.

d. Liens:

As security for compliance with the terms related to the investment  grants from
the state of Israel, EFL has registered  floating liens on all of its assets, in
favor of the State of Israel.

The Company has granted to the holders of its 8% secured convertible  debentures
a first position security  interest in (i) the shares of MDT Armor  Corporation,
(ii) the assets of its IES  Interactive  Training,  Inc.  subsidiary,  (iii) the
shares of all of its subsidiaries, and (iv) any shares that the Company acquires
in future Acquisitions (as defined in the securities purchase agreement).

EFL has granted to its former CEO a security interest in certain of its property
located in Beit Shemesh, Israel, to secure sums due to him pursuant to the terms
of the settlement agreement with him.



                                      F-29
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY

a. Shareholders' rights:

The  Company's  shares  confer upon the  holders the right to receive  notice to
participate and vote in the general meetings of the Company and right to receive
dividends, if and when declared.

b. Issuance of common stock to investors:

1. In May 2001,  the Company  issued a total of  4,045,454  shares of its common
stock to a group of institutional  investors at a price of $2.75 per share, or a
total purchase price of $11,125,000. (See also Note 11.f.1 and 11.f.2.)

2. On November 21, 2001, the Company  issued a total of 1,503,759  shares of its
common stock at a purchase  price of $1.33 per share,  or a total purchase price
of $2,000,000, to a single institutional investor.

3. On December 5, 2001,  the Company  issued a total of 1,190,476  shares of its
common stock at a purchase  price of $1.68 per share,  or a total purchase price
of $2,000,000, to a single institutional investor.

4. On January  18,  2002,  the Company  issued a total of 441,176  shares of its
common stock at a purchase  price of $1.70 per share,  or a total purchase price
of $750,000, to an investor (see also Note 11.f.3).

5. On January 24, 2002,  the Company  issued a total of 1,600,000  shares of its
common stock at a purchase  price of $1.55 per share,  or a total purchase price
of $2,480,000, to a group of investors.

c. Issuance of common stock to service providers and employees:

1. On June 17, 2001 the Company  issued a  consultant a total of 8,550 shares of
its common stock in  compensation  for services  rendered by such consultant for
the  Company  for  preparation  of  certain  video  point-of-purchase  and sales
demonstration materials. At the issuance date the fair value of these shares was
determined  both by the value of the shares  issued as  reflected by fair market
price  at the  issuance  date  and by the  value of the  services  provided  and
amounted to $15,488 in  accordance  with EITF  96-18.  In  accordance  with EITF
00-18, the Company recorded this compensation  expense as marketing  expenses in
the amount of $15,488.

2. On September 17, 2001 the Company issued to selling and marketing consultants
a total of 337,571 shares of its common stock in compensation  for  distribution
services  rendered by such  consultant.  At the issuance  date the fair value of
these shares was determined  both by the value of the shares issued as reflected
by fair  market  price at the  issuance  date and by the  value of the  services
provided  and  amounted  to  $524,889  in  accordance  with  EITF  96-18  and in
accordance with EITF 00-18.  The Company recorded this  compensation  expense as
marketing expenses in the amount of $524,889.

3. On February 15, 2002 and September 10, 2002,  the Company  issued 318,468 and
50,000  shares,  respectively,  of  common  stock  at  par  consideration  to  a
consultant  for providing  business  development  and marketing  services in the
United  Kingdom.  At the  issuance  date,  the fair  value of these  shares  was
determined  both by the value of the shares  issued as  reflected by fair market
price  at the  issuance  date  and by the  value of the  services  provided  and
amounted to $394,698 and $63,000,  respectively,  in accordance with EITF 96-18.
In accordance with EITF 00-18, the Company recorded this compensation expense of
$394,698  and  $63,000,  respectively,  during the year 2002 and  included  this
amount in marketing expenses.



                                      F-30
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)

4. On September  10, 2002,  the Company  issued an aggregate of 13,000 shares of
common stock at par  consideration to two of its employees as stock bonuses.  At
the issuance  date,  the fair value of these shares was  determined  by the fair
market  value of the shares  issued as  reflected  by fair  market  price at the
issuance date in accordance  with APB No. 25. In accordance with APB No. 25, the
Company recorded this  compensation  expense of $13,000 during the year 2002 and
included this amount in general and administrative expenses.

5. In July  2003,  the  Company  issued  215,294  shares  of  common  stock to a
consultant as  commissions  on battery  orders.  At the issuance  date, the fair
value of these shares was  determined  both by the value of the shares issued as
reflected  by fair  market  price at the  issuance  date and by the value of the
services  provided and amounted to $154,331 in  accordance  with EITF 96-18.  In
accordance with EITF 00-18,  the Company recorded this  compensation  expense of
$154,331 during the year 2003 and included this amount in marketing expenses.

6. In  November  2003,  the Company  issued  8,306  shares of common  stock to a
consultant as  commissions  on battery  orders.  At the issuance  date, the fair
value of these  shares was  determined  by the fair  market  value of the shares
issued as reflected  by fair market price at the issuance  date and by the value
of the services  provided and amounted to $7,616 in accordance  with EITF 96-18.
In accordance with EITF 96-18, the Company recorded this compensation expense of
$7,616 during the year 2003 and included this amount in marketing expenses.

d. Issuance of shares to lenders

As part of the  securities  purchase  agreement  on December  31, 2002 (see Note
16.a),  the Company issued 387,301 shares at par as consideration to lenders for
the first nine months of interest expenses. At the issuance date, the fair value
of these  shares  was  determined  both by the  value of the  shares  issued  as
reflected  by fair  market  price at the  issuance  date and by the value of the
interest and  amounted to $236,250 in  accordance  with APB 14.  During 2003 the
company recorded this amount as financial expenses.

e. Issuance of notes receivable:

1. As part of its purchase of the assets of IES Interactive Training,  Inc. (see
Note 1.b.), the Company issued a $450,000 convertible  promissory note (see Note
8). This note was converted  into an aggregate of 563,971 shares of common stock
in August 2003.

f. Warrants:

1. As part of an  investment  agreement  in November  2000,  the Company  issued
warrants to  purchase  an  additional  1,000,000  shares of common  stock to the
investor,  with  exercise  prices of $11.31 for  333,333 of these  warrants  and
$12.56 per share for 666,667 of these warrants. In addition,  the Company issued
warrants to purchase  150,000  shares of common stock,  with exercise  prices of
$9.63 for 50,000 of these  warrants  and  $12.56 per share for  100,000 of these
warrants  to an  investment  banker  involved  in this  agreement.  Out of these
warrants  issued to the investor,  666,667  warrants expire on November 17, 2005
and 333,333 warrants were to expire on August 17, 2001.


                                      F-31
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)

As part of the transaction in May 2001 (see Note 11.b.1),  the Company  repriced
these warrants in the following manner:

         >>       Of  the  1,000,000  warrants  granted  to  the  investor,  the
                  exercise price of 666,667  warrants was reduced from $12.56 to
                  $3.50 and of  333,333  warrants  was  reduced  from  $11.31 to
                  $2.52. In addition,  the 333,333  warrants that were to expire
                  on August 17, 2001,  were  immediately  exercised  for a total
                  consideration of $840,000.

         >>       Moreover,  the Company  issued to this  investor an additional
                  warrant  to  purchase  250,000  shares of  common  stock at an
                  exercise price of $3.08 per share, to expire on May 3, 2006.

         >>       Of the 150,000 warrants  granted to the investment  banker the
                  exercise price of 100,000  warrants was reduced from $12.56 to
                  $3.08 and of 50,000  warrants was reduced from $9.63 to $3.08.
                  In addition, the 50,000 warrants that were to expire on August
                  17, 2001 were extended to November 17, 2005.

As a result of the  aforesaid  modifications,  including  the  repricing  of the
warrants to the investors and to the investment  banker and the additional grant
of warrants to the investor,  the Company has recorded a deemed  dividend in the
amount of  $1,196,667,  to reflect  the  additional  benefit  created  for these
certain  investors.  The fair value of the repriced warrants was calculated as a
difference  measured  between  (1)  the  fair  value  of  the  modified  warrant
determined in accordance  with the provisions of SFAS No. 123, and (2) the value
of the old warrant  immediately before its terms are modified,  determined based
on the shorter of (a) its  remaining  expected  life or (b) the expected life of
the modified option. The deemed dividend increased the loss applicable to common
stockholders  in the calculation of basic and diluted net loss per share for the
year ended December 31, 2001, without any effect on total shareholder's equity.

2. As part of the  investment  agreement  in May 2001  (see  Note  11.b.1),  the
Company  issued to the  investors a total of 2,696,971  warrants  (the "May 2001
Warrants")  to  purchase  shares of common  stock at a price of $3.22 per share;
these warrants are  exercisable by the holder at any time after November 8, 2001
and  will  expire  on May 8,  2006.  The  Company  also  issued  to a  financial
consultant that provided  investment  banking  services  concurrently  with this
transaction a total of 125,000  warrants to purchase shares of common stock at a
price of $3.22 per share;  these  warrants are  exercisable by the holder at any
time  and  will  expire  on  June  12,  2006.   In  addition  the  Company  paid
approximately  $562,000 in cash, which was recorded as deduction from additional
paid in capital.

In June 2003,  the Company  adjusted the purchase  price of 1,357,577 of the May
2001  Warrants to $0.82 per share in exchange  for  immediate  exercise of these
warrants,  and issued to the holders of these exercised warrants new warrants to
purchase a total of 905,052  shares of common stock at a purchase price of $1.45
per share (the "June 2003  Warrants").  The June 2003 Warrants  were  originally
exercisable  at any time  from and after  December  31,  2003 to June 30,  2008;
however,  in September  2003, the exercise  period of 638,385 of these June 2003
Warrants  was  adjusted  to make  them  exercisable  at any time  from and after
December 31, 2004 to June 30, 2009. As a result the company recorded during 2003
an expense of $244,810  and included  this amount in general and  administrative
expenses.



                                      F-32
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)

In  addition,  with  respect to an  additional  387,879  May 2001  Warrants,  in
December  2003 the Company  adjusted  the  purchase  price to $1.60 per share in
exchange for immediate exercise of these warrants,  and issued to the holders of
these  exercised  warrants new warrants to purchase a total of 193,940 shares of
common  stock at a purchase  price of $2.25 per share .As a result  the  company
recorded  during 2003 an expense of $74,384 and included  this amount in general
and administrative expenses.

Additionally,  in October 2003 the Company  granted to three of these  investors
additional new warrants to purchase a total of 150,000 shares of common stock at
a purchase  price of $1.20 per share.  As a result the company  recorded  during
2003  an  expense  of  $69,209   and   included   this  amount  in  general  and
administrative expenses.

3. As part of the  investment  agreement in January 2002 (see Note 11.b.4),  the
Company,  in  January  2002,  issued to a  financial  consultant  that  provided
investment  banking  services  concurrently  with this transaction a warrants to
acquire (i)  150,000  shares of common  stock at an exercise  price of $1.68 per
share, and (ii) 119,000 shares of common stock at an exercise price of $2.25 per
share;  these warrants are exercisable by the holder at any time and will expire
on January 4, 2007.

4. As part of the securities  purchase  agreement on December 31, 2002 (see Note
16.a),  the  Company  issued to the  purchasers  of its 9%  secured  convertible
debentures  due June 30, 2005,  warrants,  as follows:  (i) Series A Warrants to
purchase an aggregate  of 1,166,700  shares of common stock at any time prior to
December  31,  2007 at a price of $0.84 per share;  (ii)  Series B  Warrants  to
purchase an aggregate  of 1,166,700  shares of common stock at any time prior to
December 31, 2007 at a price of $0.89 per share;  and (iii) Series C Warrants to
purchase an aggregate  of 1,166,700  shares of common stock at any time prior to
December  31, 2007 at a price of $0.93 per share.  The  exercise  price of these
warrants was adjusted to $0.64 per share in April 2003.

In connection with these warrants, the Company recorded a deferred debt discount
of $1,290,000,  which will be amortized ratably over the life of the convertible
debentures (3 years),  unless these  warrants are  exercised,  in which case any
remaining  financial  expense will be taken in the quarter in which the exercise
occurs.  This transaction was accounted  according to APB No. 14 "Accounting for
Convertible  debt and Debt Issued with Stock  Purchase  Warrants"  and  Emerging
Issue Task Force No. 00-27 "Application of Issue No. 98-5 to Certain Convertible
Instruments"  ("EITF  00-27").  The fair value of these  warrants was determined
using Black-Scholes pricing model, assuming a risk-free interest rate of 3.5%, a
volatility factor 64%, dividend yields of 0% and a contractual life of 5 years.

During 2003, an aggregate of 1,500,042  shares were issued pursuant to exercises
of these warrants.

During 2003, the Company recorded an expense of $847,714,  of which $423,857 was
attributable to  amortization of the convertible  debentures over their term and
$423,857 was  attributable  to accelerated  amortization  due to the exercise of
warrants. Those expenses were included in the financial expenses.

5. As part of the securities  purchase agreement on September 30, 2003 (see Note
16.b),  the  Company  issued to the  purchasers  of its 8%  secured  convertible
debentures  due  September  30,  2006,  warrants  to purchase  an  aggregate  of
1,250,000  shares of common stock at any time prior to  September  30, 2006 at a
price of $1.4375 per share.



                                      F-33
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)

In connection with these warrants, the Company recorded a deferred debt discount
of $1,025,000,  which will be amortized ratably over the life of the convertible
debentures (3 years).  This  transaction  was accounted  according to APB No. 14
"Accounting for Convertible  debt and Debt Issued with Stock Purchase  Warrants"
and  Emerging  Issue  Task Force No.  00-27  "Application  of Issue No.  98-5 to
Certain  Convertible  Instruments"  ("EITF  00-27").  The  fair  value  of these
warrants was determined using Black-Scholes  pricing model, assuming a risk-free
interest rate of 1.95%,  a volatility  factor 98%,  dividend  yields of 0% and a
contractual life of 3 years.

During 2003, an aggregate of 437,500 shares were issued pursuant to exercises of
these warrants.

During 2003 the Company  recorded an expense of $414,676,  of which  $78,512 was
attributable  to  amortization of the debt discount over their term and $336,164
was attributable to amortization due to accelerated exercise of warrants.  Those
expenses were included in the financial expenses.

6. As a further part of the securities  purchase agreement on September 30, 2003
(see  Note  16.c),  the  Company  issued  to the  purchasers  of its 8%  secured
convertible  debentures due December 31, 2006, warrants to purchase an aggregate
of 1,500,000  shares of common stock at any time prior to December 31, 2006 at a
price of $1.8125 per share.  Additionally,  the Company  issued to the investors
supplemental  warrants to purchase an aggregate  of  1,038,000  shares of common
stock at any time prior to December 31, 2006 at a price of $2.20 per share.

In connection with these warrants, the Company will record financial expenses of
$ 1,545,000 and  $1,297,500 for the  additional  and the  supplemental  warrants
referred to above,  respectively,  which will be amortized ratably over the life
of  the  convertible  debentures  (3  years).  This  transaction  was  accounted
according to APB No. 14 "Accounting  for  Convertible  debt and Debt Issued with
Stock Purchase Warrants" and Emerging Issue Task Force No. 00-27 "Application of
Issue No. 98-5 to Certain  Convertible  Instruments"  ("EITF  00-27").  The fair
value of these  warrants  was  determined  using  Black-Scholes  pricing  model,
assuming a risk-free  interest rate of 2.45%, a volatility  factor 98%, dividend
yields of 0% and a contractual life of 3 years.

During 2003 the Company recorded an expense of $53,440 for amortization of these
debt discounts over their term, which is included in financial expenses.

g. Stock option plans:

1. Options to employees and others (except consultants)

a. The Company has adopted the following stock option plans, whereby options may
be granted for purchase of shares of the Company's common stock. Under the terms
of the employee plans, the Board of Directors or the designated committee grants
options and determines the vesting period and the exercise terms.

1) 1991 Employee Option Plan - 2,115,600 shares reserved for issuance,  of which
53,592 were available for future grants to employees as of December 31, 2003.

2) 1993  Employee  Option  Plan - as  amended,  6,200,000  shares  reserved  for
issuance, of which no shares were available for future grants to employees as of
December 31, 2003.



                                      F-34
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)

3) 1998  Employee  Option  Plan - as  amended,  4,750,000  shares  reserved  for
issuance,  of which no shares were  available for future grants to employees and
consultants as of December 31, 2003.

4) 1995 Non-Employee  Director Plan - 1,000,000 shares reserved for issuance, of
which  600,000 were  available for future grants to directors as of December 31,
2003.

b. Under these plans,  options  generally expire no later than 10 years from the
date of grant.  Each option can be exercised  to purchase one share,  conferring
the same  rights as the other  common  shares.  Options  that are  cancelled  or
forfeited  before  expiration  become  available for future grants.  The options
generally vest over a three-year period (33.3% per annum).

c. A summary  of the  status of the  Company's  plans  and other  share  options
(except for options  granted to  consultants)  granted as of December  31, 2003,
2002 and 2001, and changes  during the years ended on those dates,  is presented
below:

<TABLE>
<CAPTION>
                                              2003                        2002                        2001
                                    --------------------------  --------------------------  -------------------------
                                      Amount       Weighted       Amount       Weighted        Amount      Weighted
                                                    average                     average                    average
                                                   exercise                    exercise                    exercise
                                                     price                       price                       price
                                    --------------------------  --------------------------  -------------------------
                                                       $                           $                           $
                                                  ------------                ------------                 ----------
<S>                                   <C>            <C>          <C>            <C>          <C>             <C>
Options outstanding at beginning
  of year                             5,260,366      $ 2.26       4,240,228      $ 2.74       2,624,225       $ 3.82
Changes during year:
Granted (1) (2)                       5,264,260      $ 0.71       1,634,567      $ 0.87       2,172,314       $ 1.55
Exercised (3)                           689,640      $ 0.64        (191,542)     $ 1.29        (159,965)      $ 1.31
Forfeited or cancelled                 (816,675)     $ 3.51        (422,887)     $ 1.92        (396,346)      $ 4.11
                                    ------------  ------------  ------------  ------------  -------------  ----------
Options outstanding at end of year    9,018,311      $ 1.37       5,260,366      $ 2.26       4,240,228       $ 2.74
                                    ============  ============  ============  ============  =============  ==========
Options exercisable at end of year    5,826,539      $ 1.70       4,675,443      $ 2.26       2,643,987       $ 2.75
                                    ============  ============  ============  ============  =============  ==========
</TABLE>


         (1)  Includes  2,035,000,  481,435  and  1,189,749  options  granted to
         related parties in 2003, 2002 and 2001, respectively.

         (3) The Company recorded deferred stock compensation for options issued
         with an exercise  price below the fair value of the common stock in the
         amount of $4,750,  $0 and $18,000 as of  December  31,  2003,  2002 and
         2001,  respectively.  Deferred  stock  compensation  is  amortized  and
         recorded as  compensation  expenses  ratably over the vesting period of
         the option. The stock compensation expense that has been charged in the
         consolidated   statements  of  operations  in  respect  of  options  to
         employees and directors in 2003, 2002 and 2001, was $8,286,  $6,000 and
         $17,240, respectively.

         (3) In June 2002 and December 2001, the employees exercised 100,000 and
         33,314, respectively, options for which the exercise price was not paid
         at the exercise date.  The Company  recorded the owed amount of $73,000
         and $43,308,  respectively,  as "Note receivable from  shareholders" in
         the statement of shareholders'  equity.  In accordance with EITF 95-16,
         since the  original  option  grant did not permit the  exercise  of the
         options  through  loans,  and due to the Company's  history of granting
         non-recourse loans, this postponement in payments of the exercise price
         resulted in a variable plan  accounting.  However,  the Company did not
         record any  compensation due to the decrease in the market value of the
         Company's  shares during 2001 and 2002.  During the year 2002 the notes
         in the amount of $43,308 were entirely repaid and note at the amount of
         $36,500 was forgiven and appropriate compensation was recorded.  During
         the year 2003, the company  recorded  compensation in amount of $38,500
         due to increase in the market value of the company's shares.



                                      F-35
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)


d. The options  outstanding  as of December  31, 2003 have been  separated  into
ranges of exercise price, as follows:

<TABLE>
<CAPTION>
                          Total options outstanding                Exercisable options outstanding
              --------------------------------------------------- ----------------------------------
 Range of         Amount          Weighted          Weighted          Amount           Weighted
                                   average
              outstanding at      remaining                       exercisable at
 exercise      December 31,      contractual         average       December 31,         average
  prices           2003             life         exercise price        2003         exercise price
------------                   ----------------  ----------------                   ----------------
     $                              Years               $                                  $
------------                   ----------------  ----------------                   ----------------
<S>               <C>                 <C>               <C>           <C>                  <C>
0.01-2.00         7,773,767           7.48              0.90          4,584,740            0.98
2.01-4.00           314,544           3.56              3.07            314,544            3.07
4.01-6.00           885,000           6.28              4.60            882,255            4.60
6.01-8.00            35,000           2.05              7.73             35,000            7.73
8.01                 10,000           3.75              9.06             10,000            9.06
              ---------------- ----------------  ---------------- ----------------  ----------------
                  9,018,311           7.20              1.37          5,826,539            1.70
              ================ ================  ================ ================  ================
</TABLE>


Weighted-average  fair values and  exercise  prices of options on dates of grant
are as follows:

<TABLE>
<CAPTION>
                             Equals market price             Exceeds market price            Less than market price
                         -----------------------------   ------------------------------   ------------------------------
                           Year ended December 31,          Year ended December 31,          Year ended December 31,
                         -----------------------------   ------------------------------   ------------------------------
                          2003       2002       2001      2003       2002        2001      2003      2002         2001
                         --------   --------  --------   --------  ----------  --------   --------  --------   ---------
<S>                      <C>        <C>       <C>        <C>       <C>         <C>        <C>       <C>        <C>
 Weighted average         $ 0.950    $ 1.265   $ 1.579    $ -       $  -        $ 1.466    $ -       $ 0.755     $ 1.300
   exercise prices
 Weighted average fair          0          0         0                                0                    0
   value on grant date     $ 0.73     $ 0.56    $ 0.50     $ -       $  -        $ 0.56     $ -       $ 0.25     $ 0.790
</TABLE>


2. Options issued to consultants:

a. The Company's outstanding options to consultants as of December 31, 2003, are
as follows:

<TABLE>
<CAPTION>
                                         2003                         2002                         2001
                              ---------------------------  ---------------------------  ---------------------------
                                 Amount       Weighted        Amount       Weighted        Amount       Weighted
                                               average                      average                      average
                                              exercise                     exercise                     exercise
                                                price                        price                        price
                              ---------------------------  ---------------------------  ---------------------------
                                                  $                            $                            $
                                            -------------                -------------                -------------
<S>                               <C>          <C>             <C>          <C>              <C>         <C>
 Options outstanding at           245,786      $   5.55        245,786      $   5.55         175,786     $   6.57
   beginning of year
 Changes during year:
   Granted (1)                     83,115      $   0.99              -            -          130,000     $   6.02
   Exercised                      (15,000)     $   0.49              -            -          (60,000)    $   5.13
 Repriced (2):

   Old exercise price                   -            -               -            -          (56,821)    $   9.44
   New exercise price                   -            -               -            -           56,821     $   4.78
                              ------------                 ------------                 -------------

 Options outstanding at
   end of year                    313,901      $   4.59        245,786      $   5.55         245,786     $   5.55
                              ============  =============  ============  =============  ============= =============

 Options exercisable at
   end of year                    193,901      $   3.46        125,786      $   6.42         125,786     $   6.42
                              ============  =============  ============  =============  ============= =============
</TABLE>

     (1) 120,000 options out of 130,000 options granted in 2001 to the Company's
     selling and marketing  consultants  are subject to the  achievement  of the
     targets specified in the agreements with these consultants. The measurement
     date for these options has not yet occurred, as these targets have not been
     met,  in  accordance  with EITF 96-18.  When the  targets is  achieved  the
     Company  will record  appropriate  compensation  upon the fair value at the
     same date at which the targets is achieved



                                      F-36
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 11: - SHAREHOLDERS' EQUITY (Cont.)


     (2) During the year 2001 the Company repriced 56,821 options to its service
     providers.  The  fair  value  of  repriced  warrants  was  calculated  as a
     difference  measured  between (1) the fair value of the  modified  warrants
     determined in accordance with the provisions of SFAS 123, and (2) the value
     of the old warrant  immediately before its terms were modified,  determined
     based on the shorter of (a) its remaining expected life or (b) the expected
     life of the modified option. As a result of the repricing,  the Company has
     recorded an additional  compensation at the amount of $21,704, and included
     this amount in marketing expenses.

b. The Company  accounted  for its options to  consultants  under the fair value
method of SFAS No.  123 and EITF  96-18.  The fair value for these  options  was
estimated  using  a  Black-Scholes   option-pricing  model  with  the  following
weighted-average assumptions:

<TABLE>
<CAPTION>
                                                  2003              2002             2001
                                             ----------------  ---------------  ---------------
<S>                                          <C>               <C>
              Dividend yield                          0%                -               0%
              Expected volatility                    78%                -              82%
              Risk-free interest                    2.3%                -         3.5-4.5%
              Contractual life of up to         10 years                -         10 years
</TABLE>


c. In  connection  with the grant of stock options to  consultants,  the Company
recorded stock compensation  expenses totaling $29,759,  $0 and $139,291 for the
years ended December 31, 2003, 2002 and 2001,  respectively,  and included these
amounts in marketing and general and administrative expenses.

3. Dividends:

In the event that cash dividends are declared in the future, such dividends will
be paid in U.S.  dollars.  The Company does not intend to pay cash  dividends in
the foreseeable future.

4. Treasury Stock:

Treasury  stock  is  the  Company's  common  stock  that  has  been  issued  and
subsequently reacquired.  The acquisition of common stock is accounted for under
the cost method, and presented as reduction of stockholders' equity.

h. Issuances in connection with acquisitions:

In September 2003, the Company  acquired an additional 12% interest in MDT Armor
Corporation and an additional  24.5% interest in MDT Protective  Industries Ltd.
in exchange for the  issuance to AGA Means of  Protection  and Commerce  Ltd. of
126,000 shares of its common stock.



                                      F-37
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 12: - INCOME TAXES

a. Taxation of U.S. parent company (Arotech):

As of December 31,  2003,  Arotech has  operating  loss  carryforwards  for U.S.
federal income tax purposes of approximately $17.0 million,  which are available
to  offset  future  taxable  income,  if any,  expiring  in 2010  through  2022.
Utilization  of U.S net operating  losses may be subject to  substantial  annual
limitations due to the "change in ownership"  provisions of the Internal Revenue
Code of 1986 and similar state  provisions.  The annual limitation may result in
the expiration of net operating loses before utilization.

b. Israeli subsidiary (EFL):

1. Tax benefits under the Law for the Encouragement of Capital Investments, 1959
(the "Investments Law"):

A small  part  of  EFL's  manufacturing  facility  has  been  granted  "Approved
Enterprise"  status under the  Investments  Law,  and is entitled to  investment
grants  from the State of Israel of 38% on  property  and  equipment  located in
Jerusalem,  and 10% on  property  and  equipment  located  in its  plant in Beit
Shemesh,  and to  reduced  tax  rates  on  income  arising  from  the  "Approved
Enterprise," as detailed below.

The approved investment program is in the amount of approximately  $500,000. EFL
effectively  operated  the  program  during  1993,  and is  entitled  to the tax
benefits  available under the Investments Law. EFL is entitled to additional tax
benefits as a "foreign investment company," as defined by the Investments Law.

The  tax-exempt  income  attributable  to  the  "Approved   Enterprise"  can  be
distributed to  shareholders  without  subjecting the Company to taxes only upon
the complete  liquidation of the Company.  If these retained  tax-exempt profits
are  distributed  in a manner  other  than in the  complete  liquidation  of the
Company they would be taxed at the corporate tax rate applicable to such profits
as if the Company had not elected the alternative system of benefits,  currently
between  25%  for  an  "Approved  Enterprise."  As of  December  31,  2003,  the
accumulated deficit of the Company does not include tax-exempt profits earned by
the Company's "Approved Enterprise."

The  entitlement  to the  above  benefits  is  conditional  upon  the  Company's
fulfilling  the  conditions  stipulated  by  the  Investments  Law,  regulations
published   thereunder  and  the   instruments  of  approval  for  the  specific
investments  in "approved  enterprises."  In the event of failure to comply with
these  conditions,  the benefits may be canceled and the Company may be required
to refund the amount of the benefits,  in whole or in part,  including interest.
As of December 31, 2003, according to the Company's management,  the Company has
fulfilled all conditions.

The main tax benefits available to EFL are:

a) Reduced tax rates:

During the period of benefits (seven to ten years), commencing in the first year
in which EFL earns  taxable  income from the  "Approved  Enterprise,"  a reduced
corporate  tax rate of  between  10% and 25%  (depending  on the  percentage  of
foreign  ownership,  based on present ownership  percentages of 15%) will apply,
instead of the regular tax rates.



                                      F-38
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 12: - INCOME TAXES(Cont.)


The period of tax  benefits,  detailed  above,  is subject to limits of 12 years
from the  commencement  of  production,  or 14 years  from  the  approval  date,
whichever is earlier. Hence, the first program will expire in the year 2004. The
benefits  have not yet been  utilized  since the Company has no taxable  income,
since its incorporation.

b) Accelerated depreciation:

EFL is entitled to claim  accelerated  depreciation  in respect of machinery and
equipment  used  by the  "Approved  Enterprise"  for the  first  five  years  of
operation of these assets.

Income from  sources  other than the  "Approved  Enterprise"  during the benefit
period will be subject to tax at the regular corporate tax rate of 36%.

2.   Measurement   of  results  for  tax  purposes  under  the  Income  Tax  Law
(Inflationary Adjustments), 1985

Results  for tax  purposes  are  measured in real terms of earnings in NIS after
certain  adjustments  for increases in the Consumer Price Index. As explained in
Note 2b, the financial  statements are presented in U.S. dollars. The difference
between  the  annual  change  in the  Israeli  consumer  price  index and in the
NIS/dollar  exchange  rate causes a difference  between  taxable  income and the
income  before  taxes shown in the  financial  statements.  In  accordance  with
paragraph  9(f) of SFAS No. 109, EFL has not provided  deferred  income taxes on
this difference  between the reporting  currency and the tax bases of assets and
liabilities.

3. Tax  benefits  under the Law for the  Encouragement  of Industry  (Taxation),
1969:

EFL is an "industrial company," as defined by this law and, as such, is entitled
to certain tax  benefits,  mainly  accelerated  depreciation,  as  prescribed by
regulations published under the inflationary adjustments law, the right to claim
public issuance expenses and amortization of know-how, patents and certain other
intangible property rights as deductions for tax purposes.

4. Tax rates applicable to income from other sources:

Income  from  sources  other  than the  "Approved  Enterprise,"  is taxed at the
regular rate of 36%.

5. Tax loss carryforwards:

As of December 31, 2003,  EFL has operating and capital loss  carryforwards  for
Israeli tax  purposes  of  approximately  $84.0  million,  which are  available,
indefinitely, to offset future taxable income.



                                      F-39
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 12: - INCOME TAXES(Cont.)


c. Deferred income taxes:

Deferred  income  taxes  reflect  the net tax effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes and amounts used for income tax purposes. Significant components of the
Company's  deferred  tax  assets  resulting  from tax loss  carryforward  are as
follows:

<TABLE>
<CAPTION>
                                                                December 31,
                                                     -----------------------------------
                                                          2003                2002
                                                     ---------------    ----------------
<S>                                                   <C>                <C>
 Operating loss carryforward                          $33,958,434        $   29,257,118
 Reserve and allowance                                    843,453               303,204
                                                     ---------------    ----------------

 Net deferred tax asset before valuation allowance     34,801,887            29,560,322
 Valuation allowance                                     (34,801,887)       (29,560,322)
                                                     ---------------    ----------------
                                                      $           -      $            -
                                                     ===============    ================
</TABLE>


The Company and its  subsidiaries  provided  valuation  allowances in respect of
deferred tax assets  resulting from tax loss  carryforwards  and other temporary
differences.  Management currently believes that it is more likely than not that
the  deferred  tax  regarding  the  loss   carryforwards   and  other  temporary
differences  will not be realized.  The change in the valuation  allowance as of
December 31, 2003 was $5,241,565.

d. Loss from continuing  operations before taxes on income and minority interest
in loss (earnings) of a subsidiary:

<TABLE>
<CAPTION>
                                                         Year ended December 31
                                     ---------------------------------------------------------------
                                            2003                  2002                  2001
                                     -------------------   -------------------   -------------------
<S>                                   <C>                   <C>                   <C>
         Domestic                     $    (7,181,774)      $    (5,250,633)      $    (5,828,828)
         Foreign                           (1,697,617)          (13,254,195)          (11,457,960)
                                     -------------------   -------------------   -------------------
                                      $    (8,879,391)       $  (18,504,358)      $   (17,286,788)
                                     ===================   ===================   ===================
</TABLE>


e. Taxes on income were comprised of the following:

<TABLE>
<CAPTION>
                                                         Year ended December 31
                                     ---------------------------------------------------------------
                                            2003                  2002                  2001
                                     -------------------   -------------------   -------------------
<S>                                   <C>                   <C>                   <C>
         Current taxes                $        44,102       $             -       $             -
         Taxes in respect of prior
           years                              352,091                     -                     -
                                     -------------------   -------------------   -------------------
                                      $       396,193       $             -       $             -
                                     ===================   ===================   ===================

         Domestic                     $        33,020       $             -       $             -
         Foreign                              363,173                     -                     -
                                     -------------------   -------------------   -------------------

                                      $       396,193       $             -       $             -
                                     ===================   ===================   ===================
</TABLE>



                                      F-40
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 12: - INCOME TAXES(Cont.)

f. A reconciliation between the theoretical tax expense,  assuming all income is
taxed at the  statutory  tax rate  applicable  to income of the  Company and the
actual tax expense as reported in the Statement of Operations, is as follows:

<TABLE>
<CAPTION>
                                                                      Year ended December 31,
                                                       -------------------------------------------------------
                                                            2003                2002                2001
                                                       ----------------    ---------------     ---------------
<S>                                                    <C>                 <C>                 <C>
Loss from continuing operations before taxes, as
  reported in the consolidated statements of income    $ (8,879,391)       $ (4,582,792)       $ (4,025,789)
                                                       ================    ===============     ===============

Statutory tax rate                                           35%                35%                 35%
                                                       ================    ===============     ===============
Theoretical tax income on the above amount at the       $ (3,107,787)       $ (1,603,977)       $ (1,409,026)
  U.S. statutory tax rate
Deferred taxes on losses for which valuation
  allowance was not provided                               1,178,215           1,603,977           1,409,026
Non-deductible expenses                                    1,940,019                   -                   -
State taxes                                                   33,020                   -                   -
Other                                                            635                   -                   -
Taxes in respect of prior years due to change in
  estimates                                                  352,091                   -                   -
                                                       ----------------    ---------------     ---------------

Actual tax expense                                      $    396,193        $          -        $          -
                                                       ================    ===============     ===============

</TABLE>

NOTE 13: - SELECTED STATEMENTS OF OPERATIONS DATA

Financial income (expenses), net:

<TABLE>
<CAPTION>
                                                                  Year ended December 31,
                                                      ------------------------------------------------
                                                          2003              2002             2001
                                                      --------------    -------------    -------------

Financial expenses:
<S>                                                    <C>               <C>              <C>
Interest, bank charges and fees                        $   (355,111)     $  (89,271)      $  (49,246)
Amortization of compensation related to beneficial
convertible feature of convertible debenture and
warrants issued to the holders of convertible
debenture                                                (3,359,987)              -                -
Foreign currency translation differences                    115,538          15,202          (16,003)
                                                      --------------    -------------    -------------

                                                         (3,599,560)        (74,069)         (65,249)
                                                      --------------    -------------    -------------
Financial income:

   Interest                                                 129,101         174,520          327,830
                                                      --------------    -------------    -------------

Total                                                  $ (3,470,459)     $  100,451       $  262,581
                                                      ==============    =============    =============
</TABLE>


                                      F-41
<PAGE>


AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 14: - RELATED PARTY DISCLOSURES

<TABLE>
<CAPTION>
                                                                            Year ended December 31,
                                                           ----------------------------------------------------------
                                                                 2003                2002                 2001
                                                           -----------------   -----------------    -----------------
Transactions:
<S>                                                        <C>                  <C>
Reimbursement of general and administrative expenses              -             $     36,000         $     23,850
                                                           =================   =================    =================
Financial income (expenses), net from notes receivable
  and loan holders                                                -             $     (7,309)        $    (36,940)
                                                           =================   =================    =================
</TABLE>

NOTE 15: - SEGMENT INFORMATION

a. General:

The Company and its subsidiaries operate primarily in two business segments (see
Note 1a for a brief  description  of the  Company's  business)  and  follow  the
requirements of SFAS No. 131.

The  Company  previously  managed  its  business  in three  reportable  segments
organized on the basis of differences in its related products and services. With
the  discontinuance  of Consumer  Batteries  segment (see Note  1.e-Discontinued
Operation) and acquiring two subsidiaries (see Notes 1.b.and c.), two reportable
segments remain: Electric Fuel Batteries,  and Defense and Security Products. As
a result the Company  reclassified  information  previously reported in order to
comply with new segment reporting.

The Company's  reportable  operating segments have been determined in accordance
with the Company's internal  management  structure,  which is organized based on
operating activities.  The accounting policies of the operating segments are the
same as those described in the summary of significant  accounting policies.  The
Company  evaluates  performance  based  upon  two  primary  factors,  one is the
segment's operating income and the other is based on the segment's  contribution
to the Company's future strategic growth.

b. The following is information about reported segment gains, losses and assets:


<TABLE>
<CAPTION>
                                                                 Defense and
                                                                  Security
                                            Batteries             Products           All Other              Total
                                         -----------------    ----------------    -----------------    -----------------
2003
<S>                                       <C>                  <C>                 <C>                  <C>
Revenues from outside customers           $   5,868,899        $  11,457,742       $           -        $  17,326,641
Depreciation expense and amortization          (527,775)            (927,665)           (139,630)          (1,595,070)
Direct expenses (1)                          (5,945,948)         (10,892,933)         (4,539,674)         (21,378,555)
                                         -----------------    ----------------    -----------------    -----------------
Segment gross loss                             (604,824)            (362,856)         (4,679,304)          (5,646,984)
                                         =================    ================    =================
Financial   income  (in   deduction  of               -                    -                   -           (3,471,700)
  minority rights)
                                                                                                       -----------------
Net loss from continuing operation                                                                         (9,118,684)
                                                                                                       =================

Segment assets (2)                            2,128,062            1,628,562             450,864            4,207,488
                                         =================    ================    =================    =================
Expenditures for segment assets                 247,989              208,497             124,463              580,949
                                         =================    ================    =================    =================
2002
Revenues from outside customers           $   1,682,296        $   4,724,443       $           -        $   6,406,739
Depreciation expense and amortization          (252,514)            (676,753)           (194,014)          (1,123,281)
Direct expenses (1)                          (3,062,548)          (4,353,770)         (2,905,743)         (10,322,061)
                                         -----------------    ----------------    -----------------    -----------------
Segment gross loss                       $   (1,632,766)        $   (306,080)       $ (3,099,757)          (5,038,603)
                                         =================    ================    =================    =================
Financial income                                                                                              100,451
                                                                                                       -----------------
Net loss from continuing operation                                                                      $   4,938,152
                                                                                                       =================

Segment assets (2)                       $    2,007,291        $   1,683,825       $     575,612        $   4,266,728
                                         =================    ================    =================    =================

Expenditures for segment assets          $      246,664        $      58,954       $      70,486        $     376,104
                                         =================    ================    =================    =================
</TABLE>


                                      F-42
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 15: - SEGMENT INFORMATION(Cont.)


<TABLE>
<CAPTION>
                                                                 Defense and
                                                                  Security
                                            Batteries             Products           All Other              Total
                                         -----------------    ----------------    -----------------    -----------------
2001
<S>                                      <C>                   <C>                 <C>                     <C>
Revenues from outside customers          $    2,093,632        $           -       $           -           $2,093,632
Depreciation expense                           (304,438)                   -            (225,577)            (530,015)
Direct expenses (1)                          (2,295,501)                   -          (3,556,486)          (5,851,987)
                                         -----------------    ----------------    -----------------    -----------------
Segment gross loss                       $     (506,307)        $          -        $ (3,782,063)          (4,288,370)
                                         =================    ================    =================
Financial income net                                                                                          262,581
                                                                                                       -----------------
Net loss from continuing operations                                                                     $  (4,025,789)
                                                                                                       =================

Segment assets (2)                       $    2,044,257        $   1,175,521       $     702,915        $   2,744,172
                                         =================    ================    =================    =================
Expenditures for segment assets          $      229,099        $     229,099       $     323,985        $     553,084
                                         =================    ================    =================    =================
</TABLE>


     (1) Including sales and marketing, general and administrative expenses.

     (2) Including property and equipment and inventory.

c. Summary information about geographic areas:

The following  presents total revenues  according to end customers  location for
the years ended December 31, 2003,  2002 and 2001,  and long-lived  assets as of
December 31, 2003, 2002 and 2001:

<TABLE>
<CAPTION>
                               2003                            2002                            2001
                   ------------------------------  ------------------------------  ------------------------------
                       Total        Long-lived         Total        Long-lived         Total        Long-lived
                     revenues         assets         revenues         assets         revenues         assets
                   --------------  --------------  --------------  --------------  -------------- ---------------
                                                           U.S. dollars
                   ----------------------------------------------------------------------------------------------
<S>                 <C>            <C>              <C>             <C>             <C>            <C>
U.S.A.              $10,099,652    $6,778,050       $  2,787,250    $  6,710,367    $  1,057,939   $     60,531
Germany              2,836,725              -             38,160               -         526,766              -
England                 29,095              -             47,696               -          36,648              -
Thailand                95,434              -            291,200               -               -              -
Israel               3,576,139      2,954,441          2,799,365       3,367,320          13,773      2,160,275
Other                  689,596              -            443,068               -         458,506              -
                   --------------  --------------  --------------  --------------  -------------- ---------------
                    $17,326,641     $  9,732,491    $  6,406,739    $ 10,077,687    $  2,093,632   $  2,220,806
                   ==============  ==============  ==============  ==============  ============== ===============
</TABLE>




                                      F-43
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 15: - SEGMENT INFORMATION(Cont.)

d. Revenues from major customers:

<TABLE>
<CAPTION>
                                                            Year ended December 31,
                                              ----------------------------------------------------
                                                  2003               2002               2001
                                                                      %
                                              ----------------------------------------------------
     Electric Fuel Batteries:
<S>                                                                                        <C>
              Customer A                              -                  -                 22%
              Customer B                              2%                 7%                20%
              Customer C                              1%                 2%                13%
              Customer D                             27%                 8%                12%
     Defense and Security Products:

              Customer A                             17%                43%                 -
              Customer B                             16%                 -                  -

e. Revenues from major products:

                                                            Year ended December 31,
                                              ----------------------------------------------------
                                                  2003               2002               2001
                                              --------------     --------------     --------------

     EV                                        $   408,161        $   460,562        $   894,045
     WAB                                           703,084            647,896            951,598
     Military batteries                          4,757,116            573,839            247,989
     Car armoring                                3,435,715          2,744,382                  -
     Interactive use-of-force training           7,961,302          1,980,060                  -
     Other                                          61,263                  -                  -
                                              --------------     --------------     --------------
     Total                                     $17,326,641         $6,406,749         $2,093,632
                                              ==============     ==============     ==============
</TABLE>

NOTE 16: - CONVERTIBLE DEBENTURES

a. 9% Secured Convertible Debentures due June 30, 2005

Pursuant to the terms of a  Securities  Purchase  Agreement  dated  December 31,
2002,  the  Company  issued and sold to a group of  institutional  investors  an
aggregate principal amount of 9% secured convertible debentures in the amount of
$3.5 million due June 30, 2005.  These  debentures  are  convertible at any time
prior to June 30, 2005 at a  conversion  price of $0.75 per share,  or a maximum
aggregate  of  4,666,667  shares of common  stock  (see also Note  11.f.4).  The
conversion  price of these  debentures  was adjusted to $0.64 per share in April
2003. In accordance with EITF 96-19,  "Debtor's Accounting for a Modification or
Exchange  of Debt  Instruments,"  the terms of  convertible  debentures  are not
treated as  changed or  modified  when the cash flow  effect on a present  value
basis  is  less  than  10%,  and  therefore  the  Company  did  not  record  any
compensation  related to the change in the conversion  price of the  convertible
debentures.

During 2003, an aggregate of $2,350,000 in 9% secured convertible debentures was
converted into an aggregate of 3,671,875 shares of common stock.

In  determining   whether  the  convertible   debentures  include  a  beneficial
conversion  feature in accordance  with EITF 98-5  "Accounting  for  Convertible
Securities  with  Beneficial  Conversion  Features  or  Continently   Adjustable
Conversion  Ratios" and EITF 00-27,  the total  proceeds  were  allocated to the
convertible  debentures and the detachable warrants based on their relative fair
values. In connection with these convertible debentures, the Company will record
financial  expenses  of  $600,000  with  respect  to the  beneficial  conversion
feature.  The  $600,000  is  amortized  from the date of  issuance to the stated
redemption date - June 30, 2005 - as financial expenses.



                                      F-44
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 16: - CONVERTIBLE DEBENTURES(Cont.)


During 2003 the Company  recorded an expense of $481,714,  of which $174,000 was
attributable  to  amortization  of  the  beneficial  conversion  feature  of the
convertible   debenture  over  its  term  and  $307,714  was   attributable   to
amortization due to conversion of the convertible debenture into shares.

b. 8% Secured Convertible Debentures due September 30, 2006

Pursuant to the terms of a Securities  Purchase  Agreement  dated  September 30,
2003,  the  Company  issued and sold to a group of  institutional  investors  an
aggregate principal amount of 8% secured convertible debentures in the amount of
$5.0 million due September 30, 2006.  These  debentures  are  convertible at any
time prior to September 30, 2006 at a conversion  price of $1.15 per share, or a
maximum aggregate of 4,347,826 shares of common stock (see also Note 11.f.5).

During 2003, an aggregate of $3,775,000 in 8% secured convertible debentures was
converted into an aggregate of 3,282,608 shares of common stock.


In  determining   whether  the  convertible   debentures  include  a  beneficial
conversion  option in  accordance  with EITF 98-5  "Accounting  for  Convertible
Securities  with  Beneficial  Conversion  Features  or  Continently   Adjustable
Conversion  Ratios" and EITF 00-27,  the total  proceeds  were  allocated to the
convertible  debentures and the detachable warrants based on their relative fair
values. In connection with these convertible debentures, the Company will record
financial  expenses of  $1,938,043  with  respect to the  beneficial  conversion
feature.  The  $1,938,043  is amortized  from the date of issuance to the stated
redemption date - September 30, 2006 - as financial expenses.

During 2003 the Company recorded an expense of $1,503,080, of which $134,646 was
attributable  to  amortization  of  the  beneficial  conversion  feature  of the
convertible   debenture  over  its  term  and  $1,368,434  was  attributable  to
amortization due to conversion of the convertible debenture into shares.

c. 8% Secured Convertible Debentures due December 31, 2006

Pursuant to the terms of a Securities  Purchase  Agreement  dated  September 30,
2003,  the  Company  issued and sold to a group of  institutional  investors  an
aggregate principal amount of 8% secured convertible debentures in the amount of
$6.0 million due December 31, 2006. These debentures are convertible at any time
prior to  December  31,  2006 at a  conversion  price of $1.45 per  share,  or a
maximum aggregate of 4,137,931 shares of common stock (see also Note 11.f.6).


                                      F-45
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 16: - CONVERTIBLE DEBENTURES(Cont.)

In  determining   whether  the  convertible   debentures  include  a  beneficial
conversion  option in  accordance  with EITF 98-5  "Accounting  for  Convertible
Securities  with  Beneficial  Conversion  Features  or  Continently   Adjustable
Conversion  Ratios" and EITF 00-27,  the total  proceeds  were  allocated to the
convertible  debentures and the detachable warrants based on their relative fair
values. In connection with these convertible debentures, the Company will record
financial  expenses of  $3,157,500  with  respect to the  beneficial  conversion
feature.  The  $3,157,500  is amortized  from the date of issuance to the stated
redemption date - December 31, 2006 - as financial expenses.

During 2003 the Company  recorded an expense of $59,362,  which  represents  the
amortization of the beneficial  conversion feature of the convertible  debenture
over its term.


NOTE 17: - SUBSEQUENT EVENTS (UNAUDITED)

a. Debenture conversion:

In January 2004, a total of  $1,150,000  principal  amount of 9% debentures  was
converted into an aggregate of 1,796,875  shares of common stock at a conversion
price of $0.64 per share.

b. Issuance of common stock to investors:

In January  2004,  the Company  issued to a group of  investors  an aggregate of
9,840,426  shares of  common  stock at a price of $1.88  per  share,  or a total
purchase price of $18,500,000. (See also Note 17.c.)

c. Issuance of warrants to investors:

As part of the  investment  agreement  in  January  2004 (see Note  17.b.),  the
Company  issued to a group of  investors  warrants to purchase an  aggregate  of
9,840,426  shares of common stock at a price of $1.88 per share.  These warrants
are  exercisable by the holder at any time after August 12, 2004 and will expire
on January 12, 2007.

d. Acquisition of FAAC Incorporated:

In January  2004,  the Company  purchased all of the  outstanding  stock of FAAC
Incorporated,   a  Michigan   corporation   ("FAAC"),   from   FAAC's   existing
shareholders.  The  assets  acquired  through  the  purchase  of all  of  FAAC's
outstanding  stock consisted of all of FAAC's assets,  including  FAAC's current
assets,  property and equipment,  and other assets (including  intangible assets
such  as  goodwill,   intellectual   property  and  contractual   rights).   The
consideration  for the assets  purchased  consisted of (i) cash in the amount of
$12,000,000,  and (ii) the  issuance of  $2,000,000  in Arotech  stock,  plus an
earn-out  based on 2004 net pretax  profit,  with an additional  earn-out on the
2005 net profit from certain specific and limited programs.

e. Acquisition of Epsilor Electronic Industries, Ltd.:

In January 2004, the Company  purchased all of the outstanding  stock of Epsilor
Electronic Industries, Ltd., an Israeli corporation ("Epsilor"),  from Epsilor's
existing  shareholders.  The assets  acquired  through  the  purchase  of all of


                                      F-46
<PAGE>

                                      F-45
<PAGE>

AROTECH CORPORATION AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
In U.S. dollars

NOTE 17: - SUBSEQUENT EVENTS (UNAUDITED)(Cont.)


Epsilor's  outstanding  stock  consisted of all of Epsilor's  assets,  including
Epsilor's  current assets,  property and equipment,  and other assets (including
intangible  assets  such as  goodwill,  intellectual  property  and  contractual
rights).  The consideration for the assets purchased will consist of (i) cash in
the  amount  of  $7,000,000,  and (ii) a series of three  $1,000,000  promissory
notes, due on the first,  second and third  anniversaries of the Agreement under
the circumstances set forth in the acquisition agreement.

f. Settlement of litigation:

On  February  4, 2004,  the  Company  entered  into an  agreement  settling  the
litigation  brought against it in the Tel-Aviv,  Israel district court by I.E.S.
Electronics  Industries,  Ltd. ("IES Electronics") and certain of its affiliates
in connection  with the Company's  purchase of the assets of its IES Interactive
Training,  Inc.  subsidiary  from IES Electronics in August 2002. The litigation
had sought monetary damages in the amount of approximately $3 million.  Pursuant
to the terms of the  settlement  agreement,  in  addition to agreeing to dismiss
their lawsuit with prejudice, IES Electronics agreed (i) to cancel the Company's
$450,000  debt to them  that had  been due on  December  31,  2003,  and (ii) to
transfer  to the  Company  title  to  certain  certificates  of  deposit  in the
approximate  principal  amount of $112,000.  The parties also agreed to exchange
mutual releases.  In  consideration of the foregoing,  the Company issued to IES
Electronics (i) 450,000 shares of common stock,  and (ii) five-year  warrants to
purchase up to an additional  450,000 shares of common stock at a purchase price
of $1.91 per share.

In respect of the above  settlement,  the Company recorded in 2003 an expense of
$838,714,  representing  the fair  value of the  warrants  and  shares  over the
remaining  balance of the Company's  debt to IES  Electronics  as carried in the
Company  books at December 31, 2003,  less the $112,000  certificate  of deposit
that was transferred to the Company's name as noted above.

                                 - - - - - - - -


                                      F-47
<PAGE>

                          SUPPLEMENTARY FINANCIAL DATA

 Quarterly Financial Data (unaudited) for the two years ended December 31, 2003

<TABLE>
<CAPTION>
                                                                       Quarter Ended
                                            --------------------------------------------------------------------
                    2003                        March 31         June 30        September 30     December 31
        ------------------------------      --------------------------------------------------------------------
<S>                                          <C>              <C>              <C>              <C>
Net revenue................................. $    4,033,453   $    3,493,135   $    5,705,898   $    4,094,155
Gross profit................................ $    1,399,734   $    1,013,965   $    2,453,575   $    1,371,527
Net loss from continuing operations......... $   (1,291,122)  $   (2,640,920)  $       77,093   $   (5,263,735)
Net loss from discontinued operations....... $      (95,961)  $      179,127   $       (2,285)  $       29,529
Net loss for the period..................... $   (1,387,083)  $   (2,461,793)  $       74,808   $   (5,234,206)
Net loss per share - basic and diluted...... $       (0.04)   $       (0.07)   $         0.00   $       (0.12)
Shares used in per share calculation........     34,758,960       36,209,872       40,371,940       43,604,830


                                                                       Quarter Ended
                                            --------------------------------------------------------------------
                    2002                        March 31         June 30        September 30     December 31
        ------------------------------      --------------------------------------------------------------------
Net revenue................................. $      570,545   $      425,053   $    3,262,711   $    2,148,430
Gross profit................................ $      186,917   $       48,807   $    1,593,770   $      155,497
Net loss from continuing operations......... $     (990,097)  $   (1,005,877)  $     (923,122)  $   (2,019,054)
Net loss from discontinued operations....... $   (2,324,109)  $   (1,654,108)  $   (8,716,422)  $     (871,567)
Net loss for the period..................... $   (3,314,208)  $   (2,659,985)  $   (9,369,544)  $   (2,890,621)
Net loss per share - basic and diluted...... $       (0.11)   $       (0.09)   $       (0.29)   $       (0.08)
Shares used in per share calculation........     30,149,210       30,963,919       33,441,137       34,758,048
</TABLE>



                                      F-48
<PAGE>


                          FINANCIAL STATEMENT SCHEDULE

                      Arotech Corporation and Subsidiaries

                 Schedule II - Valuation and Qualifying Accounts

              For the Years Ended December 31, 2003, 2002 and 2001

<TABLE>
<CAPTION>
                                                                  Additions
                                               -------------------------------------------------
                                                 Balance at       charged to      Balance at
                                                 beginning        costs and         end of
                Description                      of period         expenses         period
---------------------------------------------  ---------------  --------------- ----------------
<S>                                            <C>
Year ended December 31, 2003
Allowance for doubtful accounts...........      $      40,636    $      20,646   $       61,282
Valuation allowance for deferred taxes....         29,560,322        5,241,565       34,801,887
                                               ---------------  --------------- ----------------
Totals....................................      $  29,600,958    $   5,262,211   $   34,863,169
                                               ===============  =============== ================
Year ended December 31, 2002
Allowance for doubtful accounts...........      $      39,153    $       1,483   $       40,636
Valuation allowance for deferred taxes....         12,640,103       16,920,219       29,560,322
                                               ---------------  --------------- ----------------
Totals....................................      $  12,679,256    $  16,921,702   $   29,600,958
                                               ===============  =============== ================
Year ended December 31, 2001
Allowance for doubtful accounts...........      $      13,600    $      25,553   $       39,153
Valuation allowance for deferred taxes....          8,987,750        3,652,353       12,640,103
                                               ---------------  --------------- ----------------
Totals....................................      $   9,001,350    $   3,677,906   $   12,679,256
                                               ===============  =============== ================
</TABLE>



                                      F-49
<PAGE>


                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit
Number                                  Description
------                                  -----------
<S>         <C>
   3.1.3....Amendment to our Amended and Restated Certificate of Incorporation
   10.72....Promissory Note dated July 1, 2002 from Robert S. Ehrlich to us
   10.86....Consulting agreement dated January 1, 2004 between us and Edward J. Borey
   10.87....Lease dated April 8, 1997, between AMR Holdings, L.L.C. and FAAC Incorporated
   10.88....Lease dated as of March 22, 2004 between us and Fisk Building Associates L.L.C.
   14.......Code of Ethics
   21.......List of Subsidiaries of the Registrant
   23.......Consent of Kost, Forer, Gabbay & Kassierer
   31.1.....Certification of Chief Executive  Officer pursuant to Section 302 of the  Sarbanes-Oxley  Act of
            2002
   31.2.....Certification of Chief Financial  Officer pursuant to Section 302 of the  Sarbanes-Oxley  Act of
            2002
   32.1.....Written Statement of Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley  Act
            of 2002
   32.2.....Written Statement of Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley  Act
            of 2002
</TABLE>