|
|

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

---

FORM 10-Q

(Mark One)

|    |                                                                                              |                                             
|--- | -------------------------------------------------------------------------------------------- | --------------------------------------------
|[X] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
|   
|    |                                                                                              | For the quarterly period ended June 30, 2008

|     |                                                                                               |                                                         
|---- | --------------------------------------------------------------------------------------------- | --------------------------------------------------------
|[  ] | 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 1-31070                          

Derma Sciences, Inc.(Exact name of small business issuer as specified in its charter)

|Pennsylvania                                                        | 23-2328753                               
|------------------------------------------------------------------- | -----------------------------------------
|(State or other jurisdiction of
     incorporation or organization) | (I.R.S. Employer Identification
     No.)

214 Carnegie Center, Suite 300Princeton, New Jersey
08540(Address of principal executive
offices)

(609) 514-4744(Issuer's telephone number)

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.þYes   oNo

Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer,
or a smaller reporting company. See the definitions of large accelerated filer, accelerated
filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
(Check one):

| |                                                                                   |                                       |                               | 
| | --------------------------------------------------------------------------------- | ------------------------------------- | ----------------------------- | 
| | Large accelerated filer
          o                                               |                                       | Accelerated filer
          o | 
| | Non-accelerated filer
           o  (Do not check if a smaller reporting company) | Smaller reporting company
          þ |                              

Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act).  Yeso Noþ

Indicate the number of shares of each of the issuer's classes of
common equity, as of the latest practicable date.

|                      |        |                                       
|--------------------- | ------ | --------------------------------------
|Date: August 13, 2008 | Class: | Common Stock, par value $.01 per share
|                      |        | Shares Outstanding: 40,140,743        

|
|

Part I

DERMA SCIENCES, INC.

FORM 10-Q

INDEX

|                               |         |                                                                                                                      |   
|------------------------------ | ------- | -------------------------------------------------------------------------------------------------------------------- | --
|Description                    | Page   
|Part I  Financial Information
|                               | Item 1. | Financial Statements                                                                                                 |   
|                               |         | Condensed Consolidated Balance
     Sheets - June 30, 2008 (Unaudited) andDecember 31, 2007                          | 3 
|                              
|                               |         | Condensed Consolidated Statements of
     Operations  Three months endedJune 30, 2008 and June 30, 2007 (Unaudited) | 4 
|                              
|                               |         | Condensed Consolidated Statements of
     Operations  Six months endedJune 30, 2008 and June 30, 2007 (Unaudited)   | 5 
|                              
|                               |         | Condensed Consolidated Statements of
     Cash Flows  Six months endedJune 30, 2008 and June 30, 2007 (Unaudited)   | 6 
|                              
|                               |         | Notes to Condensed Consolidated Financial
     Statements (Unaudited)                                                | 7 
|                              
|                               | Item 2. | Management's Discussion and
     Analysis of Financial Condition and Results of Operations                           | 18
|                              
|                               | Item 4. | Controls and
     Procedures                                                                                         | 33
|                              
|Part II - Other Information   
|                              
|                               | Item 4. | Submission of Matters
        to a Vote of Security Holders                                                          | 34
|                              
|                               | Item 6. | Exhibits                                                                                                             | 34

Forward Looking Statements

This document includes certain
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements are based on managements current
expectations and are subject to uncertainty and changes in circumstances. Actual results
may differ materially from these expectations due to changes in political, economic,
business, competitive, market and regulatory factors.

1

---

Index

Part I  Financial
Information

Item 1. FINANCIAL
STATEMENTS

2

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                  |  |               |              |                |  
|----------------------------------------------------------------- |  | ------------- | ------------ | -------------- | -
|Condensed Consolidated Balance Sheets                            
|                                                                  |  | June 30,      | December 31,
|                                                                  |  | 2008          | 2007        
|ASSETS                                                            |  | (Unaudited)   |             
|                                                                 
|Current Assets                                                    |  |               |              |                |  
|Cash and cash equivalents                                         |  | $   4,084,199 |              | $      577,096 |  
|Accounts receivable, net                                          |  | 4,341,886     |              | 3,667,119      |  
|Inventories                                                       |  | 11,878,427    |              | 9,935,977      |  
|Prepaid expenses and other current assets                         |  | 1,098,922     |              | 1,210,135      |  
|                                                                 
|Total current assets                                              |  | 21,403,434    |              | 15,390,327     |  
|Equipment and improvements, net                                   |  | 4,721,161     |              | 4,909,049      |  
|Goodwill                                                          |  | 8,273,294     |              | 9,524,305      |  
|Other intangible assets, net                                      |  | 4,960,360     |              | 5,537,653      |  
|Other assets, net                                                 |  | 726,199       |              | 509,507        |  
|                                                                 
|Total Assets                                                      |  | $ 40,084,448  |              | $ 35,870,841   |  
|                                                                 
|LIABILITIES AND SHAREHOLDERS' EQUITY                              | 
|                                                                 
|Current Liabilities                                               | 
|Line of credit borrowings                                         |  | $   4,446,123 |              | $   1,219,197  |  
|Current maturities of long-term debt                              |  | 1,813,162     |              | 1,288,532      |  
|Accounts payable                                                  |  | 3,917,349     |              | 4,092,278      |  
|Accrued expenses and other current liabilities                    |  | 1,930,459     |              | 3,421,282      |  
|                                                                 
|Total current liabilities                                         |  | 12,107,093    |              | 10,021,289     |  
|Long-term debt                                                    |  | 4,210,286     |              | 5,292,136      |  
|Other long-term liabilities                                       |  | 76,776        |              | 82,402         |  
|Deferred tax liability                                            |  | 330,122       |              | 420,059        |  
|                                                                 
|Total Liabilities                                                 |  | 16,724,277    |              | 15,815,886     |  
|                                                                 
|Shareholders' Equity                                              | 
|Convertible preferred stock, $.01 par value; 11,750,000 shares    | 
|authorized; issued and outstanding: 2,280,407 shares (liquidation | 
|preference of $4,210,231 at June  30, 2008)                       |  | 22,804        |              | 22,804         |  
|Common stock, $.01 par value; 150,000,000 authorized; issued and  | 
|outstanding: 40,140,743 shares at June 30, 2008 and 33,829,755    | 
|shares at December 31, 2007                                       |  | 401,407       |              | 338,298        |  
|Additional paid-in capital                                        |  | 39,650,817    |              | 33,540,952     |  
|Accumulated other comprehensive income                           | 
|cumulative translation adjustments                                |  | 1,667,305     |              | 1,854,787      |  
|Accumulated deficit                                               |  | (18,382,162   | )            | (15,701,886    | )
|                                                                 
|Total Shareholders' Equity                                        |  | 23,360,171    |              | 20,054,955     |  
|                                                                 
|Total Liabilities and Shareholders' Equity                        |  | $ 40,084,448  |              | $ 35,870,841   |  
|                                                                 

See accompanying consolidated notes.

3

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                   |  |                             |      |                 |  
|------------------------------------------------------------------ |  | --------------------------- | ---- | --------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)        | 
|                                                                   |  | Three months ended June 30,
|                                                                   |  | 2008                        | 2007
|                                                                  
|Net Sales                                                          |  | $ 13,083,966                |      | $   7,461,258   |  
|Cost of sales                                                      |  | 9,464,470                   |      | 4,796,060       |  
|                                                                  
|Gross Profit                                                       |  | 3,619,496                   |      | 2,665,198       |  
|                                                                  
|Operating expenses                                                 | 
|Selling, general and administrative                                |  | 4,572,077                   |      | 2,589,957       |  
|Research and development                                           |  | 106,200                     |      |                |  
|                                                                  
|Total operating expenses                                           |  | 4,678,277                   |      | 2,589,957       |  
|                                                                  
|Operating (loss) income                                            |  | (1,058,781                  | )    | 75,241          |  
|                                                                  
|Other expense, net:                                                | 
|Interest expense                                                   |  | 232,572                     |      | 47,564          |  
|Other (income) expense, net                                        |  | (29,092                     | )    | 23,141          |  
|                                                                  
|Total other expense, net                                           |  | 203,480                     |      | 70,705          |  
|                                                                  
|(Loss) income before provision for income taxes                    |  | (1,262,261                  | )    | 4,536           |  
|Provision for income taxes                                         |  | 8,227                       |      | 114,099         |  
|                                                                  
|Net Loss                                                           |  | $(1,270,488                 | )    | $    (109,563   | )
|                                                                  
|Loss per common share  basic and diluted                          |  | $         (0.03             | )    | $         (0.00 | )
|                                                                  
|Shares used in computing loss per common share - basic and diluted |  | 40,073,710                  |      | 25,258,335      |  
|                                                                  

See accompanying consolidated notes.

4

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                   |  |                           |      |                  |  
|------------------------------------------------------------------ |  | ------------------------- | ---- | ---------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)        | 
|                                                                   |  | Six months ended June 30,
|                                                                   |  | 2008                      | 2007
|                                                                  
|Net Sales                                                          |  | $ 24,808,788              |      | $ 15,427,055     |  
|Cost of sales                                                      |  | 17,980,634                |      | 9,957,429        |  
|                                                                  
|Gross Profit                                                       |  | 6,828,154                 |      | 5,469,626        |  
|                                                                  
|Operating expenses                                                 | 
|Selling, general and administrative                                |  | 8,958,943                 |      | 5,258,111        |  
|Research and development                                           |  | 154,308                   |      | 125,000          |  
|                                                                  
|Total operating expenses                                           |  | 9,113,251                 |      | 5,383,111        |  
|                                                                  
|Operating (loss) income                                            |  | (2,285,097                | )    | 86,515           |  
|                                                                  
|Other expense, net:                                                | 
|Interest expense                                                   |  | 497,487                   |      | 97,810           |  
|Other (income) expense, net                                        |  | (20,478                   | )    | 49,698           |  
|                                                                  
|Total other expense, net                                           |  | 477,009                   |      | 147,508          |  
|                                                                  
|Loss before (benefit) provision for income taxes                   |  | (2,762,106                | )    | (60,993          | )
|(Benefit) provision for income taxes                               |  | (81,830                   | )    | 187,523          |  
|                                                                  
|Net Loss                                                           |  | $ (2,680,276              | )    | $     (248,516   | )
|                                                                  
|Loss per common share  basic and diluted                          |  | $          (0.07          | )    | $          (0.01 | )
|                                                                  
|Shares used in computing loss per common share  basic and diluted |  | 37,055,958                |      | 25,252,498       |  
|                                                                  

See accompanying consolidated notes.

5

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                            |  |                           |      |               |  
|----------------------------------------------------------- |  | ------------------------- | ---- | ------------- | -
|Condensed Consolidated Statements of Cash Flows (Unaudited) | 
|                                                            |  | Six months ended June 30,
|                                                            |  | 2008                      | 2007
|                                                           
|Operating Activities                                        |  |                           |      |               |  
|Net loss                                                    |  | $ (2,680,276              | )    | $  (248,516   | )
|Adjustments to reconcile net loss to net                    | 
|cash used in operating activities:                          | 
|Depreciation of equipment and improvements                  |  | 471,014                   |      | 357,102       |  
|Amortization of intangible assets                           |  | 577,293                   |      | 273,727       |  
|Amortization of deferred financing costs                    |  | 57,647                    |      | 30,831        |  
|Recovery of bad debts                                       |  | (63,000                   | )    | (10,433       | )
|Allowance for sales adjustments                             |  | 653,118                   |      | 330,738       |  
|Provision for inventory obsolescence                        |  | 93,415                    |      | 44,641        |  
|Deferred rent expense                                       |  | (27,502                   | )    | (11,149       | )
|Compensation charge for employee stock options              |  | 406,971                   |      | 294,951       |  
|Compensation charge for restricted stock                    |  | 24,210                    |      | 24,210        |  
|Deferred income taxes                                       |  | (81,830                   | )    | 187,523       |  
|Changes in operating assets and liabilities:                | 
|Accounts receivable                                         |  | (1,259,203                | )    | 989,870       |  
|Inventories                                                 |  | (2,149,112                | )    | (1,966,130    | )
|Prepaid expenses and other current assets                   |  | 56,945                    |      | (107,395      | )
|Other assets                                                |  | (6,934                    | )    | 24,104        |  
|Accounts payable                                            |  | (6,478                    | )    | (194,410      | )
|Accrued expenses and other current liabilities              |  | (1,344,859                | )    | (135,100      | )
|Other long-term liabilities                                 |  | 20,548                    |      | (5,195        | )
|                                                           
|Net cash used in operating activities                       |  | (5,258,033                | )    | (120,631      | )
|                                                           
|Investing Activities                                        | 
|Costs of acquiring business                                 |  | (120,484                  | )    | (48,045       | )
|Refund of acquired business escrow funds                    |  | 1,193,187                 |      |              |  
|Purchase of equipment and improvements                      |  | (288,949                  | )    | (267,108      | )
|                                                           
|Net cash provided by (used in) investing activities         |  | 783,754                   |      | (315,153      | )
|                                                           
|Financing Activities                                        | 
|Net change in bank line of credit                           |  | 3,226,926                 |      |              |  
|Deferred financing costs                                    |  | (269,236                  | )    |              |  
|Long-term debt repayments                                   |  | (653,543                  | )    | (152,198      | )
|Proceeds from issuance of stock, net of costs               |  | 5,741,793                 |      |              |  
|                                                           
|Net cash provided by (used in) financing activities         |  | 8,045,940                 |      | (152,198      | )
|                                                           
|Effect of exchange rate changes on cash                     |  | (64,558                   | )    | 70,927        |  
|                                                           
|Net increase (decrease) in cash and cash equivalents        |  | 3,507,103                 |      | (517,055      | )
|Cash and cash equivalents                                   | 
|Beginning of period                                         |  | 577,096                   |      | 1,285,943     |  
|                                                           
|End of period                                               |  | $ 4,084,199               |      | $    768,888  |  
|                                                           
|Supplemental disclosures of cash flow information:          | 
|Equipment obtained with capital lease                       |  | $      96,324             |      | $    163,745  |  
|Cash paid during the period for:                            | 
|Interest                                                    |  | $    439,538              |      | $      91,389 |  
|                                                           

See accompanying consolidated notes.

6

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

1.     Organization and
Summary of Significant Accounting Policies

Derma
Sciences, Inc. and its subsidiaries (the Company) is a full line provider of
wound care, wound closure and specialty securement devices and skin care products. The
Company markets its products principally through independent distributors servicing the
long-term care, home health and acute care markets in the United States, Canada and other
select international markets. The Companys U.S. distribution facility is located in
St. Louis, Missouri, while the Companys Canadian distribution facility is located in
Toronto. The Company has manufacturing facilities in Toronto, Canada and Nantong, China.
With the first aid division (FAD) acquisition, the Company temporarily
manufactures and distributes its adhesive strips and related first aid wound care products
at a Houston, Texas location.

Basis
of Presentation

The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-Q and Article 8 of
Regulation S-X. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States of America for
complete financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three and six months ended June 30, 2008, are not necessarily
indicative of the results that may be expected for the year ending December 31, 2008.
Information included in the condensed consolidated balance sheet as of December 31, 2007 has been
derived from the consolidated financial statements and footnotes thereto for the year
ended December 31, 2007, included in Form 10-KSB previously filed with the Securities and
Exchange Commission. For further information, refer to that Form 10-KSB.

Net
Loss per Share Net loss per common share  basic is computed by dividing net
loss by the weighted average number of common shares outstanding for the period. Net loss
per common share  diluted reflects the potential dilution of earnings by including
the effects of the assumed exercise, conversion or issuance of potentially issuable shares
of common stock (potentially dilutive securities), including those
attributable to stock options, warrants, convertible preferred stock and restricted common
stock in the weighted average number of common shares outstanding for a period, if
dilutive. The effects of the assumed exercise of warrants and stock options are determined
using the treasury stock method. Potentially dilutive securities have not been included in
the computation of diluted loss per share for the three and six months ended June 30, 2008
and 2007 as the effect would be anti-dilutive.

Potentially
dilutive shares excluded as a result of the effects being anti-dilutive are as follows:

|                          |  |                                     |  |            | 
|------------------------- |  | ----------------------------------- |  | ---------- | 
|                          |  | Three and Six Months Ended June 30, | 
|                          |  | 2008                                |  | 2007       | 
|                         
|Excluded dilutive shares: |  |                                     |  |            | 
|Preferred stock           |  | 2,280,407                           |  | 2,280,407  | 
|Restricted common stock   |  | 175,000                             |  | 175,000    | 
|Stock options             |  | 8,316,480                           |  | 6,783,480  | 
|Warrants                  |  | 11,405,259                          |  | 6,169,904  | 
|                         
|Total dilutive shares     |  | 22,177,146                          |  | 15,408,791 | 

Reclassifications Certain reclassifications have been made to prior period reported amounts to
conform with the 2008 presentation.

7

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

2.     Acquisitions

NutraMax
Acquisition

On
November 8, 2007, the Company acquired the NutraMax Products, Inc., (NutraMax)
first aid division (FAD) for $13,000,000 cash and a $500,000 potential earn
out bonus. The cash purchase price consisted of $10,250,000 paid to NutraMax, $2,000,000
deposited in a supply agreement escrow account and $750,000 deposited in an
indemnification escrow account. In addition, the Company incurred $858,148 of capitalized
transaction costs related to the acquisition. On June 26, 2008 the Company and NutraMax
reached an agreement on the disposition of the escrowed funds and settled other working
capital items. In connection with the settlement the Company received payment of
$1,193,187 in full satisfaction of all indemnification and contingent acquisition related
matters which has been recorded as an adjustment to the purchase price. The purchased
assets consisted of receivables, inventory, equipment, other amortizable intangibles and
goodwill. To fund the acquisition, the Company raised $5,610,915 (net of $389,079 in
commission and other offering expenses) from the private sale of 8,571,420 shares of
common stock at a price of $0.70 per share, together with 2,142,855 five-year warrants to
purchase one share of common stock at a price of $0.77 per share. In addition, the Company
entered into a new five-year credit and security agreement comprised of an $8,000,000
revolver and a $6,000,000 term loan. At closing, the Company applied the entirety of the
$6,000,000 term loan and approximately $3,000,000 of the revolver in satisfaction of the
Companys obligations under the purchase agreement and related obligations.

The
FAD is a leading manufacturer and marketer of branded and private label adhesive strips
and related first aid products to the medical, industrial and retail markets. For its
latest fiscal year ended September 29, 2007, FAD reported audited sales of $16,688,000,
gross profit of $1,232,000 and a net loss of $880,000. The FADs product line will
serve to expand the Companys existing basic wound care line to new customers and
markets, especially the retail market where the Company did not have a presence. The
Company anticipates being able to leverage cross selling opportunities presented by the
purchase to grow sales. In addition, the Company expects to be able to reduce FAD product
costs by completing the transfer of production of FAD products, initiated by NutraMax, to
lower cost suppliers.

The
acquisition has been accounted for as a purchase. Accordingly, the results of operations
of FAD have been included in the condensed consolidated financial statements commencing
November 8, 2007. A preliminary allocation of the purchase price is outlined below:

| |                                                  |  |               |  
| | ------------------------------------------------ |  | ------------- | -
| | Purchase Price:                                  |  |               |  
|
| | Cash paid, net of settlement                     |  | $ 11,806,813  |  
| | Transaction costs                                |  | 858,148       |  
|
| | Total                                            |  | $ 12,664,961  |  
|
| | Allocation of Purchase Price:                    | 
|
| | Trade receivables                                |  | $   2,082,839 |  
| | Inventory                                        |  | 2,378,125     |  
| | Equipment                                        |  | 300,000       |  
| | Goodwill                                         |  | 5,833,252     |  
| | Identifiable intangibles subject to amortization |  | 3,000,000     |  
| | Liabilities assumed                              |  | (929,255      | )
|
| | Total                                            |  | $ 12,664,961  |  

The
allocation of the preliminary purchase price to the estimated fair values of the assets
acquired and liabilities assumed as reflected in the consolidated financial statements is
preliminary and subject to change based on finalization of the Companys valuation.
The Company is currently assessing the fair value of the identifiable

8

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

tangible and intangible assets
acquired and liabilities assumed. It is expected that the current assets and liabilities
assumed will approximate the values assigned as of the date of the acquisition. A
valuation study is presently being conducted to establish the fair market value of the
equipment and the identifiable intangibles acquired. The intangible assets acquired
consist primarily of customer lists, trademarks, a supply agreement and a non-compete
agreement. Since the date of the acquisition, the estimated identifiable intangibles have
been amortized to general administrative expense assuming a useful life of five years.
The final purchase price allocation to reflect the fair values of the assets acquired and
liabilities assumed will be based on the final results of the Companys valuation
study. The final valuation is expected to be completed in the third quarter of 2008.

The
Company has retained certain NutraMax personnel to perform sales and marketing,
manufacturing and distribution activities on a permanent and transitional basis.
Manufacturing activities are expected to continue in Houston on an as needed basis through
the third quarter 2008 to meet customer demand and build safety stock. Distribution
activities are expected to continue through 2009, at which time the Company will have
determined how best to rationalize its U.S. distribution network. The Company has entered
into a lease for NutraMaxs former facility in Houston, Texas through February, 2009.
Under the terms of the lease, the Company will pay the landlord $18,750 per month and will
be responsible for utilities and ongoing normal repair and maintenance costs.

The
unaudited pro forma information below presents combined results of operations as if the
FAD acquisition had occurred at January 1, 2007 instead of November 8, 2007. The pro forma
information is based on historical results and is not necessarily indicative of the
results of operations of the combined entity had the acquisition occurred at the beginning
of the periods presented, nor is it necessarily indicative of future results.

|                           |                                |               |  
|-------------------------- | ------------------------------ | ------------- | -
|                           | Six Months Ended June 30, 2007
|                          
|Revenues                   |                                | $ 24,059,055  |  
|                          
|Net loss                   |                                | $    (765,516 | )
|                          
|Net loss per common share: |                               
|Basic and diluted          |                                | $ (0.03       | )

3.     Inventories

Inventories
include the following:

| |                     |  |               |  |                  | 
| | ------------------- |  | ------------- |  | ---------------- | 
| |                     |  | June 30,2008  |  | December 31,2007 | 
|
| | Finished goods      |  | $   8,345,948 |  | $ 6,660,454      | 
| | Work in process     |  | 661,534       |  | 180,823          | 
| | Packaging materials |  | 1,095,073     |  | 1,152,268        | 
| | Raw materials       |  | 1,775,872     |  | 1,942,432        | 
|
| | Total inventory     |  | $ 11,878,427  |  | $ 9,935,977      | 

4.     U.S. Line of Credit

In
November, 2007, the Company entered into a new five-year revolving credit agreement
providing for maximum borrowings of $8,000,000 with its new U.S. lender. Advances under
the revolving credit agreement may be drawn, from time to time, up to the amount of 85%
of eligible receivables (as defined) and 60% of eligible inventory (as defined). Interest
on outstanding advances under the revolving credit agreement is payable at the LIBOR
monthly rate, plus 2.75%, (5.24% at June 30, 2008). In addition, the Company will pay a
monthly unused line fee of 0.5% per annum on the difference between the daily average
amount of advances outstanding under the agreement and $8,000,000 together with a monthly
collateral management fee of $2,000. Outstanding balances

9

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

under the agreement are secured by
all of the Companys and its subsidiaries existing and after-acquired tangible
and intangible assets located in the United States and Canada. At June 30, 2008 the
Company had an outstanding balance of $4,446,123 under this agreement.

The
revolving credit agreement is subject to financial covenants which require maintaining a
minimum cumulative EBITDA level and certain ratios of fixed charge coverage, senior debt
leverage and total debt leverage as defined in the agreement. Additional covenants
governing permitted investments, indebtedness and liens, together with payments of
dividends and protection of collateral, are also included in the agreement. The revolving
credit agreement contains a subjective acceleration provision whereby the lender can
declare a default upon a material adverse change in the Companys business
operations.

Effective
August 13, 2008, the Companys lender agreed to waive all prior financial and
reporting covenant defaults and amend the existing minimum EBITDA, fixed charge coverage,
senior debt leverage and total debt leverage covenants to allow the Company to continue to
implement its growth strategy in line with the lenders minimum liquidity terms.
Amendment of the covenants was predicated upon the Company segregating $2,000,000 in a
restricted account the use of which is subject to the approval of the lender. The Companys maximum revolver borrowing
capacity remained unchanged. The Company incurred fees of $25,000 associated with the
granting of the covenant amendment.

Effective
March 28, 2008, the Companys U.S. lender agreed to waive all prior financial and
reporting covenant defaults and amend the existing minimum EBITDA, fixed charge coverage,
senior debt leverage and total debt leverage covenants, to be measured on a quarterly
basis, to allow the Company to implement its growth strategy. Amendment of the covenants
was predicated upon the Companys commitment to raise a minimum of $3,000,000 by May
1, 2008 from the sale of equity and agreement to limit its maximum revolver borrowing to
the lesser of (a) the revolver loan commitment ($8,000,000) or (b) the borrowing base (as
defined), less $1,500,000. Not less than $3,000,000 of the equity infusion must be used to
pay down the existing revolver balance which amount will be credited as a component of
EBITDA for covenant compliance purposes. The Company incurred fees of $250,000 associated
with the granting of the covenant amendment, together with estimated related expenses of
$10,829 which are included as additions to deferred financing costs. In March, 2008 the
equity infusion requirement (see Note 6) was met.

5.     Long-Term Debt

U.S.
Term Loan

In
November, 2007, the Company entered into a five-year $6,000,000 term loan agreement with
its new U.S. lender. Interest on the term loan is payable at the LIBOR monthly rate plus
4.25%, (6.74% at June 30, 2008). Monthly payments of principal in the amount of $100,000
together with interest are due under the agreement. The agreement is secured by all of the
Companys and its subsidiaries existing and after-acquired tangible and
intangible assets located in the United States and Canada.

The
term loan agreement is subject to financial covenants which require maintaining a minimum
cumulative EBITDA level and certain ratios of fixed charge coverage, senior debt leverage
and total debt leverage as defined in the agreement. Additional covenants governing
permitted investments, indebtedness and liens, together with payments of dividends and
protection of collateral, are also included in the agreement. The term loan agreement
contains a subjective acceleration provision whereby the lender can declare a default upon
a material adverse change in the Companys business operations.

Effective
March 28, 2008, the foregoing financial covenants were amended as described in the third
paragraph under the heading U.S. Line of Credit (see Note 4).

10

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

Long-term
debt includes the following:

| |                           |  |              |  |                  | 
| | ------------------------- |  | ------------ |  | ---------------- | 
| |                           |  | June 30,2008 |  | December 31,2007 | 
|
| | U.S. term loan            |  | $5,300,000   |  | $5,900,000       | 
| | Promissory note           |  | 500,000      |  | 500,000          | 
| | Capital lease obligations |  | 223,448      |  | 180,668          | 
|
| | Total debt                |  | 6,023,448    |  | 6,580,668        | 
|
| | Less:  current maturities |  | 1,813,162    |  | 1,288,532        | 
|
| | Long-term debt            |  | $4,210,286   |  | $5,292,136       | 

Promissory
Note

In
connection with the acquisition of Western Medical in April 2006, a portion of the
purchase price was paid via a three-year unsecured promissory note issued to the seller.
The principal amount of the promissory note, together with simple interest of 12%, is
payable in 11 quarterly installments of interest only in the amount of $15,000 and a final
payment of accrued interest of $15,000 and the principal balance of $500,000 on April 18,
2009. The promissory note may be prepaid in part or in full at any time without penalty.

Capital
Lease Obligations

The
Company has three capital lease obligations for certain office furniture and distribution
equipment totaling $223,448 as of June 30, 2008. The capital lease obligations bear
interest at annual rates ranging from 6.8% to 9.6% with the longest lease term expiring in
February 2011.

6.     Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at June 30, 2008.
The series A preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference of $4.00 per share, votes as a class
on matters affecting the series A preferred stock and maintains voting rights identical to
the common stock on all other matters.

There
are 440,003 shares of series B convertible preferred stock outstanding at June 30, 2008.
The series B preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference of $6.00 per share, votes as a class
on matters affecting the series B preferred stock and maintains voting rights identical to
the common stock on all other matters.

There
are 619,055 shares of series C convertible preferred stock outstanding at June 30, 2008.
The series C preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference averaging $0.70 per share, votes as
a class on matters affecting the series C preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 1,071,346 shares of series D convertible preferred stock outstanding at June 30, 2008.
The series D preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference averaging $0.50 per share, votes as
a class on matters affecting the series D preferred stock and maintains voting rights
identical to the common stock on all other matters.

11

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

Common
Stock

In
March 2008, the Company raised $5,633,293 (net of $466,707 in commission and other
offering expenses) from the private sale of 6,100,000 shares of common stock at a price of
$1.00 per share, together with 3,050,000 five-year warrants to purchase one share of
common stock at a price of $1.20 per share. In addition, the placement agent for the
shares sold received 142,500 five-year warrants to purchase one share of common stock at
$1.20 per share. The proceeds were used to meet the minimum equity infusion requirements
associated with the Companys March 28, 2008 amended bank covenants, support the
Companys strategic growth initiatives and increase working capital.

In
January 2008, the Company issued 210,988 shares of common stock as follows: (a) 100,000
shares in consideration of $105,000 upon exercise of series G warrants, (b) 19,800 shares
in consideration of $12,375 upon exercise of 19,800 stock options, and (c) 91,188 shares
upon cashless exercise of 178,200 stock options.

On
December 28, 2007 the Company amended its articles of incorporation to increase the number
of authorized shares of common stock from 50,000,000 to 150,000,000.

In
November 2007, the Company raised $5,610,915 (net of $389,079 in commission and other
offering expenses) from the private sale to two institutional investors of 8,571,420
shares of the Companys common stock at the price of $0.70 per share, together with
2,142,855 five-year warrants to purchase one share of common stock at the price of $0.77.
The funds were used for the acquisition of FAD.

In
accordance with the series F warrant agreement, effective January 4, 2007, the warrant
holders effected a cashless exercise of all issued and outstanding series F warrants
comprising 1,309,441 warrants with an exercise price of $0.57 per warrant. Based on the
thirty day trailing average closing price of $0.78 per share, the warrants had a
calculated value of $0.21 each ($0.78  $0.57), or $274,983 in the aggregate, and
were exchanged for 352,175 shares of common stock.

Stock
Purchase Warrants

At
June 30, 2008, the Company had warrants outstanding to purchase 11,405,259 shares of the
Companys common stock as outlined below:

| |        |  |                   |  |                |  |                   |  | 
| | ------ |  | ----------------- |  | -------------- |  | ----------------- |  | 
| | Series |  | Number ofWarrants |  | Exercise Price |  | Expiration Date   |  | 
|
| | G      |  | 2,660,000         |  | $1.05          |  | December 31, 2008 |  | 
| | H      |  | 2,655,098         |  | $1.00          |  | April 30, 2011    |  | 
| | I      |  | 754,806           |  | $0.72          |  | April 30, 2011    |  | 
| | J      |  | 2,142,855         |  | $0.77          |  | May 31, 2013      |  | 
| | K      |  | 3,192,500         |  | $1.20          |  | April 1, 2013     |  | 
|
| | Total  |  | 11,405,259        |  |               

Stock
Options

The
Company has a stock option plan under which options to purchase a maximum of 10,000,000
shares of common stock may be issued. The plan permits the granting of both incentive
stock options and nonqualified stock options to employees and directors of the Company
and certain outside consultants and advisors to the Company. The option exercise price
may not be less than the fair market value of the stock on the date of the grant of the
option. The duration of each option may not exceed 10 years from the date of grant. Under
the plan, service based options to purchase 325,000 and 1,040,000 shares of common stock
were granted to officers, directors, agents and employees for the six months ended June
30, 2008 and 2007, respectively, with exercise prices ranging from $0.66 to $1.11 per
share. For the six months ended June 30, 2008, 30,000 plan options were forfeited. As of
June 30,

12

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

2008, options to purchase 6,249,625
shares of the Companys common stock were issued and outstanding under the plan.
During the six months ended June 30, 2008, 198,000 plan options were exercised.

The
Company has previously granted nonqualified stock options to officers, directors, agents
and employees outside of the stock option plan (non-plan options). All
non-plan options were granted at the fair market value at the date of grant. As of June
30, 2008, non-plan options to purchase 2,066,855 shares of the Companys common stock
were issued and outstanding. During the six months ended June 30, 2008 and 2007, 4,000 and
94,800 non-plan options expired, respectively.

For
the six months ended June 30, 2008 and 2007 the fair value of each service based option
award was estimated at the date of grant using the Black-Scholes option pricing model. The
weighted-average assumptions for the six months ended June 30, 2008 and 2007 were as
follows:

|                             |  |       |  |       | 
|---------------------------- |  | ----- |  | ----- | 
|                             |  | 2008  |  | 2007  | 
|                            
|Risk-free interest rate      |  | 3.05% |  | 4.73% | 
|Volatility factor            |  | 119%  |  | 118%  | 
|Dividend yield               |  | 0%    |  | 0%    | 
|Expected option life (years) |  | 6.25  |  | 6.25  | 
|Contractual life (years)     |  | 10    |  | 10    | 

In
both 2008 and 2007, the risk-free rate utilized represents the U.S. Treasury yield curve
rate which approximates the risk-free rate for the expected option life at the time of
grant. In 2008 and 2007, the volatility factor was calculated based on the seventy-five
month-end closing prices of the Companys common stock preceding the month of stock
option grant. The Company uses a seventy-five month volatility period to coincide with the
expected stock option life. Based on guidance from Staff Accounting Bulletin 107 and 110,
a stock option life of 6.25 years was utilized under the simplified method. The dividend
yield is 0% since the Company does not anticipate paying dividends in the near future.
Based on the Companys historical experience of options that expire or are cancelled
before becoming fully vested, the Company assumed an annualized forfeiture rate of 1.0%
for all options. Under the true-up provision of SFAS 123R, the Company will record
additional expense if the actual forfeiture rate is lower than estimated, and will record
a recovery of prior expense if the actual forfeiture rate is higher than estimated.

A
summary of the Companys stock option activity and related information for the six
months ended June 30, 2008 and 2007 follows:

|                        |  |           |   |                               |  |           |   |                               | 
|----------------------- |  | --------- | - | ----------------------------- |  | --------- | - | ----------------------------- | 
|                        |  | 2008      |   | 2007                          | 
|                       
|                        |  | Options   |   | WeightedAverageExercise Price |  | Options   |   | WeightedAverageExercise Price | 
|                       
|Outstanding - January 1 |  | 8,223,480 |   | $0.78                         |  | 5,838,280 |   | $0.94                         | 
|Granted                 |  | 325,000   |   | $0.92                         |  | 1,040,000 |   | $0.79                         | 
|Forfeited/Expired       |  | (34,000   | ) | $3.96                         |  | (94,800   | ) | $7.05                         | 
|Exercised               |  | (198,000  | ) | $0.62                         |  |          |   |                              | 
|                       
|Outstanding - June 30   |  | 8,316,480 |   | $0.78                         |  | 6,783,480 |   | $0.83                         | 
|                       
|Exercisable at June 30  |  | 6,155,230 |   | $0.81                         |  | 5,775,980 |   | $0.84                         | 

The
weighted average fair value per share of options granted during the six months ended June
30, 2008 and 2007 was $0.80 and $0.69, respectively.

13

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

For
the six months ended June 30, 2008 and 2007, no income tax benefit was recognized related
to stock option activity.

During
the six months ended June 30, 2008 and 2007, stock option compensation expense was
recorded using the fair value method under SFAS 123R as follows:

|                                             |  |           |  |           | 
|-------------------------------------------- |  | --------- |  | --------- | 
|                                             |  | 2008      |  | 2007      | 
|                                            
|Cost of sales                                |  | $  26,013 |  | $  29,962 | 
|Selling, general and administrative expenses |  | 380,958   |  | 264,989   | 
|                                            
|Total stock option compensation expense      |  | $406,971  |  | $294,951  | 

As
of June 30, 2008, there was $812,440 of unrecognized compensation cost related to
nonvested service based awards and $317,626 related to nonvested market based awards
granted under the plan. That cost is expected to be recognized over the options
remaining weighted average vesting period of 1.90 years for service based options and 1.40
years for market based options.

Restricted
Common Stock

On
May 11, 2006, the Company adopted a restricted common stock plan and reserved 2,500,000
shares of common stock for issuance.

On
May 12, 2006, 175,000 shares of restricted common stock were granted to non-employee
members of the Companys board of directors and will vest three years from the date
of the grant. The fair market value at the date of grant, determined by the quoted market
price, was $145,250 or $0.83 per share. The fair market value of the grant is being
recognized to compensation expense over the three-year service period. For the six months
ended June 30, 2008 and 2007, $24,210 for each period was recorded in selling, general and administrative expense
for these grants.

Shares
Reserved for Future Issuance

At
June 30, 2008, the Company had reserved the following shares of common stock for future
issuance:

|                                                 |  |            | 
|------------------------------------------------ |  | ---------- | 
|Convertible preferred shares (series A - D)      |  | 2,280,407  | 
|Common stock options available for grant         |  | 3,750,375  | 
|Common stock options outstanding                 |  | 8,316,480  | 
|Common stock warrants outstanding (series G - K) |  | 11,405,259 | 
|Restricted common stock available for grant      |  | 2,325,000  | 
|Restricted common stock grants                   |  | 175,000    | 
|                                                
|Total common stock shares reserved               |  | 28,252,521 | 

14

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

7.     Comprehensive (Loss)
Income

The
Companys comprehensive (loss) income was as follows:

|                                        |  |                            |   |                          |   |             |   |           |  
|--------------------------------------- |  | -------------------------- | - | ------------------------ | - | ----------- | - | --------- | -
|                                        |  | Three Months EndedJune 30, |   | Six Months EndedJune 30, |  
|                                        |  | 2008                       |   | 2007                     |   | 2008        |   | 2007      |  
|                                       
|Net loss as reported                    |  | $(1,270,488                | ) | $(109,563                | ) | $(2,680,276 | ) | $(248,516 | )
|Other comprehensive income (loss):      | 
|Foreign currency translation adjustment |  | 42,417                     |   | 505,794                  |   | (187,482    | ) | 564,334   |  
|                                       
|Comprehensive (loss) income             |  | $(1,228,071                | ) | $ 396,231                |   | $(2,867,758 | ) | $(315,818 | )

8.     Operating Segments

The Company
consists of three operating segments: wound care, wound closure and specialty securement
devices and skin care. Products in the wound care segment consist of basic and advanced
dressings, adhesive strips, ointments and sprays. Wound closure and specialty securement
device products include wound closure strips, nasal tube fasteners and a variety of
catheter fasteners. The skin care segment consists of bath sponges, antibacterial skin
cleansers, hair and body soaps, lotions and moisturizers.

Products
in all three operating segments are marketed to long-term care facilities, hospitals,
physicians, clinics, home health care agencies and other healthcare institutions. Basic
and advanced wound care products are manufactured both internally and outsourced, while
the manufacture of skin care products is completely outsourced. Wound closure-specialty
securement devices are significantly manufactured in-house. Internally, the segments are
managed at the gross profit level. The aggregation or allocation of other costs by segment
is not practical.

Segment
sales, gross profit and other related information for the three and six months ended June
30, 2008 and 2007 are as follows:

|               |  |                                  |   |                                           |  |           |  |              |   |                  |  
|-------------- |  | -------------------------------- | - | ----------------------------------------- |  | --------- |  | ------------ | - | ---------------- | -
|               |  | Three Months Ended June 30, 2008 |   |                                           |  |          
|              
|               |  | Wound Care                       |   | Wound Closure-SpecialtySecurement Devices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $ 12,401,507                     |   | $   494,584                               |  | $ 187,875 |  |             |   | $ 13,083,966     |  
|              
|Gross profit   |  | 3,296,188                        |   | 271,391                                   |  | 51,917    |  |             |   | 3,619,496        |  
|Total expenses |  |                                 |   |                                          |  |          |  | $ (4,889,984 | ) | (4,889,984       | )
|              
|Net loss       |  | $ (1,270,488                     | )

15

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

|               |  |                                  |   |                                           |  |           |  |              |   |                  |  
|-------------- |  | -------------------------------- | - | ----------------------------------------- |  | --------- |  | ------------ | - | ---------------- | -
|               |  | Three Months Ended June 30, 2007 |   |                                           |  |          
|              
|               |  | Wound Care                       |   | Wound Closure-SpecialtySecurement Devices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $ 6,559,732                      |   | $ 670,555                                 |  | $ 230,971 |  |             |   | $ 7,461,258      |  
|              
|Gross profit   |  | 2,233,101                        |   | 396,071                                   |  | 36,026    |  |             |   | 2,665,198        |  
|Total expenses |  |                                 |   |                                          |  |          |  | $ (2,774,761 | ) | (2,774,761       | )
|              
|Net loss       |  | $    (109,563                    | )
|              
|              
|               |  | Six Months Ended June 30, 2008   |   |                                           |  |          
|              
|               |  | Wound Care                       |   | Wound Closure-SpecialtySecurement Devices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $ 23,520,516                     |   | $ 928,628                                 |  | $ 359,644 |  |             |   | $ 24,808,788     |  
|              
|Gross profit   |  | 6,211,032                        |   | 515,197                                   |  | 101,925   |  |             |   | 6,828,154        |  
|Total expenses |  |                                 |   |                                          |  |          |  | $ (9,508,430 | ) | (9,508,430       | )
|              
|Net loss       |  | $ (2,680,276                     | )
|              
|              
|               |  | Six Months Ended June 30, 2007   |   |                                           |  |          
|              
|               |  | Wound Care                       |   | Wound Closure-SpecialtySecurement Devices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $ 13,716,040                     |   | $ 1,262,672                               |  | $ 448,343 |  |             |   | $ 15,427,055     |  
|              
|Gross profit   |  | 4,673,363                        |   | 733,590                                   |  | 62,673    |  |             |   | 5,469,626        |  
|Total expenses |  |                                 |   |                                          |  |          |  | $ (5,718,142 | ) | (5,718,142       | )
|              
|Net loss       |  | $    (248,516                    | )

The
following table presents net sales by geographic region.

|              |                             |                           |      |      | 
|------------- | --------------------------- | ------------------------- | ---- | ---- | 
|              | Three Months Ended June 30, | Six Months Ended June 30, |     
|             
|              | 2008                        | 2007                      | 2008 | 2007 | 
|             
|United States | 70%                         | 59%                       | 69%  | 58%  | 
|Canada        | 25%                         | 34%                       | 26%  | 36%  | 
|Other         | 5%                          | 7%                        | 5%   | 6%   | 

For
the six months ended June 30, 2008, the Company has a major U.S. customer comprising 11%
of U.S. sales and 11% of U.S. operations trade accounts receivable at June 30, 2008. The
Companys wholly owned

16

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

Canadian subsidiary sells to one
customer who serves as its exclusive third party distributor and comprises 100% of Canada
operations trade accounts receivable at June 30, 2008.

9.     Income Taxes

The
Company recorded a $81,830 foreign income tax benefit for the six months ended June 30,
2008, based on the operating results of the Companys wholly owned Canadian
subsidiary. No benefit was realized for the Companys net loss from U.S. operations
in the six months ended June 30, 2008 due to uncertainties surrounding the Companys
ability to utilize the net operating loss carry forwards. The Company recorded a $187,523
deferred tax provision during the six months ended June 2007 related to its Canadian
subsidiarys operating results.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred assets, a full valuation allowance has been provided.

10.    Commitments

Clinical
Services Agreement

In
January 2008, the Company entered into an agreement with a clinical services company to
provide phase II clinical studies for the angiotensin analog technology compound licensed
in November 2007.

Costs
under the agreement include services fees of approximately $23,000 per month from February
2008 to January 2010 and reimbursement of sterile manufacturing, toxicology and
statistician support services estimated in the amount of $470,000. The foregoing costs
represent an estimate of the Companys costs under the agreement; however, actual
costs could exceed these estimates. In addition, the clinical services company is the
recipient of a grant issued by the National Institute of Health and will use the proceeds
of the grant of approximately $1,575,000 to cover certain other clinical testing costs
(including patient care, toxicology studies and certain other costs). The Company is
responsible for these other costs to the extent that they exceed the amount of the grant.
If the amount under the grant is reduced by more than 10%, Derma Sciences may terminate
the agreement. In addition, the agreement may be terminated upon termination of the
angiotensin analog technology compound license agreement.

17

---



Index

|Item 2. |  | MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF OPERATION
|------- |  | --------------------------------------------------------------------------------

QUARTER ENDED
JUNE 30, 2008 COMPARED
TO QUARTER ENDED JUNE 30, 2007

Overview of Consolidated
Operating Results

The
2008 and 2007 operating results include Derma Sciences, Inc. and its subsidiaries. The
results of operations of the first aid division (FAD) have been included in
the consolidated results of operations commencing November 8, 2007. Unless otherwise
indicated by the context, the terms U.S. operations and Canadian operations are used
throughout this discussion in reference to the Companys U.S. operations and the
operations of Derma Sciences Canada Inc., respectively.

The
following table highlights the quarter ended June 30, 2008 versus 2007 operating results:

|                                            |  |                        |   |             |   |             |   |        | 
|------------------------------------------- |  | ---------------------- | - | ----------- | - | ----------- | - | ------ | 
|                                            |  | Quarter Ended June 30, |  
|                                            |  | 2008                   |   | 2007        |   | Variance    |  
|                                           
|Gross Sales                                 |  | $ 15,780,523           |   | $ 9,174,976 |   | $ 6,605,547 |   | 72.0%  | 
|Sales adjustments                           |  | (2,696,557             | ) | (1,713,718  | ) | (982,839    | ) | 57.4%  | 
|                                           
|Net sales                                   |  | 13,083,966             |   | 7,461,258   |   | 5,622,708   |   | 75.4%  | 
|Cost of sales                               |  | 9,464,470              |   | 4,796,060   |   | 4,668,410   |   | 97.3%  | 
|                                           
|Gross profit                                |  | 3,619,496              |   | 2,665,198   |   | 954,298     |   | 35.8%  | 
|                                           
|Selling, general and administrative expense |  | 4,572,077              |   | 2,589,957   |   | 1,982,120   |   | 76.5%  | 
|Research and development expense            |  | 106,200                |   | 106,200     |  
|Interest expense                            |  | 232,572                |   | 47,564      |   | 185,008     |   | 389.0% | 
|Other (income) expense, net                 |  | (29,092                | ) | 23,141      |   | (52,233     | )
|                                           
|Total expenses                              |  | 4,881,757              |   | 2,660,662   |   | 2,221,095   |   | 83.5%  | 
|                                           
|(Loss) income before income taxes           |  | (1,262,261             | ) | 4,536       |   | (1,266,797  | ) |       | 
|                                           
|Provision for income taxes                  |  | 8,227                  |   | 114,099     |   | (105,872    | ) |       | 
|                                           
|Net loss                                    |  | $(1,270,488            | ) | $  (109,563 | ) | $(1,160,925 | ) |       | 

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, distributor fees (in Canada), sales incentives,
Medicaid rebates, returns and allowances and cash discounts to derive net sales. Trade
rebates are trued-up monthly based upon an analysis of historical sales subject to rebate
and actual rebates received from distributors. The normal rebate cycle is one month.
Non-exclusive distributors generally carry one months inventory. The Companys
exclusive distributor in Canada normally carries three to four months inventory. As
distributor inventory is depleted via sales, it is replenished via purchases from the
Company. Rebates are processed and submitted for credit on a timely basis consistent with
distributor sales. If the normal rebate cycle were one-half month less than estimated at
June 30, 2008, the trade rebate reserve would be overstated by approximately $290,000. If
the normal rebate cycle were one month greater than estimated at June 30, 2008, the trade
rebate reserve would be understated by approximately $580,000. To minimize its cash
outflow invested in rebates, distributors generally strive to optimize the rebate credit
submission process.

Given
the nature of the Companys products and business, there is no external information
available to further validate the reasonableness of the trade rebate accrual balance.
Historical trends of sales subject to rebate and rebates received are evaluated monthly,
by distributor, on a 3 month, 6 month and 12 month rolling basis to update the continued
reasonableness of the assumptions used to quantify the trade rebate accrual balance.

18

---



Index

Deviations in the trends resulting,
among other causes, from distributors not submitting their rebates on a timely basis are
analyzed and factored in determining the required accrual balance.

The
Company currently pays its exclusive Canadian distributor a fixed fee of 10% on net sales
subject to the fee (as defined) for distribution services in Canada. The distributor fee
is accrued each month based on net sales to the distributor times the ratio of estimated
percentage of distributor fee expense to net sales based on past history. The percentage
of distributor fee expense to net sales is re-evaluated quarterly for reasonableness.

Sales
incentives are credits granted to specific customers based upon attainment of
pre-determined sales objectives. The agreements are generally for a period of one year.

Medicaid
rebates are accrued monthly based upon recent historical activity and reconciled quarterly
based upon receipt of rebate reports from participating state agencies. Returns and
allowances and cash discounts are accrued monthly based on recent historical activity.

Gross
to net sales adjustments comprise the following:

|                       |  |                        |   |             |  
|---------------------- |  | ---------------------- | - | ----------- | -
|                       |  | Quarter Ended June 30, |  
|                       |  | 2008                   |   | 2007        |  
|                      
|Gross Sales            |  | $ 15,780,523           |   | $ 9,174,976 |  
|                      
|Trade rebates          |  | (1,965,741             | ) | (1,274,563  | )
|Distributor fees       |  | (310,455               | ) | (216,338    | )
|Sales incentives       |  | (142,250               | ) | (52,485     | )
|Medicaid rebates       |  | (900                   | ) | (1,616      | )
|Returns and allowances |  | (176,675               | ) | (108,070    | )
|Cash discounts         |  | (100,536               | ) | (60,646     | )
|                      
|Total adjustments      |  | (2,696,557             | ) | (1,713,718  | )
|                      
|Net sales              |  | $ 13,083,966           |   | $ 7,461,258 |  

Trade rebates
increased in 2008 versus 2007 due to higher rebate intensive Canadian sales coupled with
an increase in the overall rebate percentage due to renewal of buying group contracts at
lower selling prices and continuing growth of rebate intensive U.S. private label sales.
The increase in distributor fee expense is commensurate with the increase in Canadian net
sales upon which it is based. The increase in sales incentive expense relates to the
addition of FAD incentives. The sales returns and allowances increase is due principally
to the addition of the FAD sales and a higher level of FAD returns and allowances
associated with the integration of this business, partially offset by lower Canadian
returns. Cash discounts increased commensurate with the sales increase, partially offset
by a slight decrease in the percentage of cash discounts to sales.

Rebate Reserve Roll
Forward

A
roll forward of the trade rebate accruals at June 30, 2008 and 2007 is outlined below:

|                             |  |                        |   |             |  
|---------------------------- |  | ---------------------- | - | ----------- | -
|                             |  | Quarter Ended June 30, |  
|                             |  | 2008                   |   | 2007        |  
|                            
|Beginning balance  March 31 |  | $ 2,735,127            |   | $ 2,367,804 |  
|Rebates paid                 |  | (1,653,567             | ) | (1,362,557  | )
|Rebates accrued              |  | 1,965,742              |   | 1,274,563   |  
|                            
|Ending balance  June 30     |  | $ 3,047,302            |   | $ 2,279,810 |  

19

---



Index

The
$767,492 increase in the 2008 trade rebate reserve ending balance reflects an increase in
the Canadian rebate reserve due to higher sales, an increase in the overall rebate
percentage due to renewal of buying group contracts at lower selling prices coupled with
an increase in the exclusive distributors inventory level. Continued growth of the
rebate intensive U.S. private label business coupled with a timing related decrease in
rebates paid, also contributed. There has been no other discernable change in the nature
of the Companys business as it relates to the accrual and subsequent payment of
rebates.

Net Sales and Gross Margin

The
following table highlights 2008 versus 2007 net sales and gross profit:

|               |  |                        |  |            |  |             |  |       | 
|-------------- |  | ---------------------- |  | ---------- |  | ----------- |  | ----- | 
|               |  | Quarter Ended June 30, | 
|               |  | 2008                   |  | 2007       |  | Variance    | 
|              
|Net Sales      |  | $13,083,966            |  | $7,461,258 |  | $5,622,708  |  | 75.4% | 
|              
|Cost of sales  |  | 9,464,470              |  | 4,796,060  |  | 4,668,410   |  | 97.3% | 
|              
|Gross Profit   |  | $  3,619,496           |  | $2,665,198 |  | $   954,298 |  | 35.8% | 
|              
|Gross Profit % |  | 27.7%                  |  | 35.7%      | 

Consolidated
net sales increased $5,622,708, or 75.4%, in 2008 versus 2007. Canadian net sales
increased $725,079, or 28.7% (19.4% excluding foreign exchange), to $3,249,334 in 2008
from $2,524,255 in 2007. This increase was driven by higher sales of $489,091 coupled with
favorable exchange of $235,988 associated with a 9.4% strengthening of the Canadian
dollar. Real growth, distributor inventory build and lower than normal sales in the second
quarter 2007 as a result of higher than normal first quarter sales as the Companys
exclusive Canadian distributor rebalanced its inventory are responsible for the 2008 sales
increase. Real growth as measured by sales of the Companys products reported by the
distributor, unadjusted for foreign exchange, approximated 8.9%. U.S. net sales increased
$4,897,629, or 99.2%, to $9,834,632 in 2008 from $4,937,003 in 2007. The increase was
driven by the addition of incremental FAD sales of $4,737,008 coupled with higher advanced
wound care sales of $297,015 and private label sales of $206,550, partially offset by
lower traditional wound care, specialty fixation device and skin care sales. The higher
advanced wound care sales reflect continued growth of the Companys recently launched
Medihoney product together with the balance of the line in response to increased sales and
marketing support. Gross Medihoney sales in the quarter were $295,395. The increase in
private label sales reflects timing and improved demand from several customers. Specialty
fixation device sales declined due to the discontinuation of a private label agreement in
2007. Excluding FAD sales, U.S. sales increased $160,621, or 3.3%.

Consolidated
gross profit increased $954,298, or 35.8%, in 2008 versus 2007. Company gross profit
margin percentage decreased to 27.7% in 2008 from 35.7% in 2007. Canadian gross profit
increased $142,299, or 17.2%, to $969,889 in 2008 from $827,590 in 2007. The Canadian
gross profit margin percentage decreased to 29.8% in 2008 from 32.8% in 2007. The increase
in Canadian 2008 gross profit dollars reflects the impact of higher sales partially offset
by the decline in gross profit margin percentage. The decline in gross profit margin
percentage principally reflects a significant reduction in the volume of product produced
in the Toronto facility in 2008 versus 2007. In 2007, Toronto was operating at a higher
operating level producing a number of new private label products in addition to its normal
production. This higher level of production resulted in the realization of favorable labor
and overhead absorption variances. Conversely, demand for these products and others are
less in 2008. This lower level of production resulted in the realization of unfavorable
labor and overhead absorption variances in 2008. Higher 2008 facility and product
validation costs also contributed. U.S. gross profit increased $811,700, or 44.2%, to
$2,649,608 in 2008 from $1,837,908 in 2007. The U.S. gross profit margin percentage
decreased to 26.9% in 2008 from 37.2% in 2007. The increase in U.S. gross profit margin
dollars reflects the impact of higher sales, partially offset by the decline in gross
profit margin percentage. The decrease in gross profit margin percentage is principally
attributable to the addition of lower margined FAD sales. FAD gross profit margin
percentage in the second quarter 2008 was 20.4% due principally to the need to continue
higher cost domestic manufacturing to meet customer demand. Excluding FAD, U.S. gross
profit decreased $156,205, or 8.5%, and the gross profit margin percentage would have been
33.0%. The decrease in the U.S. gross profit margin percentage (excluding FAD) is
attributable to the loss of the higher margined specialty fixation private label agreement
in 2007, unfavorable product sales mix and higher transportation and product costs.

20

---



Index

Selling, General and
Administrative Expenses

The
following table highlights 2008 versus 2007 selling, general and administrative expenses
by type:

|                       |  |                        |  |             |  |             |  |        | 
|---------------------- |  | ---------------------- |  | ----------- |  | ----------- |  | ------ | 
|                       |  | Quarter Ended June 30, | 
|                       |  | 2008                   |  | 2007        |  | Variance    | 
|                      
|Distribution           |  | $   542,194            |  | $   208,052 |  | $   334,142 |  | 160.6% | 
|Marketing              |  | 613,399                |  | 379,703     |  | 233,696     |  | 61.6%  | 
|Sales                  |  | 1,597,787              |  | 680,358     |  | 917,429     |  | 134.9% | 
|General administrative |  | 1,818,697              |  | 1,321,844   |  | 496,853     |  | 37.6%  | 
|                      
|Total                  |  | $4,572,077             |  | $2,589,957  |  | $1,982,120  |  | 76.5%  | 

Selling,
general and administrative expenses increased $1,982,120, or 76.5%, in 2008 versus 2007,
including an increase of $51,539, or 2.0%, in Canadian selling, general and administrative
expenses attributable to exchange associated with a 9.4% strengthening of the Canadian
dollar.

Distribution
expense increased $334,142, or 160.6%, in 2008 versus 2007. Expenses in Canada increased
$59,159 (including $6,758 expense related to exchange) while expenses in the U.S increased
$274,983. The increase in Canada relates to lease settlement costs associated with the
Companys former Canadian distribution center. The U.S. increase was driven by the
addition of incremental FAD expense of $259,625 (including one-time transition related
costs that are not expected to recur once the transition is completed) coupled with
incremental personnel and operating costs in St. Louis in support of the non-FAD business.

Marketing
expense increased $233,696, or 61.6%, in 2008 versus 2007. The increase is principally
attributable to planned U.S. increases of $169,922 to $549,625 in 2008 from $379,703 in
2007 of clinical personnel, trade show and promotion expense in support of the
Companys growth initiatives. Incremental FAD expenses of $30,512 and expenses in
Canada of $33,262 also contributed.

Sales
expense increased $917,429, or 134.9%, in 2008 versus 2007. Expenses in Canada increased
$75,135 (including $14,698 expense related to exchange) while expenses in the U.S.
increased $842,294. Excluding exchange, expenses in Canada increased principally due to
consulting costs related to the sale of Medihoney products, higher travel costs, higher buying
group administrative fees (distributor sales volume related) and implementation of a
distributor sales incentive program. The U.S. increase was principally attributable to an
expansion of the sales force starting in June 2007 from two representatives to one
national sales director and ten sales representatives at an incremental cost of $395,860
from $454,073 in 2007 to $849,933 in 2008, incremental expenses of $418,509 and customer
service costs of $27,925 to support the new FAD business.

General
administrative expense increased $496,853, or 37.6%, in 2008 versus 2007. Expenses in
Canada increased $53,004 (including $30,083 expense related to exchange) while expenses in
the U.S. increased $443,849. The increase in Canada principally reflects normal
year-to-year compensation and benefit increases, one new materials management position
(transferred from U.S.) and higher recruiting costs, partially offset by lower bonus and
Sarbanes Oxley consulting expenses (more extensive and costly first year testing in 2007
not repeated in 2008). The U.S. increase principally reflects incremental intangible
amortization expense of $152,000 related to the FAD acquisition, higher finance and IT
employee costs of $120,900 associated with new hires in the second half of 2007 and in
2008 to support the growth in the business and expanding regulatory requirements, higher
equity based compensation costs of $84,000, higher investor relations expense of $57,000
due to expanded efforts in this area, higher rent expense of $30,000 associated with the
new corporate headquarters, together with normal year-to-year compensation and benefit and
other inflationary cost increases, partially offset by lower bonus and Sarbanes Oxley
consulting expenses.

Research and Development
Expense

Research
and development costs of $106,199 during the second quarter 2008 relate to ongoing
development and consulting expenses associated with the DSC 127 phase II clinical trial
that was initiated in the first quarter 2008.

21

---



Index

Interest Expense

Interest
expense increased $185,010 to $232,574 in 2008 from $47,564 in 2007. Interest expense in
Canada decreased $10,112 while interest expense in the U.S. increased $195,122. The
decrease in Canada reflects the payoff of all Canadian debt in September 2007. The U.S.
increase is due to the financing associated with the FAD acquisition in November 2007.

Other Income/Expense

Other
income/expense increased $52,234 to $29,093 income in 2008 from $23,141 expense in 2007.
The main drivers for the other income of $29,093 in 2008 were higher royalty income
combined with lower foreign exchange expense. The main driver for the other expense of
$23,141 in 2007 was foreign exchange expense.

Income Taxes

The
Company recorded an $8,227 deferred foreign income tax provision for 2008 based on the
Companys Canadian subsidiarys operating results. The Canadian tax benefit is
deferred in nature as net operating loss carry forwards continue to be utilized to offset
taxes payable. No provision for taxes was made for the Companys U.S. operations in
2008 due to a net operating loss coupled with available net operating loss carry forwards.
The Company recorded a $114,099 deferred foreign tax provision in 2007 related to its
Canadian subsidiarys operating results.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net
deferred tax assets has been provided.

Net Loss

The
Company generated a net loss of $1,270,488, or ($0.03) per share (basic and diluted), in
the second quarter 2008 compared to a net loss of $109,563, or ($0.00) per share (basic
and diluted), in the second quarter 2007.

22

---



Index

SIX MONTHS ENDED
JUNE 30, 2008 COMPARED TO SIX MONTHS ENDED
JUNE 30, 2007.

Results of Operations

Overview

The
following table highlights the six months ended June 30, 2008 versus 2007 operating
results:

|                                            |  |                           |   |               |   |              |   |        | 
|------------------------------------------- |  | ------------------------- | - | ------------- | - | ------------ | - | ------ | 
|                                            |  | Six Months Ended June 30, |  
|                                            |  | 2008                      |   | 2007          |   | Variance     |  
|                                           
|Gross Sales                                 |  | $ 30,043,720              |   | $ 19,354,955  |   | $ 10,688,765 |   | 55.2%  | 
|Sales adjustments                           |  | (5,234,932                | ) | (3,927,900    | ) | (1,307,032   | ) | 33.3%  | 
|                                           
|Net sales                                   |  | 24,808,788                |   | 15,427,055    |   | 9,381,733    |   | 60.8%  | 
|Cost of sales                               |  | 17,980,634                |   | 9,957,429     |   | 8,023,205    |   | 80.6%  | 
|                                           
|Gross profit                                |  | 6,828,154                 |   | 5,469,626     |   | 1,358,528    |   | 24.8%  | 
|                                           
|Selling, general and administrative expense |  | 8,958,943                 |   | 5,258,111     |   | 3,700,832    |   | 70.4%  | 
|Research and development expense            |  | 154,308                   |   | 125,000       |   | 29,308       |   | 23.5%  | 
|Interest expense                            |  | 497,487                   |   | 97,810        |   | 399,677      |   | 408.6% | 
|Other (income) expense, net                 |  | (20,478                   | ) | 49,698        |   | 70,176       |  
|                                           
|Total expenses                              |  | 9,590,260                 |   | 5,530,619     |   | 4,059,641    |   | 73.4%  | 
|(Loss) before income taxes                  |  | (2,762,106                | ) | (60,993       | ) | (2,701,113   | ) |       | 
|                                           
|(Benefit) provision for income taxes        |  | (81,830                   | ) | 187,523       |   | 269,353      |   |       | 
|                                           
|Net loss                                    |  | $(2,680,276               | ) | $    (248,516 | ) | $(2,431,760  | ) |       | 

Gross to Net Sales
Adjustments

Gross
to net sales adjustments comprise the following:

|                       |  |                           |   |              |  
|---------------------- |  | ------------------------- | - | ------------ | -
|                       |  | Six Months Ended June 30, |  
|                       |  | 2008                      |   | 2007         |  
|                      
|Gross Sales            |  | $ 30,043,720              |   | $ 19,354,955 |  
|                      
|Trade rebates          |  | (3,887,265                | ) | (3,028,432   | )
|Distributor fees       |  | (596,477                  | ) | (505,889     | )
|Sales incentives       |  | (185,601                  | ) | (109,653     | )
|Medicaid rebates       |  | (3,900                    | ) | (3,131       | )
|Returns and allowances |  | (332,106                  | ) | (151,586     | )
|Cash discounts         |  | (229,583                  | ) | (129,209     | )
|                      
|Total adjustments      |  | (5,234,932                | ) | (3,927,900   | )
|                      
|Net sales              |  | $ 24,808,788              |   | $ 15,427,055 |  

Trade
rebates increased in 2008 versus 2007 due to higher rebate intensive Canadian sales
coupled with an increase in the overall rebate percentage due to renewal of buying group
contracts at lower selling prices and continuing growth of rebate intensive U.S. private
label sales. The increase in distribution fee expense is commensurate with the increase
in Canadian net sales upon which it is based. The increase in sales incentive expense
relates to the addition of FAD incentives. The sales returns and allowances increase is
due principally to

23

---



Index

the addition of the FAD sales and a
higher level of FAD returns and allowances associated with the integration of this
business coupled with a large private label return due to incorrect packaging, partially
offset by lower Canadian returns. Cash discounts increased commensurate with the sales
increase, partially offset by a slight decrease in the percentage of cash discounts to
sales.

Rebate Reserve Roll
Forward

A
six month roll forward of the trade rebate accruals at June 30, 2008 and 2007 is outlined
below:

|                              |  |                           |   |             |  
|----------------------------- |  | ------------------------- | - | ----------- | -
|                              |  | Six Months Ended June 30, |  
|                              |  | 2008                      |   | 2007        |  
|                             
|Beginning balance  January 1 |  | $ 2,404,861               |   | $ 1,817,558 |  
|Rebates paid                  |  | (3,244,824                | ) | (2,566,180  | )
|Rebates accrued               |  | 3,887,265                 |   | 3,028,432   |  
|                             
|Ending balance  June 30      |  | $ 3,047,302               |   | $ 2,279,810 |  

The
$767,492 increase in the 2008 trade rebate reserve ending balance reflects an increase in
the Canadian rebate reserve due to higher sales, an increase in the overall rebate
percentage due to renewal of buying group contracts at lower selling prices coupled with
an increase in the exclusive distributors inventory level. Continued growth of the
rebate intensive U.S. private label business coupled with a timing related decrease in
rebates paid, also contributed. There has been no other discernable change in the nature
of the Companys business as it relates to the accrual and subsequent payment of
rebates.

Net Sales and Gross Margin

The
following table highlights the June 30, 2008 versus 2007 product line net sales and gross
profit:

|               |  |                           |  |              |  |            |  |       | 
|-------------- |  | ------------------------- |  | ------------ |  | ---------- |  | ----- | 
|               |  | Six Months Ended June 30, | 
|               |  | 2008                      |  | 2007         |  | Variance   | 
|              
|Net Sales      |  | $24,808,788               |  | $15,427,655  |  | $9,381,733 |  | 60.8% | 
|              
|Cost of sales  |  | 17,980,634                |  | 9,957,429    |  | 8,023,205  |  | 80.6% | 
|              
|Gross Profit   |  | $  6,828,154              |  | $  5,469,626 |  | $1,358,528 |  | 24.8% | 
|              
|Gross Profit % |  | 27.5%                     |  | 35.3%        | 

Consolidated
net sales increased $9,381,733, or 60.8%, in 2008 versus 2007. Canadian net sales
increased $881,614, or 15.7% (2.6% excluding foreign exchange), to $6,496,126 in 2008 from
$5,614,512 in 2007. This increase was driven by higher sales of $144,112 coupled with
favorable exchange of $737,502 associated with an 11.7% strengthening of the Canadian
dollar. Distributor inventory build is principally responsible for the sales increase.
Real growth as measured by sales of the Companys products reported by the
distributor, unadjusted for foreign exchange, approximated 9.1%. U.S. net sales increased
$8,500,119, or 86.6%, to $18,312,662 in 2008 from $9,812,543 in 2007. The increase was
driven by the addition of incremental FAD sales of $8,516,364 coupled with higher advanced
wound care sales of $748,953, partially offset by lower private label, specialty fixation
device and skin care sales. The higher advanced wound care sales reflect continued growth
of the Companys recently launched Medihoney product together with the balance of the
line in response to increased sales and marketing support. Gross Medihoney sales in the
first half were $588,982. The decrease in private label sales reflects softening demand
from several customers in the first quarter that was partially offset by strengthened
demand in the second quarter. Specialty fixation device sales declined due to the
discontinuation of a private label agreement in 2007. Excluding FAD sales, U.S. sales
decreased $16,245.

24

---



Index

Consolidated
gross profit increased $1,358,528, or 24.8%, in 2008 versus 2007. Company gross profit
margin percentage decreased to 27.5% in 2008 from 35.5% in 2007. Canadian gross profit
decreased $172,207, or 8.7%, to $1,802,178 in 2008 from $1,974,385 in 2007. The Canadian
gross profit margin percentage decreased to 27.7% in 2008 from 35.2% in 2007. The decrease
in Canadian 2008 gross profit dollars reflects the decline in gross profit margin
percentage, partially offset by the impact of higher sales. The decline in gross profit
margin percentage principally reflects a significant reduction in the volume of product
produced in the Toronto facility in 2008 versus 2007. In 2007, Toronto was operating at a
higher operating level producing a number of new private label products in addition to its
normal production. This higher level of production resulted in the realization of
favorable labor and overhead absorption variances. Conversely, demand for these products
and others are less in 2008. This lower level of production resulted in the realization of
unfavorable labor and overhead absorption variances in 2008. Higher 2008 facility and
product validation costs also contributed. U.S. gross profit increased $1,530,737, or
43.8%, to $5,025,977 in 2008 from $3,495,240 in 2007. The U.S. gross profit margin
percentage decreased to 27.4% in 2008 from 35.6% in 2007. The increase in U.S. gross
profit margin dollars reflects the impact of higher sales, partially offset by the decline
in gross profit margin percentage. The decrease in gross profit margin percentage is
principally attributable to the addition of lower margined FAD sales. FAD gross profit
margin percentage in the first half 2008 was 19.5% due principally to the need to continue
higher cost domestic manufacturing to meet customer demand. Excluding FAD, U.S. gross
profit decreased $127,309, or 3.6%, and the gross profit margin percentage would have been
34.4%. The decrease in the U.S. gross profit margin percentage (excluding FAD) is
attributable to the loss of the higher margined specialty fixation private label agreement
in 2007, unfavorable product sales mix and higher transportation and product costs.

Selling, General and
Administrative Expenses

The
following table highlights June 30, 2008 versus 2007 operating expenses by type:

|                       |  |                           |  |             |  |             |  |        | 
|---------------------- |  | ------------------------- |  | ----------- |  | ----------- |  | ------ | 
|                       |  | Six Months Ended June 30, | 
|                       |  | 2008                      |  | 2007        |  | Variance    | 
|                      
|Distribution           |  | $1,022,181                |  | $   436,071 |  | $   586,110 |  | 134.4% | 
|Marketing              |  | 1,009,389                 |  | 667,930     |  | 341,459     |  | 51.1%  | 
|Sales                  |  | 2,938,258                 |  | 1,237,914   |  | 1,700,344   |  | 137.4% | 
|General administrative |  | 3,989,115                 |  | 2,916,196   |  | 1,072,919   |  | 36.8%  | 
|                      
|Total                  |  | $8,958,943                |  | $5,258,111  |  | $3,700,832  |  | 70.4%  | 

Selling,
general and administrative expenses increased $3,700,832, or 70.4%, in 2008 versus 2007,
including an increase of $155,336, or 3.0%, in Canadian selling, general and
administrative expenses attributable to exchange associated with an 11.7% strengthening of
the Canadian dollar.

Distribution
expense increased $586,110, or 134.4%, in 2008 versus 2007. Expenses in Canada increased
$59,954 (including $19,762 expense related to exchange) while expenses in the U.S
increased $526,156. The increase in Canada relates to lease settlement costs associated
with the Companys former Canadian distribution center. The U.S. increase was driven
by the addition of incremental FAD expense of $485,174 (including one-time transition
related costs that are not expected to recur once the transition is completed) coupled
with incremental personnel and operating costs in St. Louis in support of the non-FAD
business.

Marketing
expense increased $341,459, or 52.1%, in 2008 versus 2007. The increase is principally
attributable to planned U.S. increases of $231,522 to $899,542 in 2008 from $667,930 in
2007 of clinical personnel, trade show and promotion expense in support of the
Companys growth initiatives. Incremental FAD expenses of $47,319 and Canada expenses
of $62,618 (which initiated a more formal marketing plan in 2008) also contributed.

Sales
expense increased $1,700,344, or 137.4%, in 2008 versus 2007. Expenses in Canada
increased $135,375 (including $36,956 expense related to exchange) while expenses in the
U.S. increased $1,564,969. Excluding exchange, expenses in Canada increased principally
due to consulting costs related to the sale of Medihoney products, higher travel costs,
higher buying group administrative fees (distributor sales volume related) and
implementation of a distributor sales incentive program. The U.S. increase was
principally attributable to an expansion of the sales force starting in June 2007 from
two representatives to one national sales director and ten

25

---



Index

sales representatives at an
incremental cost of $764,640 from $813,360 in 2007 to $1,578,000 in 2008, incremental
expenses of $732,534 and higher customer service costs of $67,796 to support the new FAD
business.

General
administrative expense increased $1,072,919, or 36.8%, in 2008 versus 2007. Expenses in
Canada increased $130,751 (including $98,618 expense related to exchange) while expenses
in the U.S. increased $942,168. The increase in Canada principally reflects normal
year-to-year compensation and benefit increases, one new materials management position
(transferred from U.S.), higher travel and higher recruiting costs, partially offset by
lower bonus and Sarbanes Oxley consulting expenses (more extensive and costly first year
testing in 2007 not repeated in 2008). The U.S. increase principally reflects incremental
intangible amortization expense of $303,600 related to the FAD acquisition, higher finance
and IT employee costs of $189,300 associated with new hires in the second half of 2007 and
in 2008 to support the growth in the business and expanding regulatory requirements,
higher investor relations costs of $85,100 due to expanded efforts in this area, higher
equity based compensation costs of $75,800, higher legal costs of $66,000 related to
patent infringement defense and finalization of the Nutramax settlement, higher rent
expense of $55,500 associated with the new corporate headquarters, higher travel of
$50,900, higher IT costs of $49,600 principally in support of the FAD acquisition,
recruiting costs of $45,700, together with normal year-to-year compensation and benefit
and other inflationary cost increases, partially offset by lower bonus and Sarbanes Oxley
consulting expenses

Research and Development
Expense

Research
and development costs of $154,308 during the first half of 2008 relate to ongoing
development and consulting expenses associated with the DSC 127 phase II clinical trial
that was initiated in the first quarter 2008. The 2007 expense consists of $125,000
associated with the license of certain anti-microbial technology in March 2007.

Interest Expense

Interest
expense increased $399,678 to $497,488 in 2008 from $97,810 in 2007. Interest expense in
Canada decreased $20,322 while interest expense in the U.S. increased $420,000. The
decrease in Canada reflects the payoff of all Canadian debt in September 2007. The U.S.
increase is due to the financing associated with the FAD acquisition in November 2007.

Other Income/Expense

Other
income/expense increased $70,176 to $20,478 income in 2008 from $49,698 expense in 2007.
The main drivers for the other income of $20,478 in 2008 were higher royalty and other
miscellaneous income, partially offset by higher foreign exchange expense. The main driver
for the 2007 other expense of $23,141 was foreign exchange expense.

Income Taxes

The
Company recorded a $81,380 deferred foreign income tax benefit for the first half of 2008
based on the Companys Canadian subsidiarys operating results. The Canadian tax
benefit is deferred in nature as net operating loss carry forwards continue to be utilized
to offset taxes payable. No provision was made for the Companys U.S. operations in
the first half of 2008 due to a net operating loss coupled with available net operating
loss carry forwards. The Company recorded an $187,523 deferred foreign tax provision in
2007 related to its Canadian subsidiarys operating results.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net
deferred tax assets has been provided.

Net Loss

The
Company generated a net loss of $2,680,276, or ($0.07) per share (basic and diluted), for
the first half of 2008 compared to a net loss of $248,516, or ($0.01) per share (basic and
diluted), in the first half of 2007.

26

---



Index

Liquidity and Capital
Resources

Operational Overview

Net
sales increased 60.8% (56.0% adjusted for foreign exchange) in the first half of 2008 over
2007. This growth was driven by a sales increase in the U.S. of 86.6%, together with an
increase in Canadian sales of 15.7% (2.6% adjusted for foreign exchange). Sales growth in
the U.S. was driven by incremental sales associated with the FAD business (acquired
November 8, 2007) of $8,516,364 coupled with growth of the advanced wound care line. Gross
sales of the Companys new Medihoney product launched in October 2007 were $588,982 in
the first half of 2008. Sales of the Companys silver alginate product were $520,380
in the first half 2008. Product sales for the balance of the advanced wound care line have
also benefited from the increased level of marketing and sales support directed to this
key growth area of the business. FAD sales are expected to grow (subject to seasonal
swings in the business) as the Company works out its transition related product supply
issues. As expected, private label performance improved in the second quarter. Private
label sales are expected to increase by virtue of anticipated increases in core product
demand and the realization of new business opportunities. Skin care sales continue to
deteriorate in the face of competitive pressure and a reduction of resources allocated to
support the line. Sales for the specialty fixation and closure device line have been
relatively stable over the last several quarters. This trend is expected to continue.
Adjusted for exchange, Canada sales to its exclusive distributor have grown modestly in
2008. Underlying market growth as measured by sales of the Companys products
reported by the Canadian distributor approximated 9.1% in local currency in 2008. Expanded
marketing and sales efforts, a continued focus on contract compliance, exploring
opportunities in other market segments (other than the Companys traditional strength
in the acute care segment) and working closely with the Companys exclusive Canadian
distributor to capitalize on sales growth opportunities should generate positive results
going forward. With sales of $27,667 in the first half of 2008, the Companys new
Medihoney product has started to gain modest traction in Canada.

The
Company has realized significant product cost improvement over the last several years as a
result of its manufacturing and sourcing initiatives. The savings generated by these
initiatives have helped partially mitigate the adverse impact of price erosion and foreign
exchange on a large portion of the Companys business and served to sustain or
improve its gross profit dollars. This trend will become increasingly difficult to
perpetuate. Product cost savings associated with implementation of China and other
sourcing initiatives have been another contributor to the Companys cost reduction
success. Current market conditions in China and other markets portend increasing product
and transportation costs that will put pressure on the Companys margins. The Company
will continue to seek opportunities both internally and externally to lower its
transportation and product costs and raise selling prices wherever possible in an effort
to offset the adverse impact of these higher costs.

At
the time of the FAD acquisition in November 2007, the seller was in the process of
transferring its domestic production to a third party supplier in China and
decommissioning most of its U.S. manufacturing infrastructure and overhead. Completion of
this initiative will allow the FAD business to significantly reduce its existing product
costs thereby allowing it to better compete. Since the acquisition, the Company has had to
continue manufacturing a portion of its adhesive strip requirements in its U.S. facility
at higher cost while working to complete the transfer of products to the Chinese supplier
and evaluating other cost effective sources of supply. It is presently estimated that U.S.
production will continue at a diminishing rate through the third quarter of 2008. Gross
profit margins presently running at approximately 19.5% are expected to improve
significantly once the transfer is complete and the U.S. manufacturing activity is
curtailed.

Operating
expenses increased 70.4% (67.4% adjusted for foreign exchange) in the first half of 2008
over 2007 in line with expectations. The increase is attributable to incremental FAD
expenses (intangible asset amortization, planned sales and marketing expenses), planned
increases in distribution, marketing and sales expenses in support of the Companys
growth initiatives and higher professional service fees as a result of increasing
regulatory requirements. Excluding these expenses, growth in the balance of operating
expenses is in line with inflation and continues to be closely monitored.

In
November 2007, the Company made a significant investment in research and development via
the licensing of certain angiotensin analog technology. The initial evaluation of the
market potential and probability of obtaining approval for sale of products employing
this technology was determined to be favorable. Products employing this technology
entered phase II trials in the first quarter 2008. Completion of the phase II study is
expected to take several years. Presently, the Company plans to take the product through
phase II at an estimated cost of $1,450,000. The Company spent $154,308 on research and
development in the first half of 2008 and plans to

27

---



Index

spend a total of $760,000 by
year-end. Upon completion of the phase II study in 2010, the Company will reevaluate the
market potential of the product and the probability of its ultimately being approved for
sale to determine the best course of action.

In
November 2007, in connection with the FAD acquisition, the Company entered into a new
five-year credit and security agreement comprised of an $8,000,000 revolver and a
$6,000,000 term loan. Given the significant increase in debt, interest expense will become
a larger component of the Companys overall cost structure going forward.

The
Company reported a loss of $2,680,276 for the first half of 2008. While sales and gross
profit dollars increased, overall performance was adversely impacted by a deteriorating
gross profit margin percentage associated with a combination of unfavorable sales mix and
higher transportation and product costs. A delay in the planned leveraging of incremental
growth oriented sales and marketing investment, incremental research and development
costs, a significant increase in borrowing costs and incremental costs required to remain
compliant with increasingly stringent regulatory requirements, were also contributing
factors. The Company anticipates it will continue to operate at a loss in the near term as
it attempts to leverage its growth initiatives, continues to support the angiotensin
analog phase II study and completes the transfer of the FAD products to lower cost third
party suppliers.

Cash Flow and Working
Capital

At
June 30, 2008 and December 31, 2007, the Company had cash and cash equivalents on hand of
$4,084,199 and $577,096, respectively. The $3,507,103 increase in cash reflects net cash
provided by financing activities of $8,045,940, net cash provided in investing activities
of $783,754, net cash used in operating activities of $5,258,033 and cash used as a result
of exchange rate changes of $64,558.

Net
cash used in operating activities of $5,258,033 stems from $568,940 cash used in
operations (net loss plus non-cash items), together with $4,689,093 cash used from the net
change in operating assets and liabilities. The decrease in cash used in operations
reflects the operating loss incurred, partially offset by non-cash items. Funding of
higher receivable and inventory levels coupled with reductions in accrued expenses were
the main drivers behind the net change in ongoing operating assets and liabilities. The
change in receivables principally relates to the increase in sales. The increase in
inventory principally reflects the planned build up of FAD and new product inventory to
better meet customer service requirements. The decrease in accrued expenses and other
current liabilities principally reflects payment of the USC license fees of $840,000 and
accrued bonus in 2008. Timing related changes in Canadian reserves also contributed.

Net
cash provided by investing activities of $783,754 reflects receipt of $1,193,187 cash from
the final settlement of the FAD acquisition purchase price in June 2008. Offsetting the
cash provided by this settlement were $120,484 expended for ongoing acquisition related
costs and $288,949 in capital expenditures. The capital expenditures consisted of
purchases of equipment at the Companys manufacturing operation in Canada, trade show
booth upgrades, leasehold improvements and furniture at corporate headquarters and new
computer equipment.

Net
cash provided by financing activities of $8,045,940 reflects cash received of $5,741,793
from the sale of common stock and the exercise of common stock warrants and options, net
of expenses, increased line of credit borrowings of $3,226,926, less regularly scheduled
debt payments of $653,543, and deferred financing fees of $269,236 principally related to
the amendment of the Companys bank covenants in March 2008.

Working
capital increased $3,927,303, or 73.2%, at June 30, 2008 to $9,296,341 from $5,369,038 at
December 31, 2007. This increase is principally due to timing and relates to the balance
of funds raised from the private equity raise that was concluded on April 2, 2008 that
have not been expended of approximately $2,250,000 and the $1,193,187 of cash received in
late June 2008 from the final FAD acquisition settlement. These funds together with the
Companys other working capital are considered sufficient to support ongoing
operations for the next twelve months.

Financing Arrangements

In
August 2008, the Company and its lender modified the terms of the Companys
five-year revolving credit and security agreement. The modified terms amend the existing
minimum EBITDA, fixed charge coverage, senior debt coverage and total debt coverage
covenants. Amendment of the covenants was predicated on the

28

---



Index

Company segregating $2,000,000 in a
restricted account the use of which is subject to the approval of the Companys lender. The Companys maximum
revolver borrowing capacity remained unchanged at the lesser of (a) the revolver loan
commitment ($8,000,000) or (b) the borrowing base (as defined), less $1,500,000.

With
the cash on hand at June 30, 2008 together with available revolver borrowing capacity,
less the $2,000,000 deposited in the blocked account, it is estimated that the Company has
approximately $3,000,000 of available liquidity which the Company believes is sufficient
to fund its operations over the next twelve months.

Prospective Assessment

The
Companys strategic objective is to in-license, develop and launch novel higher
margined advanced wound care products while utilizing its core business (to the extent
possible) to fund this objective. In addition, the Company will continue to evaluate
external opportunities to leverage its core capabilities for growth. To the extent the
Company determines that it cannot finance its growth initiatives internally, it will
evaluate the feasibility of doing so via the sale of equity.

Beginning
in 2005, the Company expanded its product in-licensing and development efforts. As a
result of these efforts, the Company launched its silver alginate product in November
2006. The Company launched its first Medihoney product in October 2007. This product
represents the first of its kind and interest in the product has been high. Sales have
increased steadily and current indications are that the planned Medihoney based line of
products could result in significant incremental sales. In addition, the Company has
several other promising products in its pipeline that it expects to launch over the next
twelve to eighteen months. The Company anticipates its core business sales will remain
relatively stable over the near term.

In
recognition of its current financial condition, the Company will take the following
actions beginning in the second half of 2008:

|1. |  | The Company will expand its direct sales force from ten to thirteen personnel
                    principally to sell the Companys new advanced wound care products with
                    Medihoney as the anchor product. Additional sales, clinical and support
                    personnel will be added only as financial conditions allow.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2. |  | The Company invested in new product development with the first product being DSC
                    127. While the launch of DSC 127 is several years away, the market potential for
                    this product is considered to be significant. The product recently began phase
                    II trials to achieve proof of principle in a human model. The phase II trials
                    are expected to be completed by mid-2010. The projected cost to complete the
                    phase II trials are approximately $1,450,000. The Company plans to continue with
                    this investment and anticipates spending approximately $820,000 on the Phase II
                    over the next twelve months.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | The results
                    of the phase II trial will determine the efficacy and safety of the product and further
                    refine its market potential. The cost of the phase III trial and bringing the product to
                    market are expected to be significant. Should the Company decide to proceed with the DSC
                    127 development plan after completion of phase II, it plans to fund the additional
                    development costs out of available cash flow or the sale of equity. Alternatively, the
                    Company may determine to sublicense or sell the rights to the compound.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3. |  | In November 2007, the Company purchased the assets of the FAD for approximately
                    $12,665,000. The FAD is a leading manufacturer and marketer of adhesive strips
                    and related first aid products. The integration of the existing FAD business
                    will serve to expand the Companys existing basic and advanced wound care
                    lines to new customers and markets, especially the retail market where the
                    Company did not previously have a presence. In addition, the Company expects to
                    be able to reduce existing FAD product costs by completing the transfer of
                    production of certain FAD products to lower cost suppliers. The integration of
                    the FAD business remains a top priority for the Company.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

With
the beginning cash on hand as of June 30, 2008 and the new debt covenants, the Company
anticipates having sufficient liquidity in place to meet its operating needs through the
next twelve months.

29

---



Index

The
Common Stock of the Company is traded on the OTC Bulletin Board under the symbol
DSCI.OB. The Company has paid no cash dividends in respect of its Common Stock
and does not intend to pay cash dividends in the near future.

Update of Factors
Affecting Future Prospects

The
following factors affecting future prospects update the related factors set forth in the
Companys annual report on Form 10-KSB filed with the Securities and Exchange
Commission on April 1, 2008:

The potential increase in common
shares due to the conversion, exercise or vesting of outstanding derivative securities may
have a depressive effect upon the market value of the Companys shares.

Up
to 22,177,146 shares of the Companys common stock are potentially issuable upon the
conversion, exercise or vesting of outstanding convertible preferred stock, warrants,
options and restricted stock awards (dilutive securities). The shares of
common stock potentially issuable upon conversion, exercise or vesting of dilutive
securities are substantial compared to the 40,140,743 shares of common stock currently
outstanding.

Earnings
per share of common stock will be substantially diluted by the existence of these dilutive
securities regardless of whether they are converted, exercised or issued. This dilution of
earnings per share could have a depressive effect upon the market value of the
Companys common stock.

The Company has generated only
nominal income and it cannot guarantee future profitability.

The
Company incurred a net loss of $2,680,276 (unaudited) in the first six months of 2008,
earned net income of $668,739 in 2006, $22,241 in 2003, $61,368 in 2002 and $192,398 in
2001 and incurred losses of $2,284,605 in 2007, $1,099,990 in 2005, $2,338,693 in 2004,
$2,581,337 in 2000 and $2,998,919 in 1999. At June 30, 2008, the Company had an
accumulated deficit of $18,382,162 (unaudited). Although the Company achieved
profitability in 2006, 2003, 2002 and 2001, the Company cannot offer any assurance that it
will be able to generate sustained or significant earnings.

The Companys stock price has
been volatile and this volatility is likely to continue.

Historically,
the market price of the Companys common stock has been volatile. The high and low
prices for the years 2003 through 2007 and the first seven months of 2008 are set forth in
the table below:

| |                                                           |  |       |  |       | 
| | --------------------------------------------------------- |  | ----- |  | ----- | 
| | Derma Sciences, Inc.
        Trading Range  Common Stock | 
|
| | Year                                                      |  | Low   |  | High  | 
|
| | 2003                                                      |  | $0.35 |  | $2.30 | 
| | 2004                                                      |  | $0.43 |  | $1.90 | 
| | 2005                                                      |  | $0.42 |  | $0.78 | 
| | 2006                                                      |  | $0.45 |  | $0.90 | 
| | 2007                                                      |  | $0.58 |  | $1.40 | 
| | 2008(*)                                                   |  | $0.56 |  | $1.35 | 
| |                                                           |  |       |  |       | 
| | (*) January 1 through July 31.                            | 

30

---



Index

Events
that may affect the Companys common stock price include:

| |  |  | Quarter
to quarter variations in its operating results;
| | - |  | -------------------------------------------------------

| |  |  | Changes
in earnings estimates by securities analysts;
| | - |  | -----------------------------------------------------

| |  |  | Changes
in interest rates, foreign currency exchange or other general economic conditions;
| | - |  | ------------------------------------------------------------------------------------------

| |  |  | Changes
in market conditions in the wound care and skin care industries;
| | - |  | ------------------------------------------------------------------------

| |  |  | The
introduction of new products either by the Company or by its competitors;
| | - |  | -----------------------------------------------------------------------------

| |  |  | The
loss of a major customer; and
| | - |  | ---------------------------------

| |  |  | The
ability of the Company to obtain any required financing.
| | - |  | ------------------------------------------------------------

Although
all publicly traded securities are subject to price and volume fluctuations, it is likely
that the Companys common stock will experience these fluctuations to a greater
degree than the securities of more established and better capitalized organizations.

Additional Financial
Information

Forward Looking Statements

Statements
that are not historical facts, including statements about the Companys confidence,
strategies, expectations about new or existing products, technologies, opportunities,
market demand or acceptance of new or existing products are forward-looking statements
that involve risks and uncertainties. These uncertainties include, but are not limited to,
product demand and market acceptance risk, impact of competitive products and prices,
product development, commercialization or technological delays or difficulties,
integration of acquired companies in a timely basis, management and maintenance of key
customer and supplier relationships and trade, legal, social, financial and economic
risks.

Critical Accounting
Policies

Estimates
and assumptions are required in the determination of sales deductions for trade rebates,
sales incentives, discounts and allowances. Significant estimates and assumptions are also
required in determining the appropriateness of amortization periods for identifiable
intangible assets, the potential impairment of goodwill and the valuation of inventory.
Some of these judgments can be subjective and complex and, consequently, actual results
may differ from these estimates. For any individual estimate or assumption made by the
Company, there may also be other reasonable estimates or assumptions. The Company
believes, however, that given current facts and circumstances, it is unlikely that
applying any such other reasonable judgment would cause a material adverse effect on the
consolidated results of operations, financial position or cash flows for the periods
presented. The Companys most critical accounting policies are described below.

Revenue Recognition and
Adjustments to Revenue

Revenue
is recognized when product is shipped and title passes to the customer and collectability
is reasonably assured. When the Company recognizes revenue from the sale of its products,
it simultaneously adjusts revenue for estimated trade rebates and distribution fees (in
Canada). A trade rebate represents the difference between the invoice price to the
wholesaler and the indirect customers contract price. These rebates are estimated
based on historical experience, estimated future trends, estimated customer inventory
levels, current contract sales terms with wholesale and indirect customers and other
competitive factors. The Company pays its exclusive Canadian distributor a fixed fee based
on sales subject to the fee (as defined) for distribution services in Canada. The
distribution fee is accrued monthly based on the estimated percentage of distribution fee
expense to net sales. If the assumptions used to calculate these rebates and fees do not
appropriately reflect future activity, the Companys financial position, results of
operations and cash flows could be impacted. The Company continually monitors the factors
that influence these rebates and fees and makes adjustments as necessary.

Goodwill

At
June 30, 2008, the Company had $8,273,294 of goodwill consisting of $5,833,252
(preliminary) relating to the FAD acquisition in November, 2007 and $2,440,042 relating to
the Western Medical acquisition in April 2006. The goodwill is included in the wound care
segment for reporting purposes. The Company tests goodwill for impairment in the fourth
quarter of each year or when impairment indicators are present. The process of evaluating
the potential impairment of goodwill is highly subjective and requires significant
judgments and assumptions in estimating future cash flows to determine the fair value of
each reporting unit. These assumptions include future growth rates, discount factors,
future tax rates and other factors. The Companys cash flow forecasts are based on
assumptions that are consistent with the plans and estimates used to manage the underlying
business. In addition, the Company makes certain judgments about allocating shared assets
to the balance sheet for this segment. If the expected cash flows are not realized,
impairment losses may be recorded in the future.

31

---



Index

Inventory

The
Company writes down the value of inventory by the estimate of the difference between the
cost of the inventory and its net realizable value. The estimate takes into account
projected sales of the inventory on hand and the age of the inventory in stock. If actual
future demand or market conditions are less favorable than those projected by management,
additional inventory write-downs may be required. The provision for the write-down of
inventory is recorded in cost of sales.

Stock-Based Compensation

Effective
January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123R,
Share-Based Payment (SFAS 123R). SFAS 123R requires that
share-based payment transactions with employees, such as grants of stock options and
restricted stock, be recognized in the financial statements based on their fair value at
the grant date and recognized as compensation expense over their vesting periods. The
Company estimates the fair value of stock options as of the date of grant using the
Black-Scholes or binomial/lattice pricing model (as applicable) and restricted stock based
on the quoted market price. SFAS 123R requires significant judgment and the use of
estimates to value equity based compensation, particularly surrounding Black-Scholes or
binomial/lattice pricing model assumptions such as stock price volatility and expected
option lives, as well as expected option forfeiture rates.

32

---



Index

|Item 4. |  | CONTROLS
AND PROCEDURES
|------- |  | -----------------------

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of June 30, 2008. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective for gathering, analyzing
and disclosing the information the Company is required to disclose in the reports it files
under the Securities Exchange Act of 1934, within the time periods specified in the
SECs rules and forms.

During
the three months ended June 30, 2008, there was no change in the Companys internal
controls over financial reporting that materially affected, or is reasonably likely to
materially affect, the Companys internal controls over financial reporting.

33

---



Index

Part II  Other
Information

|Item 4. |  | Submission
of Matters to a Vote of Security Holders
|------- |  | ---------------------------------------------------

The
annual meeting of shareholders of the Company was held on May 22, 2008. At the annual
meeting, the following matters were submitted to a vote of the Companys security
holders with the results indicated:

Proposal
1  Election of Directors

The
following director-nominees, consisting of all director-nominees, were elected directors
to serve as such for one year or until their successors have been elected and qualify:
Edward J. Quilty, Stephen T. Wills, CPA, MST, Srini Conjeevaram, James T. OBrien,
Richard J. Keim, C. Richard Stafford, Esq., Robert G. Moussa and Bruce F. Wesson. Details
concerning the votes relative to each director-nominee are set forth below:

|                           |            |         |             |                 
|-------------------------- | ---------- | ------- | ----------- | ----------------
|Director-Nominee           | In Favor   | Against | Abstentions | Broker Non-Votes
|                          
|Edward J. Quilty           | 32,828,092 | 0       | 267,569     | 0               
|Srini Conjeevaram          | 32,847,599 | 0       | 248,062     | 0               
|Stephen T. Wills, CPA, MST | 32,838,099 | 0       | 257,562     | 0               
|James T. O'Brien           | 32,827,099 | 0       | 268,562     | 0               
|C. Richard Stafford, Esq.  | 32,822,599 | 0       | 273,062     | 0               
|Richard J. Keim            | 32,830,585 | 0       | 265,076     | 0               
|Robert G. Moussa           | 32,837,599 | 0       | 258,062     | 0               
|Bruce F. Wesson            | 32,848,085 | 0       | 247,576     | 0               

Proposal
2  Amendment of the Companys Stock Option Plan

Shareholders
approved the amendment of the Companys stock option plan to increase the shares of
common stock issuable thereunder to 10,000,000. Details concerning the vote on proposal 2
are set forth below:

| | In Favor         | 32,882,871 | 
| | ---------------- | ---------- | 
| | Against          | 826,722    | 
| | Abstentions      | 141,048    | 
| | Broker Non-Votes | 4,986,884  | 

Proposal
3  Ratification of Appointment of Independent Registered Public Accounting Firm

Shareholders
ratified the appointment of Ernst & Young LLP as the Companys independent
registered public accounting firm for the year ending December 31, 2008. Details
concerning the vote on proposal 3 are set forth below:

| | In Favor         | 32,882,871 | 
| | ---------------- | ---------- | 
| | Against          | 16,893     | 
| | Abstentions      | 195,896    | 
| | Broker Non-Votes | 2          | 

The
Company solicited proxies relative to each of the foregoing proposals and, as to proposal
1, each director-nominee pursuant to Regulation 14A under the Securities Exchange Act of
1934. No proxies were solicited in opposition to either of the proposals.

34

---



Index

|Item 6. |  | Exhibits
|------- |  | --------

All
exhibits required by Item 601 of Regulation S-B and required hereunder, as filed with the
Securities and Exchange Commission in Form 10-KSB on April 1, 2008, are incorporated
herein by reference.

| |         |                                                                                                                                                           
| | ------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | Exhibit | Description                                                                                                                                               
|
| | 31.1    | Certification of the Principal Executive Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 31.2    | Certification of the Principal Financial Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 32.1    | Certification of the Principal Executive Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | 32.2    | Certification of the Principal Financial Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Pursuant
to the requirements 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.

|                        |                      |                                            | 
|----------------------- | -------------------- | ------------------------------------------ | 
|                        | DERMA SCIENCES, INC. |                                           
|Dated:  August 13, 2008 | By:                  | /s/ John E. Yetter                         | 
|                        |                      | John E. Yetter, CPAChief Financial Officer | 

35

---



Index

EXHIBIT INDEX

| |         |                                                                                                                                                           
| | ------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | Exhibit | Description                                                                                                                                               
| | 31.1    | Certification of the Principal Executive Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 31.2    | Certification of the Principal Financial Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 32.1    | Certification of the Principal Executive Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | 32.2    | Certification of the Principal Financial Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002