---

U.S. SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549  FORM 10-QSB  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE
SECURITIES EXCHANGE ACT OF 1934   For Quarter Ended
     
     June 30, 2005Commission 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 100Princeton, New Jersey
08540(609) 514-4744(Address including zip code and
telephonenumber, of principal executive offices)


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

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

|Date: June 30, 2005 | Class: Common Stock, par value $.01 per share
|------------------- | ---------------------------------------------
|                    | Shares Outstanding: 12,284,007               

---

DERMA SCIENCES, INC.FORM
10-QSBINDEX

|Description |  | Page
|----------- |  | ----

Part I - Condensed Financial Information

|Item 1. | Condensed Consolidated Financial Statements                                                              |   
|------- | -------------------------------------------------------------------------------------------------------- | --
|        |                                                                                                          |   
|        | Condensed Consolidated Balance
     Sheets - June 30, 2005 and December 31, 2004                         | 3 
|        |                                                                                                          |   
|        | Condensed Consolidated Statements of
     Operations - Three months ended June 30, 2005and June 30, 2004 | 4 
|        |                                                                                                          |   
|        | Condensed Consolidated Statements of
     Operations - Six months ended June 30, 2005and June 30, 2004   | 5 
|        |                                                                                                          |   
|        | Condensed Consolidated Statements of
     Cash Flows - Six months ended June 30, 2005and June 30, 2004   | 6 
|        |                                                                                                          |   
|        | Notes to Condensed Consolidated Financial
     Statements                                                | 7 
|        |                                                                                                          |   
|Item 2. | Management's Discussion and Analysis of
     Financial Condition and Results of Operations               | 22
|        |                                                                                                          |   
|Item 3. | Controls and Procedures                                                                                  | 39

Part II - Other Information

|Item 1. | Legal Proceedings | 40
|------- | ----------------- | --
|        |                   |   
|Item 6. | Exhibits          | 40
|        |                   |   

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. CONDENSED FINANCIAL STATEMENTS

2

---

Index

DERMA SCIENCES, INC.Consolidated Balance Sheets

`=======================================================================================================
                                                                          June 30,        December 31,
                                                                            2005              2004
                                                                        (Unaudited)         (Note 1)
ASSETS
-------------------------------------------------------------------------------------------------------

Current Assets
  Cash and cash equivalents                                            $    362,941      $     46,508
  Accounts receivable, net                                                1,465,806         2,601,092
  Inventories                                                             3,884,924         4,932,232
  Prepaid expenses and other current assets                                 245,746           181,201
-------------------------------------------------------------------------------------------------------
Total current assets                                                      5,959,417         7,761,033
Equipment and improvements, net                                           3,386,028         3,662,557
Goodwill                                                                  1,110,967         1,110,967
Other intangible assets, net                                                341,840           383,911
Other assets, net                                                           346,980           132,464
-------------------------------------------------------------------------------------------------------
Total Assets                                                           $ 11,145,232      $ 13,050,932
-------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
-------------------------------------------------------------------------------------------------------
Current Liabilities
  Line of credit borrowings                                            $    693,325      $  2,820,284
  Current maturities of long-term debt                                      261,576           247,306
  Accounts payable                                                        1,370,317         1,249,409
  Accrued expenses and other current liabilities                            596,444           594,438
-------------------------------------------------------------------------------------------------------
Total current liabilities                                                 2,921,662         4,911,437
Long-term debt                                                              520,848           867,539
Other long-term liabilities                                                  82,664            53,207
-------------------------------------------------------------------------------------------------------
Total Liabilities                                                         3,525,174         5,832,183
-------------------------------------------------------------------------------------------------------
Commitments
Shareholders' Equity
Convertible preferred stock, $.01 par value; 11,750,000 shares
  authorized; issued and outstanding: 2,280,407 shares at June 30, 2005
  and December 31, 2004 (liquidation preference of $4,210,231 at June
  30, 2005 and December 31, 2004)                                            22,804            22,804
Common stock, $.01 par value, 30,000,000 shares authorized;
  issued and outstanding: 12,284,007 shares at June 30, 2005 and
  11,079,007 shares at December 31, 2004                                    122,840           110,790
Additional paid-in capital                                               19,882,090        19,371,225
Accumulated other comprehensive income -
  cumulative translation adjustments                                        633,222           699,960
Accumulated deficit                                                     (13,040,898)      (12,986,030)
-------------------------------------------------------------------------------------------------------
Total Shareholders' Equity                                                7,620,058         7,218,749
-------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity                             $ 11,145,232      $ 13,050,932
=======================================================================================================`

See accompanying consolidated notes.

3

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Index

DERMA SCIENCES, INC.Consolidated Statements of Operations (Unaudited)

`=======================================================================================================
                                                                             Three months ended
                                                                                   June 30,
                                                                             2005             2004
-------------------------------------------------------------------------------------------------------

Net sales                                                                $6,934,218       $4,914,011
Cost of sales                                                             4,761,611        3,520,187
-------------------------------------------------------------------------------------------------------
Gross Profit                                                              2,172,607        1,393,824
-------------------------------------------------------------------------------------------------------
Operating expenses                                                        1,900,157        1,678,804
Interest expense, net                                                        95,269           51,479
Other expense (income), net                                                  18,997           (6,160)
-------------------------------------------------------------------------------------------------------
Total Expenses                                                            2,014,423        1,724,123
-------------------------------------------------------------------------------------------------------

Income (loss) before provision for income taxes                             158,184         (330,299)
Provision for income taxes                                                    -                -
-------------------------------------------------------------------------------------------------------
Net Income (Loss)                                                        $  158,184       $ (330,299)
-------------------------------------------------------------------------------------------------------

Income (loss) per common share - basic                                       $0.01           $(0.03)
-------------------------------------------------------------------------------------------------------
Income (loss) per common share - fully diluted                               $0.01           $(0.03)
-------------------------------------------------------------------------------------------------------
Shares used in computing income (loss) per common share - basic          12,284,007        9,524,007
-------------------------------------------------------------------------------------------------------
Shares used in computing income (loss) per common share - diluted        14,745,538        9,524,007
=======================================================================================================`

See accompanying consolidated notes.

4

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Index

DERMA SCIENCES, INC.Consolidated Statements of Operations (Unaudited)

`=======================================================================================================
                                                                             Six months ended
                                                                                 June 30,
                                                                         2005                2004
-------------------------------------------------------------------------------------------------------

Net sales                                                               $11,827,665      $ 9,943,433
Cost of sales                                                             8,267,672        7,116,703
-------------------------------------------------------------------------------------------------------
Gross Profit                                                              3,559,993        2,826,730
-------------------------------------------------------------------------------------------------------
Operating expenses                                                        3,581,212        3,923,859
Interest expense, net                                                       179,853           98,146
Other (income) expense, net                                                (146,204)         111,490
-------------------------------------------------------------------------------------------------------
Total Expenses                                                            3,614,861        4,133,495
-------------------------------------------------------------------------------------------------------

Loss before provision for income taxes                                      (54,868)      (1,306,765)
Provision for income taxes                                                    -                -
-------------------------------------------------------------------------------------------------------
Net Loss                                                                $   (54,868)     $(1,306,765)
-------------------------------------------------------------------------------------------------------

Loss per common share - basic and diluted                                    $0.00           $(0.14)
-------------------------------------------------------------------------------------------------------
Shares used in computing loss per common share - basic and diluted       12,147,841        9,166,579
=======================================================================================================`

See accompanying consolidated notes.

5

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Index

DERMA SCIENCES, INC.Consolidated Statements of Cash Flows (Unaudited)

`=======================================================================================================
                                                                              Six months ended
                                                                                    June 30,
                                                                             2005              2004
-------------------------------------------------------------------------------------------------------
Operating Activities
    Net loss                                                            $   (54,868)     $(1,306,765)
    Adjustments to reconcile net loss to
      net cash provided by (used in) operating activities:
       Depreciation of equipment and improvements                           245,878          132,852
       Amortization of intangible assets                                     42,071           47,200
       Amortization of deferred financing costs                              35,820           42,231
       Provision for bad debts and rebates                                1,067,024            5,713
       Provision for inventory obsolescence                                  45,519           89,499
       Loss on disposal of equipment                                          4,146           82,974
       Deferred rent expense                                                 22,113           21,404
       Employee stock options                                                 1,000            -
       Changes in operating assets and liabilities:
           Restricted cash                                                    -           (1,002,295)
           Accounts receivable                                               48,144           27,726
           Inventories                                                      982,316       (1,200,710)
           Prepaid expenses and other current assets                        (92,067)          (1,025)
           Other assets                                                    (145,614)          10,302
           Accounts payable                                                 135,449        1,040,924
           Accrued expenses and other current liabilities                    (3,339)          87,442
           Long-term liabilities                                              7,273          205,288
-------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities                       2,340,865       (1,717,240)
-------------------------------------------------------------------------------------------------------
Investing Activities
    Cash paid for wound care business                                         -             (376,797)
    Purchase of equipment and improvements                                  (61,879)        (695,427)
    Proceeds from sale of equipment                                          24,998
-------------------------------------------------------------------------------------------------------
Net cash used in investing activities                                       (36,881)      (1,072,224)
-------------------------------------------------------------------------------------------------------
Financing Activities
    Net change in bank lines of credit                                   (2,084,029)         583,787
    Deferred financing costs                                               (116,590)         (60,617)
    Long-term debt repayments                                              (312,142)         (98,182)
    Proceeds from issuance of stock, net of issuance costs                  539,415        1,962,974
-------------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities                      (1,973,346)       2,387,962
-------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash                                     (14,205)          (7,572)
-------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents                        316,433         (409,074)

Cash and cash equivalents
  Beginning of period                                                        46,508            439,837
-------------------------------------------------------------------------------------------------------
  End of period                                                         $   362,941      $      30,763
-------------------------------------------------------------------------------------------------------

Supplemental cash flow information
  Note payable for acquisition of Kimberly-Clark wound care assets             -         $ 1,566,000
  Equipment obtained with capital leases                                       -         $   211,973
=======================================================================================================`

See accompanying consolidated notes.

6

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

1. Organization and
Summary of Significant Accounting Policies

Derma
Sciences, Inc. and its subsidiaries (the Company) are full line providers of
wound care, wound closure-fasteners 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 principal manufacturing and distribution facilities are
located in St. Louis, Missouri and Toronto, Canada. The Company also has a manufacturing
facility in Nantong, China.

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-QSB and Item 310(b)
of Regulation S-B. 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 month periods ended June 30, 2005, are
not necessarily indicative of the results that may be expected for the year ending
December 31, 2005. For further information, refer to the consolidated financial statements
and footnotes thereto for the year ended December 31, 2004, included in Form 10-KSB
previously filed with the Securities and Exchange Commission.

Summary
of Significant Accounting Policies:

Principles
of Consolidation  The consolidated financial statements include the accounts of
Derma Sciences, Inc. and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation.

Use
of Estimates  In conformity with accounting principles generally accepted in the
United States, the preparation of financial statements requires management to make
estimates and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Although these estimates are based on knowledge of current events and
actions which may be undertaken in the future, actual results may ultimately differ from
these estimates.

Foreign
Currency Translation  Assets and liabilities are translated using the exchange rates
in effect at the balance sheet date, while income and expenses are translated using
average rates. Translation adjustments are reported as a separate component of
shareholders equity in accumulated other comprehensive income.

Cash
and Cash Equivalents  The Company considers cash and cash equivalents as amounts on
hand, on deposit in financial institutions and highly liquid investments with a maturity
of three months or less when purchased.

Concentration
of Credit Risk  Financial instruments that subject the Company to a concentration of
credit risk consist principally of cash and cash equivalents and accounts receivable. The
Company maintains cash and cash equivalents with various financial institutions in amounts
which at times may exceed federally insured limits. Accounts are guaranteed by the Federal
Deposit Insurance Corporation (FDIC) up to $100,000. The Company has not experienced any
losses in such accounts. The Companys accounts receivable balance is net of an
allowance for doubtful accounts. The Company does not require collateral or other security
to support credit sales, but provides an allowance for doubtful accounts based on
historical experience and specifically identified risks. Accounts receivable are charged
off against the allowance for doubtful accounts when management determines that recovery
is unlikely and the Company ceases collection efforts.

Foreign
Operations Risk  The Companys future operations and earnings will depend to a
large extent on the results of its operations in Canada and its ability to continue to
maintain a continuous supply of basic wound

7

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

care products from its own operation and/or
its suppliers in China. While the Company does not envision any adverse change to the
manner in which operations in Canada and China are presently being conducted, there can be
no assurance that the Company will be able to successfully conduct such operations in the
future, and a failure to do so may have a material adverse effect on the Companys
consolidated financial position, results of operations and cash flows. Also, the success
of the Companys operations is subject to numerous contingencies, some of which are
beyond managements control. These contingencies include general and regional
economic conditions, prices for the Companys products, prices for materials and
products purchased from suppliers, competition and changes in regulations.

Inventories
 Inventories consist primarily of raw materials, packaging materials, work in
process and finished goods valued at the lower of cost or market. Cost is determined on
the basis of the first-in, first-out method.

Equipment
and improvements  Equipment and improvements are stated at cost and are depreciated
principally by the straight-line method over the estimated useful lives of the assets
ranging from three to ten years. Leasehold improvements are amortized over the lesser of
their useful lives or the remaining lease term.

Fair
Value of Financial Instruments  The carrying value of cash and cash equivalents,
accounts receivable, prepaid expenses and other current assets, accounts payable and
accrued expenses reported in the consolidated balance sheets equal or approximate fair
value due to their short maturities. The fair value of the Companys long-term debt
approximates book value as such notes are at market rates currently available to the
Company.

Other
Intangible Assets  Patents and trademarks and other intangible assets with definite
lives are stated on the basis of cost. Patent and trademarks are amortized over 12 to 17
years on a straight-line basis. Other intangible assets consisting of product rights,
formulations and specifications, regulatory approvals, customer lists and a non-compete
agreement are amortized over 5 years on a straight-line basis.

Long
Lived Assets  In accordance with Statement of Financial Accounting Standards No. 144
(SFAS 144), Accounting for Impairment or Disposal of Long Lived
Assets the Company reviews its long-lived assets with definitive lives whenever
events or changes in circumstances indicate that the carrying amount of such assets may
not be recoverable. If the carrying amount of the asset or group of assets exceeds its net
realizable value, the asset will be written down to its fair value.

Goodwill
 Goodwill of $1,110,967 represents the excess of the purchase price over the fair
value of identifiable net assets acquired in the 1998 acquisition of Sunshine Products.
This business combination was accounted for as a purchase. The Company adopted Statement
of Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets
(SFAS No. 142) on January 1, 2002. Goodwill and certain other intangible
assets having indefinite lives are no longer amortized to earnings, but instead are
subject to periodic (annual) testing for impairment. The Company tests goodwill for
impairment using the two-step process prescribed by SFAS No. 142. The first step tests for
potential impairment, while the second step measures the amount of impairment, if any. The
Company uses a discounted cash flow analysis to complete the first step in this process.
The Company conducted the required annual impairment review in the fourth quarter of 2004
and determined that the goodwill carrying value is not impaired.

Stock
Based Compensation  SFAS No. 123, Accounting for Stock-Based
Compensation, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, provides companies with a choice to follow
the provisions of SFAS No. 123 in the determination of stock-based employee compensation
expense based on the fair values of the options or to continue to use the intrinsic value
method pursuant to the provisions of Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), and related interpretations
in accounting for stock-compensation plans. The Company has elected to follow the
provisions of APB 25. Under APB 25, if the exercise price of the Companys stock
options granted to employees equals or exceeds the market price of the underlying common
stock on the date of grant, generally no compensation expense is recognized.

8

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

Pro
forma information regarding net income (loss) and net income (loss) per share is required
by SFAS No. 123, which also requires that the information be determined as if the Company
has accounted for its stock options granted to employees under the fair value method of
that Statement. The fair value for these options was estimated at the date of grant using
a Black-Scholes option pricing model with the following weighted-average assumptions for
2005 and 2004: risk-free interest rate of 4.25% and 3.90% for the three months ended March
31, 2005 and June 30, 2005, respectively, and 4.0% for 2004; dividend yield of 0%; a
volatility factor of the expected market price of the Companys Common Stock of 1.376
and 1.353 for the three months ended March 31, 2005 and June 30, 2005, respectively, and
1.463 for 2004; and an expected option life of 5 years.

The
Black-Scholes option valuation model was developed for use in estimating the fair value of
traded options which have no vesting restrictions and are fully transferable. In addition,
option valuation models require the input of highly subjective assumptions including the
expected stock price volatility. The Companys stock options have characteristics
significantly different from those of traded options. Further, changes in the subjective
input assumptions related to the options can materially affect the fair value estimate.
Therefore, in managements opinion the existing models do not necessarily provide a
reliable single measure of the fair value of the Companys stock options.

For
purposes of pro forma disclosures, the estimated fair value of stock options is amortized
to expense over the options vesting period. Therefore, future pro forma compensation
expense may be greater as additional options are granted. The Companys pro forma
information follows:

`Three Months Ended June 30,   Six Months Ended June 30,
                                               ---------------------------   -------------------------
                                                   2005          2004          2005            2004
                                                   ----          ----          ----            ----

    Net income (loss) as reported               $ 158,184     $(330,299)    $ (54,868)    $(1,306,765)
    Pro forma compensation expense               (302,162)     (352,442)     (472,388)       (534,348)
                                                ----------    ----------    ----------    ------------

    Pro forma net loss                          $(143,978)    $(682,741)    $(527,256)    $(1,841,113)
                                                ==========    ==========    ==========    ============

    Income (loss) per common share - basic
          As reported                              $ 0.01        $(0.03)       $ 0.00          $(0.14)
          Pro forma                                $(0.01)       $(0.07)       $(0.04)         $(0.20)

    Income (loss) per common share - diluted
          As reported                              $ 0.00        $(0.03)       $ 0.00          $(0.14)
          Pro forma                                $(0.01)       $(0.07)       $(0.04)         $(0.20)`

As
a result of amendments to SFAS No. 123, the Company will be required to expense the fair
value of employee stock options beginning with its fiscal quarter ending March 31, 2006.

Income
Taxes  Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax bases.
Deferred tax assets, including tax loss and credit carryforwards, and liabilities are
measured using enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. Deferred income tax expense represents the
change during the period in the deferred tax assets and deferred tax liabilities. The
components of the deferred tax assets and liabilities are individually classified as
current and non-current based on their characteristics. Deferred tax assets are reduced by
a valuation allowance when, in the opinion of management, it is more likely than not that
some portion or all of the deferred tax assets will not be realized.

9

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

Revenue
Recognition  The Company operates in three segments: wound care, wound closure and
fasteners and skin care. Sales are recorded when product is shipped, title passes to
customers and collectability is reasonably assured. Gross sales are adjusted for cash
discounts, returns and allowances, Medicaid rebates and trade rebates in the same period
that the related sales are recorded. Freight costs billed to and reimbursed by customers
are recorded as a component of revenue. Freight costs to ship product to customers are
recorded as a component of cost of sales.

Net
Income (Loss) per Share  Net income (loss) per common share  basic is computed
by dividing net income (loss) by the weighted average number of common shares outstanding
for the period. Net income (loss) per common share  diluted reflects the potential
dilution of earnings by including potentially issuable shares of common stock
(potentially dilutive securities), including those attributable to stock
options, warrants and convertible preferred stock in the weighted average number of common
shares outstanding for a period, if dilutive. Potential common stock has not been included
in the computation of diluted loss per share for the six months ended June 30, 2005 and
the three and six months ended June 30, 2004 as the effect would be anti-dilutive.

Total
dilutive shares that have or would have been used to compute income per common share on a
fully diluted basis for the three months and six months ended June 30, 2005 and 2004
(assuming profitability in all periods) are outlined below:

`Three Months Ended June 30,    Six Months Ended June 30,
                                             ---------------------------   -------------------------
                                                  2005           2004           2005           2004
                                                  ----          ----          ----            ----
Weighted average common shares
    outstanding - Basic                       12,284,007      9,524,007     12,147,841      9,166,579
                                              ----------     ----------     ----------     ----------
Potentially dilutive shares:
    Preferred stock                            2,280,407      2,280,407      2,280,407      2,282,285
    Warrants                                        -           651,431          2,289      1,020,463
    Stock options                                181,124        912,706        335,342      1,327,824
                                              ----------     ----------     ----------     ----------

       Sub-total potentially dilutive shares   2,461,531      3,844,544      2,618,038      4,630,572
                                              ----------     ----------     ----------     ----------
       Weighted average common
           shares outstanding - Dilutive      14,745,538     13,368,551     14,765,879     13,797,151
                                              ==========     ==========     ==========     ==========`

Reclassifications
 Certain reclassifications have been made to prior year reported amounts to conform
with the 2005 presentation.

2. Acquisition of
Kimberly-Clark Corporations Wound Care Assets

On
January 9, 2004, the Company purchased certain wound care assets from Kimberly-Clark
Corporation. The primary purpose of the acquisition was to obtain equipment to expand the
Companys in-house manufacturing capabilities and to broaden its product line. The
assets acquired consist of manufacturing equipment, product rights and other intangibles.
The purchase price for the assets was $1,942,797 and was paid as follows: (1) $300,100 at
closing; (2) $1,566,000 via a seller financed promissory note due December 31, 2004,
without interest; and (3) $76,697 incurred for transaction costs. The acquisition was
accounted for as a purchase of a business, effectively as of January 1, 2004, and the
purchase price was allocated to equipment in the amount of $1,600,000 and identifiable
intangible assets (see Note 6) in the amount of $342,797 based upon the estimated fair
values of the assets acquired. The promissory note was paid in full on December 30, 2004.

Kimberly-Clark
manufactured wound care products, for the account of the Company, at its facility through
April 9, 2004 to meet current customer demand and to build sufficient inventory to cover
the period during which production at the Kimberly-Clark facility was discontinued and the
equipment was transferred to the Companys

10

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

facility in Toronto, Canada. Upon
cessation of manufacturing at Kimberly-Clarks facility, the Company purchased, in
accordance with a pre-determined formula, inventory consisting of raw and packaging
materials and up to four months supply of finished goods. The purchase price of this
inventory was approximately $550,000. Cash on hand and borrowings against available credit
lines were used to pay for this inventory.

The
Company completed the transfer, installation and validation of the equipment and commenced
manufacturing in Toronto, Canada in August 2004. Through December 31, 2004, the Company
expended approximately $680,000 on equipment and manufacturing facility upgrades at its
Toronto, Canada location.

3. Accounts Receivable

Accounts
receivable include the following:

`June 30,            December 31,
                                                                 2005                  2004
                                                                 ----                  ----

        Trade accounts receivable                             $2,774,633            $2,774,293
        Less:  Allowance for doubtful accounts                   (52,242)              (57,090)
               Allowance for trade rebates                    (1,332,333)             (164,000)
                                                              -----------           -----------
             Net trade receivables                             1,390,058             2,553,203
        Other receivables                                         75,748                47,889
                                                              -----------           -----------

             Total receivables                                $1,465,806            $2,601,092
                                                              ===========           ===========`

4. Inventories

Inventories
include the following:

`June 30,            December 31,
                                                                 2005                  2004
                                                                 ----                  ----

        Finished goods                                        $2,272,818            $3,531,095
        Work in process                                           54,634                71,423
        Packaging materials                                      651,085               461,052
        Raw materials                                            906,387               868,662
                                                              -----------           -----------

             Total inventories                                $3,884,924            $4,932,232
                                                              ===========           ===========`

5. Equipment and
Improvements, net

Equipment
and improvements include the following:

`June 30,            December 31,
                                                                 2005                  2004
                                                                 ----                  ----

        Machinery and equipment                               $3,356,474            $3,407,073
        Furniture and fixtures                                   210,874               196,506
        Leasehold improvements                                   716,847               714,992
                                                              -----------           -----------
             Gross equipment and improvements                  4,284,195             4,318,571
        Less:  accumulated depreciation                         (898,167)             (656,014)
                                                              -----------           -----------

             Total equipment and improvements, net            $3,386,028            $3,662,557
                                                              ===========           ===========`

11

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

Included
in equipment and improvements at June 30, 2005 and December 31, 2004 were machinery and
equipment with a cost of $228,518 and accumulated amortization of $40,119 and $22,989,
respectively, attributable to leased equipment. Amortization of assets under capital
leases is included in depreciation expense.

6. Other Intangible
Assets, net

`June 30,            December 31,
                                                                 2005                  2004
                                                                 ----                  ----

        Patents and trademarks                                 $ 444,067             $ 444,067
        Other intangible assets                                  342,797               342,797
                                                              -----------           -----------

             Gross other intangible assets                       786,864               786,864
             Less: accumulated amortization                     (445,024)             (402,953)
                                                              -----------           -----------

             Other intangible assets, net                      $ 341,840             $ 383,911
                                                              ===========           ===========`

Amortization
of other intangible assets related to product rights is included in cost of sales.

7. Other Assets, net

Other
assets, net include the following:

`June 30,            December 31,
                                                                 2005                  2004
                                                                 ----                  ----

        Deferred financing costs, net                           $130,600             $  60,728
        Deposits                                                  69,752                71,736
        Long-term receivable                                     110,203                  -
        Other                                                     36,425                  -
                                                              -----------           -----------

             Total other assets, net                            $346,980              $132,464
                                                              ===========           ===========`

Deferred
financing costs are being amortized over the terms of the related loan agreement which
range from three to five years. The long-term receivable relates to amounts due in
connection with a distribution agreement upset fee (see Note 15).

8. Line of Credit
Borrowings

Short-term
borrowings include the following:

`June 30,            December 31,
                                                                 2005                  2004
                                                                 ----                  ----

        U.S. line of credit                                     $693,325            $1,312,756
        Canadian line of credit                                       -              1,507,528
                                                              -----------           -----------

             Total line of credit borrowings                    $693,325            $2,820,284
                                                              ===========           ===========`

12

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

U.S.
Line of Credit

On
January 31, 2005, the Company entered into a three year revolving credit facility
agreement (the New Agreement) with a new U.S. lender for a maximum principal
amount of $2,000,000. The New Agreement replaces a $2,000,000 revolving credit facility
that expired on January 31, 2005. On January 31, 2005, the Company applied advances of
approximately $1,300,000 under the New Agreement in satisfaction of the prior U.S.
lenders outstanding obligations. Future advances will be utilized to fund strategic
initiatives and general working capital requirements. The Company incurred loan
origination and legal fees of $147,300 in connection with the implementation of the New
Agreement. These fees have been deferred and are being amortized to interest expense over
the three year term of the New Agreement.

The
Company may request advances under the New Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.5%, but not less than 7.5% per annum. At June 30, 2005 the effective interest rate was
8.51%. In addition, the Company pays a monthly collateral management fee at the rate of
1.5% per annum upon the daily average amount of advances outstanding and a monthly unused
line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the new U.S. lender its guarantee of payment together
with a second lien security interest in the assets of the Companys wholly owned
Canadian subsidiary. The new U.S. lender has agreed not to exercise its rights under its
second lien security interest and guarantee against the Canadian assets without the
Canadian lenders approval.

Over
the term of the New Agreement, the Company has agreed to comply with the following
covenants as measured at the end of each month for the average of the three most recent
calendar months based upon its consolidated operating results: a) maintain EBITDA
(earnings before interest, taxes, depreciation and amortization) in the range of negative
$300,000 (as of January 31, 2005) transitioning to positive $600,000 (post December 31,
2005) and (b) maintain its fixed charge ratio (EBITDA divided by the sum of debt service,
capital expenditures, income taxes and dividends) in the range of 1.0 to 1.0 (as of
January 31, 2005) to 1.25 to 1.0 (post December 31, 2005). As it pertains to the
Companys U.S. operations, cash collections may not be less than $800,000 for each
calendar month through June 30, 2005 and $900,000 for each calendar month thereafter. In
addition, at all times the Companys cash on hand (including unused borrowing
capacity under the New Agreement) must not be less than $200,000. Additional covenants
governing permitted indebtedness, liens, payments of dividends and protection of
collateral are included in the New Agreement.

Based
upon consolidated operating results for March and April 2005, the Company was out of
compliance with its EBITDA and fixed charge ratio covenant under the New Agreement. The
U.S. lender agreed to waive these covenant violations. Effective June 30, 2005 the Company
and the U.S. lender agreed to prospectively amend the Companys monthly minimum
EBITDA and fixed change ratio covenants to better align these covenants with expected
performance. The Company incurred fees of $10,000 associated with the granting of the
covenant amendments. The Company expects to, but cannot assure that it will, maintain
compliance with all applicable loan covenants in the future.

The
Company may terminate the New Agreement at any time after January 31, 2006 by paying all
outstanding indebtedness and any other payments due the new U.S. lender and paying the new
U.S. lender a yield maintenance based early termination fee equal to the product of: (a)
the effective yield on the facility for the six months prior to termination (expressed as
an annual percentage rate), (b) $2,000,000, and (c) the quotient of the months remaining
in the original term of the New Agreement divided by 12.

On
January 13, 2005 in connection with the refinancing of the U.S. line of credit, the
Company paid off and cancelled the outstanding irrevocable standby letter of credit issued
by the former U.S. lender in the amount of $200,000 held by the Companys Canadian
lender as additional security for its credit facility. The $200,000 paid to the Canadian
lender was applied as a permanent principal reduction against the principal amount due in
2007 associated with the Companys outstanding term loan with the Canadian lender
(see Note 10). Subsequently, on

13

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

January 31, 2005 the Canadian lender agreed as part of
refinancing of the U.S. line of credit to retain its second lien security interest and
guarantee position against the Companys U.S. assets and not to exercise its rights
under its second lien security interest and guarantee against the U.S. assets without the
U.S. lenders approval.

Canadian
Line of Credit

In
September 2004, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $1,795,000
($2,200,000 Canadian) with its Canadian lender. The Companys wholly owned Canadian
subsidiary, Derma Sciences Canada Inc., may request advances under the Canadian Agreement
up to the value of 75% of eligible receivables (as defined) plus the lesser of $897,000
($1,100,000 Canadian) or 40% of eligible inventory (as defined), less priority claims.
Interest on outstanding advances is payable monthly in arrears at prime rate (as defined)
plus 1.0%, or 5.25% for Canadian dollar advances and 7.50% for U.S. dollar denominated
advances at June 30, 2005. Outstanding advances are secured by all tangible and intangible
assets of Derma Sciences Canada Inc. In addition, the Company has accorded the Canadian
lender its guarantee of payment together with a second lien security interest in the
Companys assets located in the U.S.

Over
the term of the Canadian Agreement, the Company has agreed to comply with a number of
financial covenants governing minimum working capital, current ratios, tangible net worth,
interest coverage, total indebtedness to tangible net worth and total indebtedness to
adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $408,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default.

At
June 30, 2005 Derma Sciences Canada was out of compliance with its minimum working capital
covenant. The violation occurred due to the adverse impact on Derma Sciences Canadas
working capital associated with accelerating repayment of an inter company loan and
extending credit terms on regular inter company trade receivables to the U.S. parent in
June 2005 in an effort to optimize the use of the positive cash flow associated with
implementing the new distribution agreement in Canada (see note 17). The violation has
been corrected and the Canadian lender agreed to waive the covenant violation at June 30,
2005.

9. Accrued Expenses and
Other Current Liabilities

Accrued
expenses and other current liabilities include the following:

`June 30,     December 31,
                                                                        2005           2004
                                                                        ----           ----

        Accrued compensation and related taxes                        $134,171       $218,037
        Accrued sales, goods and services taxes                        140,068        197,984
        Accrued administrative fees                                    176,029        107,916
        Accrued closure costs                                          121,483              -
        Other                                                           24,693         70,501
                                                                      --------     ----------

             Total accrued expenses and other current liabilities     $596,444       $594,438
                                                                      ========     ==========`

14

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

10. Long-Term Debt

Long-term
debt includes the following:

`June 30,     December 31,
                                                                        2005           2004
                                                                        ----           ----

        Canadian term loan                                            $609,450     $  916,805
        Capital lease obligations                                      172,974        198,040
                                                                      --------     ----------

             Total debt                                                782,424      1,114,845
        Less:  current maturities                                      261,576        247,306
                                                                      --------     ----------

             Long-term debt                                           $520,848     $  867,539
                                                                      ========     ==========`

In
connection with the acquisition of substantially all the assets of Dumex Medical Inc. in
August 2002, the Company entered into a five-year term loan agreement with a Canadian
Bank. The loan is repayable in monthly payments consisting of principal and interest.
Interest on the outstanding principal balance is payable monthly at the banks prime
rate (as defined) plus 1.25%, or 5.5% at June 30, 2005. The term loan is secured by all
tangible and intangible assets of Derma Canada and is subject to the same financial
covenants applicable to the Canadian operating line of credit (see Note 8).

The
Company has four capital lease obligations for certain distribution equipment and computer
equipment totaling $172,974. The capital leases bear interest at annual rates ranging from
3.9% to 10.2% with the longest lease term expiring in April 2009.

11. Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at June 30, 2005.
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, 2005.
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, 2005.
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, 2005.
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.

15

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

Common
Stock

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,774, net of $159,226 in offering expenses, were used for
working capital. The offering commenced prior to December 31, 2004. During 2005, the
Company sold 1,205,000 units at $0.50 per unit and received total offering proceeds of
$539,415, net of $80,585 in offering expenses. As of December 31, 2004, the Company had
sold 1,555,000 units at $0.50 per unit and received total offering proceeds of $681,359,
net of $78,641 in offering expenses.

Stock
Options

During
the three and six months ended June 30, 2005, the Company issued stock options as follows:

`Number of             Per Share
                                                   Issued Stock Options     Exercise Price
                                                   --------------------     --------------

        Three months ended March 31, 2005               1,021,000                $0.50
        Three months ended June 30, 2005                  465,000                $0.42
                                                        ---------

        Total for six months ended June 30, 2005        1,486,000
                                                        =========`

There
were no other changes in outstanding options during the six months ended June 30, 2005.

Stock
Purchase Warrants

During
the three months ended March 31, 2005, the Company issued 1,205,000 series G warrants in
conjunction with the private offering discussed above. There were no other changes in
outstanding warrants during the six months ended June 30, 2005.

At
June 30, 2005, the Company had warrants outstanding to purchase 5,939,448 shares of the
Companys common stock as outlined below:

`Series    Number of Warrants    Exercise Price    Expiration Date
        ------    ------------------    --------------    ---------------

          E            1,870,007            $0.85         July 18, 2005
          F            1,309,441            $0.57         January 6, 2007
          G            2,760,000            $1.05         December 31, 2008`

Shares
Reserved for Future Issuance

At
June 30, 2005, 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 outstanding                  5,950,655
        Common stock options available for grant            286,000
        Common stock warrants (series E - G)              5,939,448
                                                         ----------

        Total common stock shares reserved               14,456,510
                                                         ==========`

16

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

12. Comprehensive Income
(Loss)

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

`Three Months Ended June 30,   Six Months Ended June 30,
                                                 ---------------------------   -------------------------
                                                     2005          2004           2005            2004
                                                     ----          ----           ----            ----

    Net income (loss) as reported                  $158,184     $(330,299)     $ (54,868)    $(1,306,765)
    Other comprehensive (loss) income:
        Foreign currency translation adjustment     (39,550)        6,419        (66,738)        (20,822)
                                                   ---------    ----------     ----------    ------------

    Comprehensive income (loss)                    $118,634     $(323,880)     $(121,606)    $(1,327,587)
                                                   =========    ==========     ==========    ============`

13. Operating Segments

The Company
consists of three operating segments: wound care, wound closure-fasteners and skin care.
Products in the wound care segment consist of basic and advanced dressings, ointments and
sprays designed to treat wounds. Wound closure-fasteners products include wound closure
strips, nasal tube fasteners, a variety of catheter fasteners and net dressings. The skin
care segment consists of bath sponges, antibacterial skin cleansers, hair and body soaps,
lotions and moisturizers designed to enable customers to implement and maintain successful
skin care / hygiene programs.

Products
in all three operating segments are marketed to long-term care facilities, hospitals,
physicians, clinics, home health care agencies and other healthcare institutions. The
manufacture of advanced wound care and wound closure-fastener products is primarily
outsourced. Basic wound care and skin care products are manufactured in-house with the
exception of the bath sponge line. Internally, the segments are managed at the gross
profit level. The aggregation or allocation of other costs by segment is not practical.

Segment
net sales and gross profit for the three months and six months ended June 30, 2005 and
2004 were as follows:

`Three Months Ended June 30, 2005
                                    --------------------------------

                                        Wound Closure-                                      Total
                          Wound Care      Fasteners      Skin Care     Other Costs         Company
                          ----------      ---------      ---------     -----------         -------

Net sales                $5,880,353       $  669,973     $ 383,892            -          $ 6,934,218
                         ----------       ----------     ----------    ------------      ------------

Gross profit (loss)       1,932,826          339,126       (99,345)           -            2,172,607
Total expenses              -                  -              -        $(2,014,423)       (2,014,423)
                                                                                         ------------

Net income                                                                               $   158,184
                                                                                         ============

Net long-lived assets    $3,260,200            -        $1,331,758    $    246,877       $ 4,838,835
                         ==========                     ===========   =============      ============`

17

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

`Three Months Ended June 30, 2004
                                    --------------------------------

                                        Wound Closure-                                      Total
                         Wound Care       Fasteners      Skin Care     Other Costs         Company
                          ----------      ---------      ---------     -----------         -------

Net sales                $3,455,605       $  939,998     $ 518,408            -          $ 4,914,011
                         ----------       ----------     ----------    ------------      ------------

Gross profit                826,778          469,021        98,025            -            1,393,824
Total expenses              -                  -              -        $(1,724,123)      $(1,724,123)
                                                                                         ------------

Net loss                                                                                 $  (330,299)
                                                                                         ============

Net long-lived assets    $3,359,891            -        $1,313,221    $    283,372       $ 4,956,484
                         ==========                     ===========   =============      ============




                                    Six Months Ended June 30, 2005
                                    ------------------------------

                                        Wound Closure-                                      Total
                         Wound Care       Fasteners      Skin Care     Other Costs         Company
                          ----------      ---------      ---------     -----------         -------

Net sales                $9,751,483       $1,298,271     $ 777,911            -          $11,827,665
                         ----------       ----------     ----------    ------------      ------------

Gross profit (loss)       2,990,814          663,262       (94,083)           -            3,559,993
Total expenses              -                  -              -        $(3,614,861)      $(3,614,861)
                                                                                         ------------

Net loss                                                                                 $   (54,868)
                                                                                         ============

Net long-lived assets    $3,260,200            -        $1,331,758    $    246,877       $ 4,838,835
                         ==========                     ===========   =============      ============




                                    Six Months Ended June 30, 2004
                                    ------------------------------

                                        Wound Closure-                                      Total
                         Wound Care       Fasteners      Skin Care     Other Costs         Company
                          ----------      ---------      ---------     -----------         -------

Net sales                $7,064,952       $1,898,268     $ 980,213            -          $ 9,943,433
                         ----------       ----------     ----------    ------------      ------------

Gross profit              1,692,918          936,404       197,408            -            2,826,730
Total expenses              -                  -              -        $(4,133,495)      $(4,133,495)
                                                                                         ------------

Net loss                                                                                 $(1,306,765)
                                                                                         ============

Net long-lived assets    $3,359,891            -        $1,313,221    $    283,372       $ 4,956,484
                         ==========                     ===========   =============      ============`

Long-lived
assets consist of property and equipment, patents and trademarks, other intangible assets
and goodwill. Wound care long-lived assets consist principally of Derma Sciences Canada
Inc., equipment and improvements and other intangible assets acquired in the January 2004
Kimberly-Clark wound care asset acquisition and patents and trademarks. Wound
closure-fasteners are for the most part outsourced and accordingly are not supported by
long-lived assets. Skin care long-lived assets consist of goodwill associated with the
acquisition of Sunshine Products, Inc. and equipment and improvements associated
therewith. Corporate headquarters and the Companys U.S. distribution center
equipment and improvements are included in the other costs column since they service all
three business segments.

18

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

For
the three and six months ended June 30, 2005 the skin care segment gross profit (loss)
includes a $98,000 charge for closure of the Companys soap and lotion manufacturing
facility in St. Louis, Missouri (see footnote 18).

The
following table presents net sales by geographic region.

`Three Months Ended June 30,    Six Months Ended June 30,
                              2005            2004         2005             2004
                              ----            ----         ----             ----

         United States         34%             53%          40%              55%
         Canada                62%             43%          56%              41%
         Other                  4%              4%           4%               4%`

Canada
net sales for the three and six months ended June 30, 2005 represent a higher percentage
of total net sales compared with 2004 as a result of the one-time benefit of approximately
$1,840,000 related to the sale of inventory on hand to fill the distribution pipeline in
conjunction with the appointment of an exclusive third party distributor for the
Companys Canadian subsidiary in the second quarter 2005 (see footnote 17).

The
following table presents net long-lived assets by geographic region.

`June 30, 2005        June 30, 2004
                           -------------        -------------

         United States        $1,933,897          $2,053,409
         Canada                2,879,830           2,863,666
         Other                    25,108              39,409
                              ----------          ----------

               Total          $4,838,835          $4,956,484
                              ==========          ==========`

14. Income Taxes

No
provision for income taxes has been made in the second quarter 2005 and 2004 and the six
months ended June 30, 2005 and 2004 given the Companys net operating losses. No
benefit has been recorded as the realization of the net operating losses is not assured.

At
December 31, 2004, the Company has net operating loss carryforwards of approximately
$8,130,000 for federal income tax purposes that begin to expire in years 2012 through
2024. For state income tax purposes, the Company has net operating loss carryforwards in a
number of jurisdictions in varying amounts and with varying expiration dates. The most
significant net operating loss is in New Jersey, site of the Companys domicile. This
state presently has a moratorium on the use of net operating losses. As of December 31,
2004, the Company has foreign (primarily Canadian) net operating loss carryforwards of
approximately $1,065,000 which begin to expire in 2009. The timing in which the Company
can utilize its U.S. net operating loss carryforwards in any year or in total may be
limited under the Internal Revenue Code section 382 regarding changes in ownership of
corporations. Due to uncertainties surrounding the Companys ability to use its net
operating loss carryforwards, a full valuation allowance has been provided for all periods
presented.

19

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

15. Distribution
Agreement Upset Fee

In
August 2004, the Companys exclusive distribution agreement for certain catheter
fasteners expired and was not renewed by the manufacturer. Sales and gross profit of these
catheter fasteners for the three and six months ended June 30, 2005 and 2004 were as
follows:

`Three Months Ended June 30,          Six Months Ended June 30,
                         ---------------------------          -------------------------
                           2005               2004              2005             2004
                           ----               ----              ----             ----

         Sales            $29,000           $313,000           $95,300         $624,000
         Gross profit     $15,400           $141,000           $46,100         $282,000`

In
accordance with the Companys distribution agreement with a major customer for these
catheter fasteners, if the customer subsequently entered into an agreement with the
manufacturer to distribute these products, then the customer shall pay the Company an
upset fee of $200,000 payable in forty-eight monthly installments of $4,167. As of January
2005, the customer advised the Company that it had entered into an agreement with the
manufacturer to distribute the catheter fasteners and that it was liable for payment of
the upset fee. In January 2005, the Company discounted the future cash flow stream
associated with the payment of the upset fee and recognized a gain of $164,300 in other
income. The current portion of the receivable has been recorded in accounts receivable and
the long-term portion in other assets in the balance sheet.

16. Employee Termination
Costs

On
March 9, 2004 the Company terminated the employment of its Executive Vice President and
President of its Derma Sciences Canada Inc. subsidiary. The Company recorded an estimated
charge of $450,000 representing severance, benefits and other costs associated with this
termination. The charge was recorded against general administrative expense in the
statement of operations. The liability was initially recorded to the extent of $225,000 in
other current liabilities and to the extent of $225,000 in other long-term liabilities in
the balance sheet.

On
September 24, 2004 the Company settled the foregoing litigation. In accordance with the
settlement, the Company extended the expiration date of previously granted options to
purchase 500,000 shares of the Companys common stock at $0.50 per share from May 9,
2004 to September 30, 2006. The settlement costs and other costs associated with the
termination totaling $301,600 were recorded in general and administrative expense in the
2004 consolidated statement of operations.

17. Appointment of
Canadian Distributor

On
May 9, 2005 the Company entered into a five-year agreement expiring May 1, 2010 with a
Canadian company to serve as the exclusive distributor of its products in Canada. The
agreement also appoints the distributor as the Companys servicing agent to fulfill
supply contracts held directly by the Company. The agreement automatically renews
thereafter for consecutive periods of one year each on the same terms and conditions
unless either party gives notice of its intent not to renew 180 days prior to expiry.
Either party shall have the right to terminate the agreement when an event of default (as
defined) has occurred with respect to the other party.

Effective
June 1, 2005 the distributor assumed responsibility for order processing, product delivery
and maintenance and warehousing of sufficient inventory to meet agreed upon order
fulfillment requirements. On an ongoing basis, the distributor will place inventory
replenishment orders with the Company at agreed upon prices, 120 days in advance of
scheduled delivery. Unless amended, each order becomes non-cancelable 90 days in advance
of scheduled delivery.

With
respect to sales made by the distributor to the Companys contract customers in its
capacity as a servicing agent, the Company will pay the distributor an agreed upon
distribution fee and a specified incentive for growth (as achieved). The Company will
reimburse the distributor for the difference between the price paid by the distributor and
the Companys contract price with its customer upon submission by the distributor of
an agreed upon

20

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements (Unaudited)

---

rebate report. With respect to sales made by the distributor to its
customers, the distributors compensation will consist solely of the excess of the
proceeds over the cost of the product and the Company will not be responsible for payment
of any distribution fee. Further, the agreement requires the distributor to meet specified
minimum sales growth targets of 15%, 12%, 12% and 12% in the first four years and private
label product purchase targets failing which the Company may cancel the agreement. The
Company believes that the agreement will provide better service to its customers
throughout Canada and greater opportunity for sales growth.

In
connection with implementing the agreement, the Company sold to the distributor its
existing inventory of saleable finished product on hand and will sell all saleable
finished product it committed to manufacture prior to signing of the agreement for
delivery by the Company through September 2005 at the agreed upon prices to initially
stock and maintain its distribution pipeline. It is expected the Companys saleable
finished product commitments will be fulfilled by October 2005 at which time the
distributor will begin to receive product based upon its initial orders placed with the
Company beginning in June 2005. Other than the one-time sale in May and June 2005 of its
existing inventory on hand which is estimated to represent two to two and one-half months
sales, prospective sales are expected to resume historical trends affected only by
existing market conditions and the growth opportunities inherent in the agreement. Given
economic order quantities and normal lead times associated with the products sold to the
distributor, it is expected that a two to three month safety stock will be required
prospectively by the distributor to maintain required customer service requirements. In
addition, the Company incurred one-time costs consisting of severance and other costs to
dismantle its distribution capabilities and sub-lease its distribution warehouse. A
summary of the estimated one-time benefit and cost of the agreement recognized in the
three months ended June 30, 2005 is outlined below:

`Net Sales                 $1,840,000
                Cost of Sales              1,240,000
                                          ----------

                Gross Profit                 600,000
                Expenses                     105,000
                                          ----------

                Pretax Income             $  495,000
                                          ==========`

Further,
implementation of the agreement resulted in an estimated one-time positive cash flow
benefit of $2,705,000 stemming from lower receivable and inventory requirements going
forward and the one-time pretax income benefit of the sale of existing saleable finished
product inventory on hand to the distributor.

18. Manufacturing
Facility Closure

In
June 2005, the Company announced its intention to close its skin care manufacturing
facility in St. Louis, Missouri and outsource the facilitys production with a view
to reducing overhead and improving cost competitiveness. Facility closure and transition
to the new supplier are expected to be complete by the end of September 2005.

As
of June 30, 2005, the Company recorded a charge of $98,000 for estimated severances and
lease costs associated with the closure. The existing equipment will either be transferred
to the Companys Toronto, Canada facility, leased to the supplier or sold. Other
one-time closure related costs estimated at $50,000, consisting principally of facility
clean up, inventory write-offs and equipment write-offs and ongoing estimated monthly
lease and facility maintenance costs of $7,500, net of existing committed lease costs and
estimated sub-lease income through lease expiration on January 31, 2007, will be expensed
to cost of sales as incurred.

19. Subsequent Events

Expiration of Series E
Stock Purchase Warrants

The
Companys 1,870,007 Series E stock purchase warrants expired unexercised on July 18, 2005.

21

---

Index

Item 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

QUARTER ENDED JUNE 30, 2005 COMPARED
TO QUARTER ENDED JUNE 30, 2004.

Results of Operations

Overview

The
second quarter 2005 and 2004 operating results include Derma Sciences, Inc. and its
subsidiaries. Unless otherwise indicated by the context, the term Canadian operations is
used throughout this discussion in reference to the operations of Derma Sciences Canada
Inc. and the term U.S. operations is used throughout this discussion in reference to the
Companys U.S. operations.

The
Company engages in the manufacture, marketing and sale of three dermatological product
lines consisting of wound care, wound closure and fasteners and skin care. The wound care
line is composed of basic and advanced wound care products. Basic wound care consists of
gauze dressings, abdominal pads, laparotomy sponges, burn dressings and bandages. Advanced
wound care products consist of ointments, packing strips, hydrogel dressings, hydrocolloid
dressings, foam dressings and impregnated gauze dressings. The wound closure and fastener
line consists of wound closure strips and a variety of catheter fasteners. The skin care
line consists of bath sponges, skin cleansers, soaps, hair and body washes and
moisturizers.

The
following table highlights the quarters ended June 30, 2005 versus June 30, 2004 operating
results:

`Quarter Ended June 30,
                                         ----------------------
                                          2005           2004                  Variance
                                          ----           ----                  --------

Gross Sales                          $ 8,210,230     $5,167,851        $ 3,042,379       58.9%
Adjustments                           (1,276,012)      (253,840)        (1,022,172)     402.7%
                                     ------------    -----------       ------------

Net sales                              6,934,218      4,914,011          2,020,207       41.1%
Cost of sales                          4,761,611      3,520,187          1,241,424       35.3%
                                     ------------    -----------       ------------

Gross profit                           2,172,607      1,393,824            778,783       55.9%
Gross profit percentage                     31.3%          28.4%
Operating expenses                     1,900,157      1,678,804            221,353       13.2%
Interest expense, net                     95,269         51,479             43,790       85.1%
Other expense (income), net               18,997         (6,160)            25,157        -
                                     ------------    -----------       ------------

Total expenses                         2,014,423      1,724,123            290,300       16.8%
Income (loss) before income taxes        158,184       (330,299)           488,483
Provision for income taxes                  -              -                  -           -
                                     ------------    -----------       ------------

Net income (loss)                    $   158,184     $ (330,299)       $   488,483        -
                                     ============    ===========       ============`

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, 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 by distributor. The
normal rebate cycle is one month. Non-exclusive distributors generally carry one
months 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 at
June 30, 2005, the trade rebate reserve would be overstated by approximately $35,000. If
the normal rebate cycle were two months at June 30, 2005, the trade rebate reserve would
be understated by approximately $70,000. To minimize its cash outflow invested in rebates,
distributors generally strive to optimize the rebate credit submission process.

22

---

Index

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 accrual trade rebate balance.
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.

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 have historically been accounted for on a cash basis which
approximates accrual based accounting given the month to month consistency of these
charges.

Gross
to net sales adjustments comprise the following:

`Quarter Ended June 30,
                                         ----------------------
                                          2005           2004
                                          ----           ----

          Gross Sales                 $8,210,230     $5,167,851
                                      -----------    -----------

          Trade rebates               (1,222,550)      (186,715)
          Medicaid rebates                (6,000)        (9,342)
          Returns and allowances          (6,911)       (29,467)
          Cash discounts                 (40,551)       (28,316)
                                      -----------    -----------

          Total adjustments           (1,276,012)      (253,840)
                                      -----------    -----------

          Net sales                   $6,934,218     $4,914,011
                                      ===========    ===========`

Trade rebates
increased significantly in the second quarter 2005 versus 2004 due to the Companys
implementing an exclusive third party distribution agreement in the second quarter for its
Canadian business, continuing growth of rebate intensive U.S. private label sales and a
general increase in the level of sales subject to rebate (contract business)
in other areas of the Companys business. Implementing the third party distribution
agreement was responsible for approximately $972,000 of the increase as the majority of
the Canadian sales represents contract business subject to rebate. Canadian sales subject
to rebate were made in May and June 2005, while the payment of rebates on these sales did
not commence until July 2005. A continuing trend towards lower levels of Medicaid
reimbursed sales is responsible for the lower level of Medicaid rebates. The decrease in
sales returns and allowances stems from several large returns received in the second
quarter 2004 that were not repeated in 2005. The increase in cash discounts principally
reflects the growth of sales to larger customers that routinely take advantage of
available discount terms.

Rebate Reserve Roll
Forward

A
quarterly roll forward of the trade rebate accruals at June 30, 2005 and 2004 is outlined
below:

`Quarter Ended June 30,
                                               ----------------------
                                                 2005          2004
                                                 ----          ----

          Beginning balance - April 1        $  305,700     $ 195,000
          Rebates paid                         (164,787)     (213,715)
          Rebates accrued                     1,222,550       186,715
                                             -----------    ----------

          Ending balance - June 30           $1,363,463     $ 168,000
                                             ===========    ==========`

The
$1,057,763 net increase in the second quarter 2005 trade rebate reserve reflects the
$972,000 incremental reserve associated with implementing the third party distribution
agreement in Canada during the second quarter coupled with lower rebates paid due to
extended rebate payment terms with two large customers. There has been no other
discernable change in the nature of the Companys business as it relates to the
accrual and

23

---

Index

subsequent payment of rebates, nor has there been any material prior period
related adjustments to the trade rebate accrual in the second quarter 2005. The $27,000
decrease in the second quarter 2004 trade rebate reserve reflects the work down of a
higher than normal beginning accrual balance due to significant sales of product subject
to rebate in December 2003 and January 2004 partially offset by the commencement of
extended rebate payment terms with two large customers.

Net Sales and Gross Margin

The
following table highlights the June 30, 2005 versus June 30, 2004 product line net sales
and gross profit:

`Quarter Ended June 30,
                                       ----------------------
                                        2005            2004               Variance
                                        ----            ----               --------
     Product Line Net Sales
     ----------------------

     Wound care                     $5,880,353      $3,455,605      $2,424,748     70.2%
     Wound closure and fasteners       669,973         939,998        (270,025)   (28.7%)
     Skin care                         383,892         518,408        (134,516)   (25.9%)
                                    -----------     ----------      -----------

         Total                      $6,934,218      $4,914,011      $2,020,207     41.1%
                                    ===========     ==========      ===========

     Product Line Gross Profit
     -------------------------

     Wound care                     $1,932,826      $  826,778      $1,106,048    133.8%
     Wound closure and fasteners       339,126         469,021        (129,895)   (27.7%)
     Skin care                         (99,345)         98,025        (197,370)     -
                                    -----------     ----------      -----------

         Total                      $2,172,607      $1,393,824      $  778,783     55.9%
                                    ===========     ==========      ===========`

Wound
care sales increased $2,424,748, or 70.2%, to $5,880,353 in 2005 from $3,455,605 in 2004.
The increase is attributable to a basic wound care increase of $2,186,701, or 87.0%. This
increase was driven by a significant increase in Canadian basic wound care sales of
$2,206,202 comprised of growth of $2,019,015 and favorable exchange of $187,187
(reflecting a 8.3% strengthening of the Canadian dollar) while U.S. sales were down
$19,501, or 4.5%, due to competitive pressure. The Canadian sales growth was driven by a
one-time benefit of approximately $1,840,000 related to the sale of inventory on hand to
fill the distribution pipeline in conjunction with the appointment of an exclusive third
party distributor for Canada in the second quarter coupled with normal growth of $179,015,
or 8.6%, due principally to improved contract compliance and improving sales in the home
healthcare market, partially offset by the loss of contract business in the eastern
provinces due to competitive pressure. Advanced wound care sales increased $238,049, or
25.3%, to $1,179,005 in 2005 from $940,956 in 2004. This increase was driven by continued
growth of the Companys private label sales to U.S. customers and improving Dermagran
sales. These increases were partially offset by lower former Kimberly-Clark branded and
private label product sales attributable to competitive pressure and the absence in 2005
of the 2004 buy-in of product that preceded closure of the Kimberly-Clark manufacturing
facility and transfer of the equipment to the Companys facility in Canada and lower
silver product sales as customer demand for these products remains soft.

Wound
care gross profit increased $1,106,048, or 133.8%, to $1,932,826 in 2005 from $826,778 in
2004. Gross profit margin increased to 32.9% in 2005 from 23.9% in 2004. Approximately
$600,000 of the increased gross margin dollars relates to the one-time sale of inventory
to fill the new Canadian distributors pipeline. The balance of the margin dollar
increase and improved gross margin percentage are due to the increase in sales and the
flow through of lower basic wound care costs negotiated in 2004, lower advanced wound care
costs associated with manufacturing the former Kimberly-Clark products in-house versus the
acquisition related negotiated costing used in 2004 and the non-recurrence of one-time
advanced wound care private label manufacturing start-up costs incurred in the second
quarter 2004.

Wound
closure and fastener sales decreased $270,025, or 28.7%, to $669,973 in 2005 from $939,998
in 2004. A reduction of approximately $284,000 in sales of certain catheter fasteners in
2005 versus 2004 associated with the loss of the Companys exclusive distribution
agreement for the sale of these products in August 2004 is

24

---

Index

primarily responsible for the
decrease. Sales in the balance of the line were relatively stable in the aggregate with
higher suture strip sales partially offset by lower other catheter sales.

Wound
closure-fastener gross profit decreased $129,895, or 27.7%, to $339,126 in 2005 from
$469,021 in 2004. Gross profit margins improved slightly to 50.6% in 2005 from 49.9% in
2004. The decrease in margin dollars is consistent with the sales shortfall. The margin
improvement principally reflects the benefit of the loss of the exclusive catheter
fastener business which was slightly lower margined than the average for the line.

Skin
care sales decreased $134,516, or 25.9%, to $383,892 in 2005 from $518,408 in 2004 due to
continuing competitive pressure and the loss of several key customers. Skin care gross
profit decreased $197,370 to a loss of $99,345 in 2005 from a profit of $98,025 in 2004.
Included in the 2005 loss is a provision of $98,000 for severance and lease costs
associated with the closure of the skin care manufacturing facility in St. Louis.
Excluding the $98,000 provision, the skin care line operated at essentially break even for
the second quarter 2005. This performance continues to reflect a highly competitive
marketplace characterized by declining market prices and higher internal manufacturing
costs associated with increasing material and freight costs and the adverse impact of
lower production volumes on operating efficiency and fixed overhead absorption.

Operating Expense

The
following table highlights June 30, 2005 versus June 30, 2004 operating expenses by type:

`Quarter Ended June 30,
                                       ----------------------
                                        2005            2004              Variance
                                        ----            ----              --------

     Distribution                   $  340,020      $  256,524       $ 83,496    32.5%
     Marketing                         128,507         121,376          7,131     5.9%
     Sales                             476,958         446,420         30,538     6.8%
     General administrative            954,672         854,484        100,188    11.7%
                                    ----------      ----------       --------

         Total                      $1,900,157      $1,678,804       $221,353    13.2%
                                    ==========      ==========       ========`

Operating
expense increased $221,353, or 13.2%, to $1,900,157 in 2005 from $1,678,804 in 2004
including an increase of $38,692, or 2.3%, attributable to exchange associated with a 8.3%
strengthening of the Canadian dollar on the Canadian operations.

Distribution
expense increased $83,496, or 32.5%, in 2005 versus 2004. Expenses in Canada increased
$129,987 (including $7,881 expense related to exchange) while expenses in the U.S
decreased $46,491. The increase in Canada was attributable to implementation of the new
distribution agreement. Effective June 1, 2005 the new distributor assumed responsibility
for order processing, product delivery and inventory maintenance and warehousing. The fee
for these services in June 2005 preceded the Companys plan to offload the
corresponding costs of its own distribution network primarily in the area of lease costs,
public warehouse fees and other fixed costs resulting in incremental costs for the month.
In addition, the Company incurred approximately $52,000 in one-time severance and other
related costs associated with the transition to the new distribution agreement. The U.S.
decrease was attributable to lower compensation costs associated with running the new U.S.
distribution facility opened in March 2004 more cost effectively in 2005 and the absence
in 2005 of start up related costs incurred in 2004 associated with bringing the new U.S
distribution center on line and closing one of the Companys other distribution
centers.

Marketing
expense increased $7,131, or 5.9%, in 2005 versus 2004. The increase is principally
attributable to higher literature and promotion expense in support of the Companys
growth initiatives.

Sales
expense increased $30,538, or 6.8%, in 2005 versus 2004. Expenses in Canada increased
$67,416 (including $7,787 expense related to exchange) while expenses in the U.S.
decreased $36,878. The increase in Canada is attributable to a higher level of sales
support activities consisting principally of travel, convention attendance and sampling to
expand market visibility and improve contract compliance and one-time severance and travel
costs associated with implementing the new distribution agreement. The U.S. decrease was
attributable to lower compensation of approximately $41,000 associated with lower sales
representative commissions, lower

25

---

Index

manufacturers representative commissions due to
the discontinuance of manufacturers representatives in the second quarter 2004 and
an open position in the second quarter 2005. Elimination of a sales database consultant
and related expenses generated savings of approximately $17,400. Offsetting these
decreases were higher recruiting cost of $14,000 to fill the open position and higher
travel expenses of $7,800 associated with the Companys growth initiatives.

General
administrative expense increased $100,188, or 11.7%, in 2005 versus 2004. Expenses in
Canada increased $74,708 (including $23,024 expense related to exchange) while expenses in
the U.S. increased $25,480. The increase in Canada reflects one-time costs of $41,700 for
severance and other costs associated with implementing the new distribution agreement
together with higher compensation costs associated with the hiring of a Director of
Materials and Logistics in the second quarter 2005. The U.S. increase principally reflects
board of directors fees initiated in January 2005, higher benefit costs and higher travel
expense partially offset by the impact of various cost reduction and containment
initiatives in the administrative overhead area.

Interest Expense, Net

Interest
expense, net increased $43,790, or 85.1%, to $95,269 in 2005 from $51,479 in 2004.
Interest expense in Canada decreased $2,870 (net of $2,726 expense related to exchange)
while interest expense in the U.S. increased $45,668. The decrease in Canada reflects
lower outstanding line of credit and term loan balances in 2005, partially offset by
slightly higher interest rates and fees. Canadas outstanding line of credit balance
was significantly reduced beginning in mid-May 2005 and reached zero by the end of June
2005 through use of the initial one-time positive cash flow generated by implementation of
the new distribution agreement. Canadas term loan was significantly reduced in
January 2005 as a result of the pay off of an outstanding irrevocable standby letter of
credit issued by the U.S. lender in the amount of $200,000 held by the Canadian lender as
additional security for its credit facility. The $200,000 payment was applied to the term
loan as a permanent principal reduction against the principal amount due in 2007. The U.S.
increase is due to higher outstanding line of credit balances, higher interest rates and
higher line of credit fees in 2005 versus 2004. In January 2005, the U.S. operation
refinanced its line of credit at a higher overall cost. In addition, in 2004 the Company
did not move into a net borrowing position until June 2004.

Other Income/Expense

Other
income/expense increased $25,157 to $18,997 expense in 2005 from $6,160 income in 2004.
The increase is primarily driven by foreign exchange losses in Canada and other net
miscellaneous expenses in 2005 compared to 2004 that included a couple of one-time gain
items related to the sale of excess equipment and slow moving inventory.

Income Taxes

The
Company did not record any tax expense in the second quarter 2005 or 2004 given its net
operating losses and/or available net operating loss carryforwards.

Net Income (Loss)

The
Company generated net income of $158,184, or $0.01 income per share basic and $0.01 income
per share diluted in 2005, compared to a $330,299 loss, or $0.03 loss per share (basic and
diluted) in 2004.

26

---

Index

SIX MONTHS ENDED JUNE 30, 2005
COMPARED TO SIX MONTHS ENDED JUNE 30, 2004.

Results of Operations

Overview

The
following table highlights the six months ended June 30, 2005 versus June 30, 2004
operating results:

`Six Months Ended June 30,
                                        -------------------------
                                          2005            2004                  Variance
                                          ----            ----                  --------

     Gross Sales                     $13,447,268     $10,450,881      $ 2,996,387       28.7%
     Adjustments                      (1,619,603)       (507,448)      (1,112,155)     219.2%
                                     ------------    ------------     ------------

     Net sales                        11,827,665       9,943,433        1,884,232       18.9%
     Cost of sales                     8,267,672       7,116,703        1,150,969       16.2%
                                     ------------    ------------     ------------

     Gross profit                      3,559,993       2,826,730          733,263       25.9%
     Gross profit percentage                30.1%           28.4%
     Operating expenses                3,581,212       3,923,859         (342,647)      (8.7%)
     Interest expense, net               179,853          98,146           81,707       83.3%
     Other (income) expense, net        (146,204)        111,490         (257,694)       -
                                     ------------    ------------     ------------

     Total expenses                    3,614,861       4,133,495         (518,634)      12.5%
     Loss before income taxes            (54,868)     (1,306,765)       1,251,897       95.8%
     Provision for income taxes             -               -                -           -
                                     ------------    ------------     ------------

     Net loss                        $   (54,868)    $(1,306,765)     $ 1,251,897       95.8%
                                     ============    ============     ============`

Gross to Net Sales
Adjustments

Gross
to net sales adjustments comprise the following:

`Six Months Ended June 30,
                                           -------------------------
                                            2005             2004
                                            ----             ----

          Gross Sales                  $13,447,268      $10,450,881
                                       ------------     ------------

          Trade rebates                 (1,495,734)        (374,632)
          Medicaid rebates                 (13,420)         (23,742)
          Returns and allowances           (38,494)         (33,249)
          Cash discounts                   (71,955)         (75,825)
                                       ------------     ------------

          Total adjustments             (1,619,603)        (507,448)
                                       ------------     ------------

          Net sales                    $11,827,665      $ 9,943,433
                                       ============     ============`

Trade rebates
increased significantly in the first half 2005 versus 2004 due to the Companys
implementing an exclusive third party distribution agreement in the second quarter 2005
for its Canadian business, continuing growth of rebate intensive U.S. private label sales
and a general increase in the level of sales subject to rebate (contract
business) in other areas of the Companys business. Implementing the third
party distribution agreement was responsible for approximately $972,000 of the increase as
the majority of the Canadian sales represent contract business subject to rebate. Canadian
sales subject to rebate were made in May and June 2005, while payment of rebates on these
sales did not commence until July 2005. A continuing trend towards lower levels of
Medicaid reimbursed sales is responsible for the lower level of Medicaid rebates. Sales
returns and allowances were comparable period to period and on balance reflect a normal
level of activity. The slight decrease in cash discounts

27

---

Index

reflects the Companys
efforts to tighten its discount terms while experiencing a trend in sales growth towards
larger customers that routinely take advantage of available discount terms.

Rebate Reserve Roll
Forward

A
six month roll forward of the trade rebate accruals at June 30, 2005 and 2004 is outlined
below:

`Six Months Ended June 30,
                                              -------------------------
                                                 2005          2004
                                                 ----          ----

          Beginning balance - January 1      $  235,200     $ 212,000
          Rebates paid                         (367,471)     (418,632)
          Rebates accrued                     1,495,734       374,632
                                             -----------    ----------

          Ending balance - June 30           $1,363,463     $ 168,000
                                             ===========    ==========`

The
$1,128,263 net increase in the first half 2005 trade rebate reserve reflects the $972,000
incremental reserve associated with implementing the third party distribution agreement in
Canada during the second quarter 2005 coupled with lower rebates paid due to extended
rebate payment terms with two large customers. 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, nor has there been any material prior period related adjustments to
the trade rebate accruals in 2005. The $44,000 decrease in the first half 2004 trade
rebate reserve reflects the work down of a higher than normal beginning accrual balance
due to significant sales of product subject to rebate in December 2003 and January 2004
coupled with a decrease in the amount of corresponding sales subject to rebate in the
following months as customers worked down their existing inventory levels. This decrease
was partially offset by the commencement of extended rebate payment terms with two large
customers during the first half of 2004.

Net Sales and Gross Margin

The
following table highlights the June 30, 2005 versus June 30, 2004 product line net sales
and gross profit:

`Six Months Ended June 30,
                                        -------------------------
                                          2005        2004                Variance
                                          ----        ----                --------
     Product Line Net Sales
     ----------------------

     Wound care                      $ 9,751,483      $7,064,952       $2,686,531       38.0%
     Wound closure and fasteners       1,298,271       1,898,268         (599,997)     (31.6%)
     Skin care                           777,911         980,213         (202,302)     (20.6%)
                                     ------------     -----------      -----------

         Total                       $11,827,665      $9,943,433       $1,884,232       18.9%
                                     ============     ===========      ===========

     Product Line Gross Profit
     -------------------------

     Wound care                      $ 2,990,814      $1,692,918       $1,297,896       76.7%
     Wound closure and fasteners         663,262         936,404         (273,142)     (29.2%)
     Skin care                           (94,083)        197,408         (291,491)       -
                                     ------------     -----------      -----------

         Total                       $ 3,559,993      $2,826,730       $  733,263       25.9%
                                     ============     ===========      ===========`

Wound
care sales increased $2,686,531, or 38.0%, to $9,751,483 in 2005 from $7,064,952 in 2004.
The increase is attributable to a basic wound care increase of $2,551,446, or 51.8%. This
increase was driven by a significant increase in Canadian basic wound care sales of
$2,497,077 comprised of growth of $2,170,819 and favorable exchange of $326,258
(reflecting a 7.4% strengthening of the Canadian dollar) while U.S. sales increased
$54,369, or 6.4%. The Canadian sales growth was driven by a one-time benefit of
approximately $1,840,000 related to the sale of inventory on hand to fill the distribution
pipeline in conjunction with the appointment of an exclusive third party distributor for
Canada in the second quarter coupled with normal growth of $330,819, or 8.1%, due

28

---

Index

principally to improved contract compliance and improving sales in the home
healthcare market partially offset by the loss of contract business in the eastern provinces due to competitive pressure. Advanced
wound care sales increased $135,085, or 6.3%, to $2,271,835 in 2005 from $2,136,750 in 2004. This increase was driven by continued
growth of the Companys private label sales to U.S. customers and improving Dermagran sales. These increases were partially
offset by lower former Kimberly-Clark branded and private label product sales attributable to competitive pressure and the absence
in 2005 of the 2004 buy-in of product that preceded closure of the Kimberly-Clark manufacturing facility and transfer of the
equipment to the Companys facility in Canada and lower silver product sales as customer demand for these products remain
soft.

Wound
care gross profit increased $1,297,896, or 76.7%, to $2,990,814 in 2005 from $1,692,918 in
2004. Gross profit margin increased to 30.7% in 2005 from 24.0% in 2004. Approximately
$600,000 of the increased gross margin dollars relates to the one-time sale of inventory
to fill the new Canadian distributors pipeline. The balance of the margin dollar
increase and improved gross margin are due to the increase in sales and the flow through
of lower basic wound care costs negotiated in 2004, lower advanced wound care costs
associated with manufacturing the former Kimberly-Clark products in-house versus the
acquisition related negotiated costing used in 2004 and the non-recurrence of one-time
advanced wound care private label manufacturing start-up costs incurred in the second
quarter 2004, and a one-time $59,400 inventory write-off in the first quarter 2004.

Wound
closure and fastener sales decreased $599,997, or 31.6%, to $1,298,271 in 2005 from
$1,898,268 in 2004. A reduction of approximately $540,000 in sales of certain catheter
fasteners in 2005 versus 2004 associated with the loss of the Companys exclusive
distribution agreement for the sale of these products in August 2004 is primarily
responsible for the decrease. Lower other catheter sales due to competitive pressure
partially offset by a slight increase in suture strip sales are responsible for the
balance of the sales decrease.

Wound
closure and fastener gross profit decreased $273,142, or 29.2% to $663,262 in 2005 from
$936,404 in 2004. Gross profit margins improved to 51.1% in 2005 from 49.3% in 2004. The
decrease in margin dollars is consistent with the sales shortfall. The margin improvement
principally reflects the benefit of the loss of the exclusive catheter fastener business,
which was slightly lower margined than the average for the line.

Skin
care sales decreased $202,302, or 20.6%, to $777,911 in 2005 from $980,213 in 2004 due to
continuing competitive pressure and the loss of several key customers. Skin care gross
profit decreased $291,491 to a loss of $94,083 in 2005 from a profit of $197,408 in 2004.
Included in the 2005 loss is a provision of $98,000 for severance and lease costs
associated with the decision in the second quarter to close the skin care manufacturing
facility in St. Louis to improve cost efficiency. Excluding the $98,000 provision, the
skin care line operated at essentially break even for the first half of 2005. This
performance continues to reflect a highly competitive marketplace characterized by
declining market prices and higher internal manufacturing costs associated with increasing
material and freight costs and the adverse impact of lower production volumes on operating
efficiency and fixed overhead absorption.

Operating Expense

The
following table highlights June 30, 2005 versus June 30, 2004 operating expenses by type:

`Six Months Ended June 30,
                                   -------------------------
                                     2005            2004                 Variance
                                     ----            ----                 --------

     Distribution                $  584,687      $  563,449       $  21,238      3.8%
     Marketing                      225,302         209,272          16,030      7.7%
     Sales                          932,172         903,093          29,079      3.2%
     General administrative       1,839,051       2,248,045        (408,994)   (18.2%)
                                 -----------     -----------      ----------

         Total                   $3,581,212      $3,923,859       $(342,647)    (8.7%)
                                 ===========     ===========      ==========`

Operating
expense decreased $342,647, or 8.7% to $3,581,212 in 2005 from $3,923,859 in 2004
including an increase of $102,401, or 2.6% attributable to exchange associated with a 7.4%
strengthening of the Canadian dollar on the Canadian operations.

29

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Index

Distribution
expense increased $21,238, or 3.8% in 2005 versus 2004. Expenses in Canada increased
$136,342 (including $14,887 expense related to exchange) while expenses in the U.S.
decreased $115,104. The increase in Canada was attributable to implementation of the new
distribution agreement. Effective June 1, 2005 the new distributor assumed responsibility
for order processing, product delivery and inventory maintenance and warehousing. The fee
for these services in June 2005 preceded the Companys plan to offload the
corresponding fixed costs of its own distribution network resulting in incremental costs
for the month. In addition, the Company incurred approximately $52,000 in one-time
severance and other related costs associated with the transition to the new distribution
agreement. The U.S. decrease reflects the impact of the U.S. distribution integration
initiative that took place in the first half of 2004 when the Company closed one facility
and moved its St. Louis distribution center out of the skin care manufacturing facility
into a new dedicated distribution center located nearby. The decrease in expense reflects
the non recurrence of approximately $60,000 of one-time costs to close one of the
distribution centers and various start-up related expenses associated with bringing the
new distribution center opened in March 2004, on-line. Partially offsetting these expense
reductions were higher lease costs associated with the new, larger distribution center.

Marketing
expense increased $16,030, or 7.7% in 2005 versus 2004. The increase is principally
attributable to higher literature and promotion expense in support of the Companys
growth initiatives.

Sales
expense increased $29,079, or 3.2% in 2005 versus 2004. Expenses in Canada increased
$93,329 (including $13,979 expense related to exchange) while expenses in the U.S.
decreased $64,250. The increase in Canada is attributable to a higher level of sales
support activities consisting principally of travel, convention attendance and sampling to
expand market visibility and improve contract compliance and one-time severance and travel
costs associated with implementing the new distribution agreement. The U.S. decrease was
attributable to lower compensation of approximately $45,000 associated with lower sales
representative commissions, lower manufacturers representative commissions due to
the decision to discontinue the use of manufacturers representatives in the second
quarter 2004 and an open position in the second quarter 2005. Elimination of a sales
database consultant and related expenses generated savings of approximately $30,300.
Partially offsetting these decreases were higher recruiting and travel costs.

General
and administrative expense decreased $408,994, or 18.2% in 2005 versus 2004. Expenses in
Canada decreased $385,801 (net of $73,534 expense related to exchange) while expenses in
the U.S. decreased $23,193. The decrease in Canada reflects the non-recurrence in 2005 of
a $450,000 charge for employee termination costs recorded in the first quarter 2004.
Partially offsetting this decrease were one-time costs of $41,700 for severance and other
costs associated with implementing the new distribution agreement together with higher
compensation costs associated with the hiring of a Director of Materials and Logistics in
the second quarter 2005. In the aggregate, other general administrative expenses were
essentially flat period to period. The decrease in the U.S. reflects the non-recurrence in
2005 of a $42,600 bad debt write-off taken in the first quarter 2004 coupled with lower
public relations, legal and regulatory costs due to cost containment efforts. These
savings were partially offset by higher Sarbanes Oxley related accounting fees and higher
information technology costs associated with the Companys decision in early 2004 to
invest resources in this area to upgrade its hardware and overall systems capabilities.

Interest Expense, Net

Interest
expense, net increased $81,707, or 83.3%, to $179,853 in 2005 from $98,146 in 2004.
Interest expense in Canada decreased $2,425 (net of $4,980 expense related to exchange)
while interest expense in the U.S. increased $80,658. The decrease in Canada reflects
lower outstanding line of credit and term loan balances in 2005, partially offset by
slightly higher interest rates and fees. Canadas outstanding line of credit balance
was significantly reduced beginning in mid-May 2005 to zero by the end of June 2005
through the use of the initial one-time positive cash flow generated by implementation of
the new distribution agreement. Canadas term loan was significantly reduced in
January 2005 as a result of the pay off of an outstanding irrevocable standby letter of
credit issued by the U.S. lender in the amount of $200,000 held by the Canadian lender as
additional security for its credit facility. The $200,000 payment was applied to the term
loan as a permanent principal reduction against the principal amount due in 2007. The
increase in the U.S. is due to higher outstanding line of credit balances, higher interest
rates and higher line of credit fees in 2005 versus 2004. In January 2005, the U.S.
refinanced its line of credit at a higher overall cost. In addition, in 2004 the Company
did not move into a net borrowing position until June 2004.

30

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Index

Other Income/Expense

Other
income/expense increased $257,694 to $146,204 income in 2005 from $111,490 expense in
2004. The increase is primarily driven by $164,300 of income relative to a distribution
agreement upset fee recorded in the first quarter 2005 and the non-recurrence in 2005 of
$94,428 in obsolete equipment write-offs recorded in the first quarter 2004. Aside from
these items the net impact of miscellaneous income and expense items was comparable period
to period.

Income Taxes

The
Company did not record any tax expense in the first half 2005 or 2004 given its net
operating losses and available net operating loss carryforwards.

Net Loss

The
Company incurred a net loss of $54,868, or $0.00 loss per share (basic and diluted) in the
first half 2005 compared to a $1,306,765 loss, or $0.14 loss per share (basic and diluted)
in the first half 2004.

Liquidity and Capital
Resources

Operational Overview

In
the first half of 2005, sales of the Companys U.S. private label products continued
to increase at a slower than planned rate. In addition, the Company continues to
experience competitive sales pressure in its U.S. skin care, silver and basic wound care
business. Conversely, Dermagran and Canadian basic wound care sales exceeded plan.

In
the second quarter 2005, the Company realized a significant one-time benefit associated
with entering into an exclusive distribution agreement for its products in Canada. In
connection with implementing the agreement in the second quarter 2005, the Company
realized estimated one time net sales, gross margin and net income of $1,840,000, $600,000
and $495,000, respectively, related to the sale to the new distributor of its existing
inventory required to stock the new distributors pipeline, less the Companys
one time costs to dismantle its existing distribution network. Further, implementation of
the agreement resulted in an estimated one-time positive cash flow benefit of $2,705,000
stemming from prospective lower receivable and inventory requirements coupled with the net
income realized.

As
expected, the Company has realized the benefit of its major manufacturing and sourcing
initiatives completed in 2004. Notwithstanding the adverse impact of sales pricing and mix
on margins, the Company has realized an improvement in its overall gross margin percentage
in 2005 stemming from lower product costs. In an effort to enhance manufacturing
efficiency and competitiveness, the Company decided to shut down its relatively
inefficient skin care manufacturing facility and outsource the manufacture of these
products. A $98,000 reserve was recorded to cost of sales in the second quarter to cover
the initial cost of closure. An agreement was signed in July 2005 to outsource the
manufacture of the Companys skin care products.

Excluding
one-time costs in both periods and the impact of exchange, 2005 operating costs were
essentially flat with 2004 reflecting an effort to restrain expenses to the extent
possible without adversely affecting the underlying infrastructure previously put in place
to support planned growth.

Excluding
a one-time gain of $164,300 related to a distribution agreement upset fee, the first
quarter 2005 net loss was $377,352. Excluding the one-time gain of $495,000 associated
with the implementation of the new distribution agreement and the $98,000 expense
associated with the closure of the skin care manufacturing facility, the second quarter
2005 net loss was $238,816. Adjusting for one-time items, the loss for the first half of
2005 was $616,168 versus $54,868, as reported. Notwithstanding the benefit of the Canadian
distribution agreement on liquidity, this performance continues to put pressure on the
Companys overall liquidity. In response, the Company will continue to focus on, and
take the steps necessary to accelerate sales growth while properly aligning operating
expenses with expected revenues.

31

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Index

On
January 9, 2004, the Company purchased the Kimberly-Clark Corporation wound care business
for total consideration of $1,942,797. The consideration consisted of cash of $376,797 and
a seller financed, non-interest bearing promissory note due on or before December 31, 2004
of $1,566,000. The cash outlay consisted of $300,100 paid at closing and $76,697 for
acquisition related costs. The equipment purchased was installed in a newly renovated area
in the Companys manufacturing facility in Toronto, Canada that was completed in
August 2004. The cost to transfer, install and validate the equipment was approximately
$680,000. The promissory note was paid in full on December 30, 2004 using restricted cash
on deposit with the U.S. lender and available line capacity.

On
February 25, 2004, the Company closed a private offering of 2,057,145 shares of its common
stock at a price of $1.05 per share. Offering proceeds were used to fund the acquisition
of the Kimberly-Clark Corporation wound care business and for general working capital
purposes. Offering proceeds of $1,961,797, net of offering expenses of $198,203, were
received.

On
September 24, 2004, the Company settled litigation brought against it and its wholly owned
Canadian subsidiary by a former executive relative to the executives termination of
employment. Pursuant to the settlement, the Company agreed to pay the sum of $269,500 over
a period of seven months and extend the expiration date of previously granted options to
purchase 500,000 shares of the Companys common stock at $0.50 per share from May 9,
2004 to September 30, 2006. The settlement costs, together with estimated other costs
associated with the termination aggregating $301,600, were charged against the reserve
established in March 2004 to cover the estimated cost of the litigation. The balance due
the former employee was fully paid as of April 2005.

In
2004, the Company entered into operating and capital leases totaling approximately
$4,222,000 in commitments through 2012, with terms ranging from three to five years,
relative to the following: extension of the Canada manufacturing facility lease in the
amount of $1,902,000, lease for the new U.S. distribution center in the amount of
$1,118,000, Canada distribution and U.S. manufacturing facility extensions in the amount
of $903,000 and U.S. distribution center equipment and upgrades to the Company-wide
telecommunications and information technology equipment in the amount of $299,000. No
further significant lease obligations are anticipated in the foreseeable future.

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,774, net of $159,226 in offering expenses, were used for
working capital. The offering was initiated in December 2004. In 2004, the Company sold
1,555,000 units and received offering proceeds of $681,359, net of $78,641 in offering
expenses. In 2005, the Company sold 1,205,000 units and received offering proceeds of
$539,415, net of $80,585 in offering expenses.

In
2004, the Companys exclusive distribution agreement for certain catheter fasteners
expired and was not renewed by the manufacturer. In accordance with the Companys
distribution agreement with a major customer for the fasteners, if the customer
subsequently enters into an agreement with the manufacturer to distribute these products,
then the customer shall pay the Company an upset fee of $200,000 in forty-eight monthly
installments of $4,167. As of January 2005, the customer advised the Company that it had
entered into an agreement with the manufacturer to distribute the catheter fasteners and
that it was liable for payment of the upset fee. In January 2005, the Company discounted
the future cash flow stream associated with the payment of the upset fee and recognized a
gain of $164,300.

On
May 9, 2005 the Company entered into a five-year agreement expiring May 1, 2010 with a
Canadian company to serve as the exclusive distributor of its products in Canada.
Effective June 1, 2005 the distributor assumed responsibility for order processing,
product delivery and maintenance and warehousing of sufficient inventory to meet order
fulfillment requirements. With respect to sales made by the distributor to the
Companys contract customers in its capacity as a servicing agent, the Company will
pay the distributor a distribution fee and a specified incentive for growth (as achieved).
The Company will reimburse the distributor for the difference between the price paid by
the distributor and the Companys contract price with its customer upon submission by
the distributor of a rebate report. With respect to sales made by the distributor to its
customers, the distributors compensation will consist solely of the excess of the
proceeds over the cost of the product and the Company will not be responsible for payment
of any distribution fee. Further, the agreement requires the distributor to meet specified
minimum sales growth targets of 15%, 12%, 12% and 12% in the first four years and private
label product purchase

32

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Index

targets failing which the Company may cancel the agreement. The
Company believes that the agreement will provide better service to its customers
throughout Canada and greater opportunity for prospective sales and profit growth.

In
connection with implementing the agreement, the Company sold to the distributor its
existing inventory of saleable finished product on hand and will sell all saleable
finished product it committed to manufacture prior to signing of the agreement for
delivery by the Company through September 2005 at the agreed upon prices to initially
stock and maintain its distribution pipeline. It is expected the Companys saleable
finished product commitments will be fulfilled by October 2005 at which time the
distributor will begin to receive product based upon its initial orders placed with the
Company beginning in June 2005. Other than the one-time sale in May and June 2005 of its
existing inventory on hand, which is estimated to represent two to two and one-half months
sales, prospective sales are expected to resume historical trends affected only by
existing market conditions and the growth opportunities inherent in the agreement. Given
economic order quantities and normal lead times associated with the products sold to the
distributor, it is expected that a two to three month safety stock will be required
prospectively by the distributor to maintain required customer service requirements. In
addition, the Company incurred one-time costs consisting of severance and other costs to
dismantle its distribution capabilities and sub-lease its distribution warehouse. A
summary of the estimated one-time benefit and costs of the agreement recognized in the
three months ended June 30, 2005 is outlined below:

`Net Sales          $1,840,000
                         Cost of Sales       1,240,000
                                            ----------

                         Gross Profit          600,000
                         Expenses              105,000
                                            ----------

                         Pretax Income      $  495,000
                                            ==========`

Further,
implementation of the agreement resulted in an estimated one-time positive cash flow
benefit of $2,705,000 stemming from lower receivable and inventory requirements going
forward and the one-time pretax income benefit of the sale of existing saleable finished
product inventory on hand to the distributor.

In
June 2005, the Company announced its intention to close its skin care manufacturing
facility in St. Louis, Missouri and outsource the facilitys production with a view
to reducing overhead and improving cost competitiveness. Facility closure and transition
to the new supplier are expected to be complete by the end of September 2005.

As
of June 30, 2005, the Company recorded a charge of $98,000 for estimated severances and
lease costs associated with the closure. The existing equipment will either be transferred
to the Companys Toronto, Canada facility, leased to the supplier or sold. Other
one-time closure related costs estimated at $50,000, consisting principally of facility
clean up, inventory write-offs and equipment write-offs and ongoing estimated monthly
lease and facility maintenance costs of $7,500, net of existing committed lease cost and
estimated sub-lease income through lease expiration on January 31, 2007, will be expensed
as incurred.

In
June 2005 in connection with implementation of the new distribution agreement, the Company
sub-leased its Canadian distribution center through June 2008 at its existing rates and
terms. The sub-lessee has the right to continue leasing the facility after June 2008 on a
month to month basis with the Companys approval or extend the lease term for up to
two additional years. The Companys lease expires August 2009. Total payments under
the sub-lease agreement through June 2008 aggregate approximately $360,000.

Cash Flow

At
June 30, 2005 and December 31, 2004, the Company had cash and cash equivalents on hand of
$362,941 and $46,508, respectively. The $316,433 increase represents a timing difference
that results from net cash provided by operating activities of $2,340,865 partially offset
by net cash used in financing activities of $1,973,346, net cash used in investing
activities of $36,881 and cash used as a result of exchange rate changes of $14,205.
Subject to constraints surrounding the movement of cash between legal entities, the
Companys objective is to

33

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Index

maintain minimum cash balances on hand while using
available funds to pay down its outstanding line of credit balances.

Net
cash provided by operating activities stems from an estimated $2,705,000 positive cash
infusion associated with implementation of the Canadian distribution agreement in the
second quarter 2005 partially offset by estimated cash used in ongoing operations of
$381,000 (exclusive of a one-time distribution upset fee gain of $164,300 and the $98,000
provision for closure of the skin care manufacturing facility). Of the estimated $381,000
cash used in operations, approximately $125,000 represented cash burn (net losses less non
cash items) and the balance of approximately $256,000 represented cash used from the net
change in operating assets and liabilities. Replenishment of lower than normal inventory
levels for several key products was the major driver behind the net change in ongoing
operating assets and liabilities. Cash provided by operations of approximately $17,000 and
increases in receivables and other assets related to the $164,300 distribution upset fee
also contributed.

Net
cash used in financing activities principally reflects the use of the funds generated from
operating activities to pay down the Companys outstanding line of credit balance by
$2,084,029. Other uses pertain to the debt repayment of $312,142, including, in addition
to normal scheduled payments, a one-time payment of $200,000 in January 2005 related to
the payoff of the outstanding standby letter of credit issued by the U.S. lender in favor
of the Companys Canadian lender as additional security for the Companys credit
facility and deferred financing costs of $116,590 related to refinancing the U.S. line of
credit in January 2005. Partially offsetting these cash uses were net proceeds of $539,415
from the sale of common stock in the first quarter 2005.

Net
cash used in investing activities of $36,881 reflects modest capital investment of $61,879
consistent with the Companys plan to limit capital expenditures to that necessary to
continue running the business until operational performance improves, less proceeds from
the sale of excess equipment.

Working Capital

Working
capital increased $188,159, or 6.6%, at June 30, 2005 to $3,037,755 from $2,849,596 at
December 31, 2004. The increase reflects the net impact of the cash inflows and outflows
outlined in the Cash Flow section above.

Financing Arrangements
 United States

On
January 31, 2005 the Company entered into a three year revolving credit facility agreement
(the New Agreement) with a new U.S. lender for a maximum principal amount of
$2,000,000. The New Agreement replaces a $2,000,000 revolving credit facility that expired
on January 31, 2005 with the previous U.S. lender. At January 31, 2005 maximum potential
advances under the New Agreement were approximately $1,700,000. On January 31, 2005, the
Company applied advances of approximately $1,300,000 under the New Agreement in
satisfaction of the prior U.S. lenders outstanding obligations. Future advances will
be utilized to fund strategic initiatives and general working capital requirements. The
Company incurred loan origination and legal fees of approximately $147,300 in connection
with the implementation of the New Agreement. These fees have been deferred and are being
amortized to interest expense over the three year term of the New Agreement.

The
Company may request advances under the New Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.5%, but not less than 7.5% per annum. At June 30, 2005 the effective interest rate was
8.51%. In addition, the Company pays a monthly collateral management fee at the rate of
1.5% per annum upon the daily average amount of advances outstanding and a monthly unused
line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the new U.S. lender its guarantee of payment together
with a second lien security interest in the assets of the Companys wholly owned
Canadian subsidiary. The new U.S. lender has agreed not to exercise its rights under its
second lien security interest and guarantee against the Canadian assets without the
Canadian lenders approval.

34

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Index

Maximum
potential advances under the New Agreement at June 30, 2005 were $1,696,779. Advances
outstanding against the line were $693,325 at June 30, 2005, leaving an additional
$1,003,454 available for borrowing.

Over
the term of the New Agreement, the Company has agreed to comply with the following
covenants as measured at the end of each month for the average of the three most recent
calendar months based upon its consolidated operating results: a) maintain EBITDA
(earnings before interest, taxes, depreciation and amortization) in the range of negative
$300,000 (as of January 31, 2005) transitioning to positive $600,000 (post December 31,
2005) and (b) maintain its fixed charge ratio (EBITDA divided by the sum of debt service,
capital expenditures, income taxes and dividends) in the range of 1.0 to 1.0 (as of
January 31, 2005) to 1.25 to 1.0 (post December 31, 2005). In addition, as it pertains to
the Companys U.S. operations, cash collections may not be less than $800,000 for
each calendar month through June 30, 2005 and $900,000 for each calendar month thereafter,
and at all times the Companys cash on hand (including unused borrowing capacity
under the New Agreement) must not be less than $200,000. Additional covenants governing
permitted indebtedness, liens, payments of dividends and protection of collateral are
included in the New Agreement.

Based
upon consolidated operating results for March and April 2005, the Company was out of
compliance with its EBITDA and fixed charge ratio covenant under the New Agreement. The
U.S. lender agreed to waive these covenant violations. Effective June 30, 2005 the Company
and the U.S. lender agreed to prospectively amend the Companys monthly minimum
EBITDA and fixed change ratio covenants to better align these covenants with expected
performance. The Company incurred fees of $10,000 associated with the granting of the
covenant amendments. The Company expects to, but cannot assure that it will, maintain
compliance with all applicable loan covenants in the future.

The
Company may terminate the New Agreement at any time after January 31, 2006 by paying all
outstanding indebtedness and any other payments due the U.S. lender and paying the U.S.
lender a yield maintenance based early termination fee equal to the product of: (a) the
effective yield on the facility for the six months prior to termination (expressed as an
annual percentage rate), (b) $2,000,000, and (c) the quotient of the months remaining in
the original term of the New Agreement divided by 12.

On
January 13, 2005, in connection with the refinancing of the U.S. line of credit, the
Company paid off and cancelled the outstanding irrevocable standby letter of credit issued
by the U.S. lender in the amount of $200,000 held by the Companys Canadian lender as
additional security for its credit facility. The $200,000 paid to the Canadian lender was
applied as a permanent principal reduction against the principal amount due in 2007
associated with the Companys outstanding term loan with the Canadian lender.
Subsequently, on January 31, 2005 the Canadian lender agreed as part of refinancing of the
U.S. line of credit to retain its second lien security interest and guarantee position
against the Companys U.S. assets and not to exercise its rights under its second
lien security interest and guarantee against the U.S. assets without the new U.S.
lenders approval.

On
December 30, 2004, the Company paid off the promissory note due Kimberly-Clark Corporation
in the amount of $1,566,000 using the restricted cash on deposit with the U.S. lender of
$1,000,000 and available line capacity. In addition, the irrevocable standby letter of
credit issued on behalf of the Kimberly-Clark Corporation in the amount of $1,566,000 was
cancelled. In connection with this transaction, the maximum principal amount of the line
was reduced from $4,000,000 to $2,000,000. All other terms of the prior agreement remained
in full force and effect.

On
January 30, 2004 the Company entered into a modified one year line of credit agreement
with its previous U.S. lender (the prior agreement). The maximum principal
amount of the line increased to $4,000,000 from $3,000,000. In connection with entering
into this line of credit agreement, the Company deposited $1,000,000 of cash in a
restricted account with the U.S. lender and the U.S. lender issued an irrevocable standby
letter of credit on the Companys behalf for the benefit of Kimberly-Clark
Corporation in the amount of $1,566,000. Advances were used to fund strategic initiatives
and for general working capital purposes. Estimated maximum potential advances under the
prior agreement were equal to the lesser of (A) $4,000,000 or (B) the sum of (i) 80% of
eligible receivables (as defined), (ii) 50% of eligible inventory (as defined), (iii) an
amount equal to the immediate liquidation value of funds deposited with the U.S. lender in
a restricted account as security for any letters of credit

35

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Index

extended by the lender on the
Companys behalf up to $1,000,000, less the aggregate amount of any outstanding
letters of credit issued by the U.S. lender.

Outstanding
advances were secured by all tangible and intangible assets of the Companys U.S.
operations. Over the term of the Agreement, the Company agreed to maintain its fixed
charge ratio (as defined) at not less than 1.25:1.0 as measured quarterly on a twelve
month trailing basis. Additional covenants governing permitted indebtedness, changes in
entity status, purchases of securities and protection of collateral were included in the
Agreement. Ongoing operating losses resulted in the Company being out of compliance with
certain of its U.S. line of credit covenants at March 31, June 30 and September 30, 2004.
In return for a commitment to secure alternative financing for its U.S. obligations prior
to the January 31, 2005 maturity date of the prior agreement, the U.S. lender agreed to
waive the Companys prior covenant violations and to maintain the line of credit
until maturity thereof. The Company has incurred waiver fees of $7,500 and agreed to an
increase in the rate of interest payable under the line. All other terms of the prior
agreement were maintained in full force and effect.

Financing Arrangements
 Canada

In
September 2004, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $1,795,000
($2,200,000 Canadian) with its Canadian lender. The Companys wholly owned Canadian
subsidiary, Derma Sciences Canada Inc., may request advances under the Canadian Agreement
up to the value of 75% of eligible receivables (as defined) plus the lesser of $897,000
($1,100,000 Canadian) or 40% of eligible inventory (as defined), less priority claims.
Interest on outstanding advances is payable monthly in arrears at prime rate (as defined)
plus 1.0%, or 5.25% for Canadian dollar advances and 7.50% for U.S. dollar denominated
advances at June 30, 2005. Outstanding advances are secured by all tangible and intangible
assets of Derma Sciences Canada Inc. In addition, the Company has accorded the Canadian
lender its guarantee of payment together with a second lien security interest in the
Companys assets located in the U.S. Maximum potential advances under the Canadian
agreement at June 30, 2005 were $492,000. Advances outstanding against the Canadian
agreement were zero at June 30, 2005, leaving an additional $492,000 available for
borrowing.

Over
the term of the Canadian Agreement, the Company has agreed to comply with a number of
financial covenants governing minimum working capital, current ratios, tangible net worth,
interest coverage, total indebtedness to tangible net worth and total indebtedness to
adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $408,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default.

At
June 30, 2005 Derma Sciences Canada was out of compliance with its minimum working capital
covenant. The violation occurred due to the adverse impact on Derma Sciences Canadas
working capital associated with accelerating repayment of an inter company loan and
extending credit terms on regular inter company trade receivables to the U.S. parent in
June 2005 in an effort to optimize the use of the positive cash flow associated with
implementing the new distribution agreement in Canada. The violation has been corrected
and the Canadian lender agreed to waive the covenant violation at June 30, 2005.

Losses
principally associated with the write-off of obsolete equipment, employee termination
costs and a revamping of manufacturing operations in Toronto resulted in Derma Sciences
Canada being out of compliance with certain of its income based loan covenants that are
measured annually at December 31, 2004. The Canadian lender agreed to waive the covenant
violations at December 31, 2004. The Company incurred fees of $12,000 associated with the
granting of the waivers in 2004. The Company expects to, but cannot assure that it will,
maintain compliance with all applicable loan covenants in the future.

Prospective Assessment

The
Company seeks to increase sales and gross margins and return to profitability by
increasing sales of contracted private label products and focusing on organic growth of
its core product lines in the U.S. and Canada.

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The recently signed exclusive distribution
agreement in Canada represents an opportunity for sales and profit growth in the second
half of 2005. In the first half of 2005, the Company began to realize the benefit of lower
basic wound care product costs negotiated in mid-2004 and lower advanced wound care costs
associated with the commencement in late 2004 of in-house manufacture of a wide range of
products using the equipment purchased from Kimberly-Clark Corporation. Further, over the
balance of 2005 the Company expects to benefit from the non-recurrence of the one-time
costs incurred in the last half of 2004 associated with bringing the manufacture of the
Kimberly-Clark products on line. Steps have been taken to reduce operating expenses
wherever possible and to limit incremental spending in this area to that necessary to
support existing operations. Operational expenditures will continue to be closely
monitored and adjusted as necessary to ensure alignment with expected sales and margin
growth.

Capital
spending has been, and will continue to be, limited to that necessary to maintain current
operations until the Companys financial performance improves. The Company will
continue to closely monitor inventory levels with the objective of reducing its investment
in inventory wherever possible.

The
Company believes that available funds from expected improving operations and available
lines of credit will be sufficient to satisfy the Companys liquidity requirements
for the foreseeable future. If need be, the Company expects that it would be able to
secure additional equity funding to improve liquidity. In addition, the Company will
continue to evaluate external opportunities to leverage its core capabilities for growth.

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

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, 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,
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 represented in this section.
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. 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. If the
assumptions used to calculate these rebates do not appropriately reflect future activity,
the Companys financial position, results of operations and cash flows could be

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impacted. The Company continually monitors the factors that influence these rebates and
make adjustments as necessary.

Goodwill

At
June 30, 2005, the Companys skin care segment had $1,110,967 of goodwill. 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 the 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.

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.

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Item 3.  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, 2005. 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, 2005, 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.

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Part II  Other
Information

Item 1. Legal Proceedings

None

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 March 31, 2005, 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 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 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 caused this
report to be signed on its behalf by the undersigned thereunto duly authorized.

|                       |  | DERMA SCIENCES, INC.                                                                         
|---------------------- |  | ---------------------------------------------------------------------------------------------
|                       |  |                                                                                              
|                       |  |                                                                                              
|                       |  |                                                                                              
|Dated: August 12, 2005 |  | By:/s/ John E.
     Yetter
         John E. Yetter, CPA
         Chief Financial
     Officer

40

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