---

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
     
     March 31, 2004Commission 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: March 31, 2004 | Class: Common Stock, par value $.01 per share
|-------------------- | ---------------------------------------------
|                     | Shares Outstanding: 9,524,007                

---

DERMA SCIENCES, INC.FORM
10-QSBINDEX

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

Part I - Financial Information

|        |                                                                                                  |   
|------- | ------------------------------------------------------------------------------------------------ | --
|Item 1. | Consolidated Financial Statements                                                                |   
|        |                                                                                                  |   
|        | Consolidated Balance Sheets - March
     31, 2004 and December 31, 2003                          | 3 
|        |                                                                                                  |   
|        | Consolidated Statements of Operations
     - Three months ended March 31, 2004and March 31, 2003 | 4 
|        |                                                                                                  |   
|        | Consolidated Statements of Cash Flows -
     Three months ended March 31, 2004and March 31, 2003 | 5 
|        |                                                                                                  |   
|        | Notes to Consolidated Financial
     Statements                                                  | 6 
|        |                                                                                                  |   
|Item 2. | Management's Discussion and Analysis of
     Financial Condition and Results of Operations       | 17
|        |                                                                                                  |   
|Item 3. | Controls and Procedures                                                                          | 22

Part II - Other Information

|Item 1. | Legal Proceedings                     | 23
|------- | ------------------------------------- | --
|        |                                       |   
|Item 6. | Exhibits and Reports on Form
     8-K | 23
|        |                                       |   

Forward Looking Statements

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

1

---

Index

Part I - Financial Information

Item 1.  FINANCIAL STATEMENTS

2

---

DERMA SCIENCES, INC.Consolidated Balance Sheets

`=====================================================================================================
                                                                           March 31,     December 31,
                                                                             2004            2003
                                                                          (Unaudited)
ASSETS
-----------------------------------------------------------------------------------------------------
Current Assets
  Cash and cash equivalents                                             $    184,918    $    439,837
  Cash, restricted                                                         1,001,125            -
  Accounts receivable, net                                                 2,475,436       2,627,092
  Inventories                                                              4,723,080       4,003,258
  Prepaid expenses and other current assets                                  382,120         351,962
-----------------------------------------------------------------------------------------------------
Total current assets                                                       8,766,679       7,422,149
Property and equipment, net                                                2,794,520       1,077,688
Goodwill                                                                   1,110,967       1,110,967
Other intangible assets, net                                                 478,353         158,604
Other assets, net                                                            140,693         156,765
-----------------------------------------------------------------------------------------------------
Total Assets                                                            $ 13,291,212    $  9,926,173
-----------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
-----------------------------------------------------------------------------------------------------
Current Liabilities
  Line of credit                                                        $  1,051,024    $  1,361,708
  Current maturities of long-term debt                                       202,486         178,720
  Note payable                                                             1,566,000            -
  Accounts payable                                                         1,375,756         731,438
  Accrued expenses and other current liabilities                             471,667         313,315
-----------------------------------------------------------------------------------------------------
Total current liabilities                                                  4,666,933       2,585,181
-----------------------------------------------------------------------------------------------------
Long-term Liabilities
  Long-term debt                                                             929,194         849,981
  Other long-term liabilities                                                228,020            -
-----------------------------------------------------------------------------------------------------
Total long-term liabilities                                                1,157,214         849,981
-----------------------------------------------------------------------------------------------------
Total Liabilities                                                          5,824,147       3,435,162
-----------------------------------------------------------------------------------------------------
Shareholders' Equity
Common stock, $.01 par value, 30,000,000 shares authorized;
  issued and outstanding: 9,524,007 shares at March 31, 2004 and
  7,462,695 shares at December 31, 2003                                       95,240          74,627
Convertible preferred stock, $.01 par value; 11,750,000 shares
  authorized; issued and outstanding: 2,280,407 shares at March 31, 2004
  (liquidation preference of $4,210,231) and 2,284,574 shares at
  December 31, 2003 (liquidation preference of $4,235,233)                    22,804          22,846
Additional paid-in capital                                                18,705,880      16,746,690
Accumulated other comprehensive income                                       266,944         294,185
Accumulated deficit                                                      (11,623,803)    (10,647,337)
-----------------------------------------------------------------------------------------------------
Total Shareholders' Equity                                                 7,467,065       6,491,011
-----------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity                              $ 13,291,212    $  9,926,173
=====================================================================================================`

See accompanying notes.

3

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Index

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

`=====================================================================================================
                                                                              Three months ended
                                                                                   March 31,
                                                                             2004            2003
-----------------------------------------------------------------------------------------------------
Net sales                                                               $  5,029,422     $ 4,216,239

Cost of sales                                                              3,579,613       2,689,229
-----------------------------------------------------------------------------------------------------
Gross Profit                                                               1,449,809       1,527,010
-----------------------------------------------------------------------------------------------------
Operating expenses                                                         2,261,958       1,455,097
Interest expense, net                                                         46,667         113,439
Other expense (income), net                                                  117,650         (49,596)
-----------------------------------------------------------------------------------------------------
Total Expenses                                                             2,426,275       1,518,940
-----------------------------------------------------------------------------------------------------
(Loss) income before provision for income taxes                             (976,466)          8,070
Provision for income taxes                                                     -               -
-----------------------------------------------------------------------------------------------------
Net (Loss) Income                                                       $   (976,466)   $      8,070
-----------------------------------------------------------------------------------------------------
(Loss) income per common share - basic and diluted                            ($0.11)          $0.00
-----------------------------------------------------------------------------------------------------
Shares used in computing (loss) income per common share - basic            8,809,151       4,631,276
-----------------------------------------------------------------------------------------------------
Shares used in computing (loss) income per common share - diluted          8,809,151       7,174,116
=====================================================================================================`

See accompanying notes.

4

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Index

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

`====================================================================================================
                                                                              Three months ended
                                                                                    March 31,
                                                                              2004            2003
----------------------------------------------------------------------------------------------------
Operating Activities
    Net (loss) income                                                   $  (976,466)    $     8,070
    Adjustments to reconcile net (loss) income to
      net cash used in operating activities:
       Depreciation                                                          73,917          37,206
       Amortization                                                          44,208          74,072
       Deferred financing costs                                               -               7,500
       Provision for bad debts and rebates                                   53,492           5,176
       Provision for inventory obsolescence                                  77,400          12,000
       Loss on disposal of property and equipment                            94,428           2,132
       Changes in operating assets and liabilities:
           Restricted cash                                               (1,001,125)           -
           Accounts receivable                                              124,104         (31,709)
           Inventories                                                     (822,688)        (41,184)
           Prepaid expenses and other current assets                        (30,871)       (129,439)
           Other assets                                                       9,430          (6,893)
           Accounts payable                                                 648,367         165,185
           Accrued expenses and other current liabilities                   160,443        (192,548)
           Long-term liabilities                                            225,844            -
----------------------------------------------------------------------------------------------------
Net cash used in operating activities                                    (1,319,517)        (90,432)
----------------------------------------------------------------------------------------------------
Investing Activities
    Cash paid for wound care business                                      (376,510)           -
    Purchases of property and equipment                                    (135,880)        (26,572)
----------------------------------------------------------------------------------------------------
Net cash used in investing activities                                      (512,390)        (26,572)
----------------------------------------------------------------------------------------------------
Financing Activities
    Net change in bank line of credit                                      (292,497)       (817,548)
    Deferred financing costs                                                (60,617)        (19,757)
    Long-term debt repayments                                               (44,083)        (65,929)
    Proceeds from issuance of stock, net of issuance costs                1,979,761          (5,642)
----------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities                       1,582,564        (908,876)
----------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash equivalents                 (5,576)            949
----------------------------------------------------------------------------------------------------
Net decrease in cash and cash equivalents                                  (254,919)     (1,024,931)

Cash and cash equivalents
  Beginning of period                                                       439,837       1,496,357
----------------------------------------------------------------------------------------------------
  End of period                                                         $   184,918     $   471,426
----------------------------------------------------------------------------------------------------

Supplemental cash flow information:
  Note payable for acquisition of Kimberly-Clark wound care assets      $ 1,566,000            -
  Equipment obtained  with capital lease                                $   159,097            -
====================================================================================================`

See accompanying notes.

5

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

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 consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States 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 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 month period ended March 31, 2004, are not necessarily indicative of
the results that may be expected for the year ending December 31, 2004. For further
information, refer to the consolidated financial statements and footnotes thereto for the
year ended December 31, 2003, included in Form 10-KSB 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.

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 component of shareholders
equity in accumulated other comprehensive income (loss).

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

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. The
Company performs periodic evaluations of the relative credit standing of those financial
institutions, and the Companys policy is designed to limit exposure to any one
institution. The Companys accounts receivable 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.

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.

6

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Property
and Equipment  Property and equipment 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 depreciated 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.

Intangible
Assets  Patents and trademarks and other intangible assets are stated on the basis
of cost. Patents and trademarks are amortized over 12 to 17 years on a straight-line
basis. Other intangible assets are amortized over 5 years on a straight line basis.

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 (SFAS No. 142), Goodwill and
Other Intangible Assets 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 2003
and determined that the goodwill carrying value was not impaired. A similar review will be
performed in the fourth quarter of 2004.

Long
Lived Assets  In accordance with SFAS 144, Accounting for Impairment or
Disposal of Long Lived Assets the Company reviews its long-lived assets 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.

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 determination of stock-based compensation expense or to
continue with the provisions of APB No. 25, Accounting for Stock Issued to
Employees 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 equals or exceeds the market price of the
underlying Common Stock on the date of grant, generally no compensation expense is
recognized. The Company has issued common stock options to certain executives with vesting
contingent upon the achievement of performance targets. These options could result in a
compensation charge in the future based on the difference between the exercise price of
the options and the market price of the Companys common stock if the performance
targets are met and the options vest.

Pro
forma information regarding net income (loss) and earnings (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 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 2004 and 2003:
risk-free interest rate of 4.0%, dividend yield of 0%; a volatility factor of the expected
market price of the Companys Common Stock of 1.463 and 1.663, respectively; 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.

7

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

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:

`Quarter Ended March 31,
                                                                        ----------------------------
                                                                              2004         2003
                                                                        ------------    ------------

         Net (loss) income - as reported                                $  (976,466)    $     8,070
         Pro forma compensation expense                                    (181,906)        (81,247)
                                                                        ------------    ------------
         Pro forma net loss                                             $(1,158,372)    $   (73,177)
                                                                        ============    ============

         Income (loss) per common share - basic and diluted
             As reported                                                     $(0.11)          $0.00
             Pro forma                                                       $(0.13)         $(0.02)`

Income
Taxes  The Company accounts for taxes using an asset and liability approach. The
asset and liability approach requires the recognition of deferred tax assets and
liabilities for the expected future tax consequences of temporary differences between the
financial reporting and tax basis of assets and liabilities.

Revenue
Recognition  The Company operates in three segments: wound care, wound
closure-fasteners and skin care. Sales are recorded when product is shipped and title
passes to customers. Gross sales are adjusted for cash discounts, Medicaid rebates and
trade rebates to derive net sales. Freight costs to ship product to customers are recorded
as a component of cost of sales. Freight costs billed to and reimbursed by customers are
recorded as a component of revenue.

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 other common stock equivalents, including stock options,
warrants and convertible preferred stock in the weighted average number of common shares
outstanding for a period, if dilutive.

Reclassifications
 Certain reclassifications have been made to prior year amounts reported to conform
with the 2004 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 assets acquired consist of manufacturing equipment, product rights and
other intangibles. The purchase price for the assets was $1,942,510 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) $76,410 incurred for transaction costs. The
purchase price has been preliminarily allocated to equipment in the amount of $1,600,000
and intangible assets (Note 6) in the amount of $342,510 based upon these assets
estimated fair values.

During
the first quarter 2004, the Kimberly-Clark wound care product line generated $630,523 in
net sales. 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 is discontinued and the equipment is transferred to the
Companys facility in Toronto, Canada. Upon cessation of manufacturing at
Kimberly-Clarks facility, the Company will purchase, 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 is estimated to be
$600,000. Cash on hand and borrowings against available credit lines will be used to pay
for this inventory.

8

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

The
Company expects that it will take three months from the date of cessation of manufacturing
at Kimberly-Clark to transfer, install and validate the equipment and commence
manufacturing in Toronto, Canada. The cost to complete the transfer is estimated at
$560,000. The majority of this cost is expected to be capitalized.

The
unaudited pro forma information below presents results of operations as it the acquisition
had occurred on January 1, 2003. The pro forma information is based on historical results
and is not necessarily indicative of the operations of the combined entity had the
acquisition occurred on January 1, 2003 , nor is it necessarily indicative of future
results. Pro forma results for 2004 have not been presented as the acquisition occurred on
January 9, 2004 and the recorded results would not have been materially different had the
acquisition occurred on January 1, 2004.

`Three Months Ended March 31, 2003

         Net sales                                                  $4,750,000
         Net loss                                                    $(315,000)
         Loss per common share-basic and diluted                        $(0.07)`

3. Accounts Receivable

Accounts
receivable include the following:

`March 31, 2004   December 31, 2003
                                                     --------------   -----------------

        Trade accounts receivable                      $2,615,638        $2,802,985
        Less:  Allowance for doubtful accounts            (46,518)          (35,785)
               Allowance for trade rebates               (195,000)         (212,000)
                                                       -----------       -----------
             Net trade receivables                      2,374,120         2,555,200
        Other receivables                                 101,316            71,892
                                                       -----------       -----------

             Total receivables                         $2,475,436        $2,627,092
                                                       ===========       ===========`

The allowance for trade
rebates reflects estimated rebates embedded in outstanding trade receivables.

4. Inventories

Inventories
include the following:

`March 31, 2004   December 31, 2003
                                                     --------------   -----------------

        Finished goods                                 $3,539,719        $2,814,651
        Work in process                                   131,604           172,536
        Packaging materials                               343,210           307,635
        Raw materials                                     708,547           708,436
                                                       -----------       -----------

             Total inventory                           $4,723,080        $4,003,258
                                                       ===========       ===========`

9

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

5. Property and Equipment

Property
and equipment include the following:

`March 31, 2004   December 31, 2003
                                                     --------------   -----------------

        Machinery and equipment                        $2,996,756        $1,277,352
        Furniture and fixtures                            189,681           183,967
        Leasehold improvements                            106,487            49,541
                                                       -----------       -----------
             Gross property and equipment               3,292,924         1,510,860
        Less:  accumulated depreciation                  (498,404)         (433,172)
                                                       -----------       -----------

             Net property and equipment                $2,794,520        $1,077,688
                                                       ===========       ===========`

Machinery and equipment
increased in the quarter ended March 31, 2004 due principally to the acquisition of Kimberly-Clark Corporation's wound care
assets. The Company recorded a charge of $94,428 in the quarter ended March 31, 2004 related to the disposal of obsolete
equipment.

6. Other Intangible Assets, net

`March 31, 2004   December 31, 2003
                                                     --------------   -----------------

        Patents and trademarks                         $  444,067        $  444,067
        Other intangible assets                           383,077            40,567
                                                       -----------       -----------

             Gross other intangible assets                827,144           484,634
             Less: accumulated amortization              (348,791)         (326,030)
                                                       -----------       -----------

             Other intangible assets, net              $  478,353        $  158,604
                                                       ===========       ===========`

Intangible assets increased
in the quarter ended March 31, 2004 due to the acquisition of Kimberly-Clark Corporation's wound care assets.

7. Other Assets, net

Other assets, net include the
following:

`March 31, 2004    December 31, 2003
                                                     --------------   -----------------

        Deferred financing costs, net                  $   71,322        $    77,415
        Deposits                                           69,371             69,834
        Other                                                -                 9,516
                                                       -----------       -----------

             Total other assets, net                   $  140,693        $   156,765
                                                       ===========       ===========`

10

---

Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

8. Short Term Borrowings

Short
term borrowings include the following:

`March 31, 2004   December 31, 2003
                                                     --------------   -----------------

        U.S. line of credit                                  -                 -
        Note payable - Kimberly-Clark Corporation      $1,566,000              -
        Canadian line of credit                         1,051,024        $1,361,708
                                                       -----------       -----------

             Total short-term borrowings               $2,617,024        $1,361,708
                                                       ===========       ===========`

U.S.
Line of Credit

In
March 2003 the Company entered into a one year line of credit agreement (subject to annual
renewal) with a U.S. lender (the Agreement) for a maximum principal amount of
$2,000,000. On December 24, 2003, the Company entered into a new one year line of credit
agreement with its U.S. lender for a maximum principal amount of $3,000,000. The Company
terminated its prior U.S. line of credit on February 28, 2003 by repaying the $1,000,000
outstanding indebtedness and paying a $50,000 early termination fee. In addition, the
Company charged $66,342 to interest expense during 2003 for deferred financing costs
associated with the prior U.S. line of credit.

On
January 30, 2004 the Company entered into a new one year line of credit agreement with its
U.S. lender. The maximum principal amount of the line increased to $4,000,000 from
$3,000,000. No funds were drawn against the line at March 31, 2004. Advances will be used
to fund strategic initiatives and for general working capital purposes. Estimated maximum
potential advances under the agreement are 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
extended by the lender on the Companys behalf up to $1,000,000, less the aggregate
of any outstanding letters of credit issued by the lender. Interest on outstanding
advances is payable monthly in arrears at the one month LIBOR rate (as published in
The Wall Street Journal), plus 3.0%, or 4.1% at March 31, 2004. In addition,
the Company paid an annual line fee of $40,000. This line fee and any one-time lender or
legal costs associated with securing the line of credit will be deferred and amortized to
interest expense over the line term of one year.

In
connection with entering into the new line of credit agreement in January 2004, the
Company deposited $1,000,000 of cash in a restricted account with the U.S. lender and the
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.

Outstanding
advances are secured by all tangible and intangible assets of the Companys U.S.
operations. Over the term of the Agreement, the Company has 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, purchase of securities and protection of collateral are included in the
Agreement. Outstanding standby letters of credit, less the restricted cash, serve to
reduce the Companys potential borrowing capacity under the Agreement by $766,000.

The
first quarter 2004 operating loss resulted in the Company being out of compliance with
certain U.S. line of credit covenants at March 31, 2004. The U.S. lender agreed to waive
the covenant violations at March 31, 2004 and adjust the covenants prospectively. The
Company anticipates that it will be able to comply with the adjusted covenants for the
foreseeable future.

Note
Payable  Kimberly-Clark Corporation

The
Kimberly-Clark Corporation and the Company amended the January 9, 2004 purchase agreement
on January 30, 2004. This amended agreement provides for payment of the $1,566,000 balance
due in accordance with an amended promissory note, secured by an irrevocable letter of
credit issued by the Companys lender, requiring a single payment of $1,566,000,
without interest, on or before December 31, 2004.

11

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Canadian
Line of Credit

On
December 30, 2003, the Company renewed its revolving credit facility agreement (the
Dumex Agreement) for a maximum principal amount of $1,675,000 with a Canadian
bank. The renewed credit facility expires on December 31, 2004. The Companys wholly
owned Canadian subsidiary, Dumex Medical Canada Inc., may request advances under the Dumex
Agreement up to the value of seventy-five percent (75%) of its eligible receivables (as
defined) and fifty percent (50%) of eligible inventory (as defined) up to a maximum of
$725,000. Interest on outstanding advances is payable monthly at the prime rate (as
defined) plus 1.0%, or 5.5% for advances outstanding at March 31, 2004. Outstanding
advances are secured by all tangible and intangible assets of Dumex Medical Canada Inc. In
addition, the Canadian bank has a second lien security interest in the assets of the
Companys U.S. operations. The Company has also guaranteed payment of amounts due
under the Dumex Agreement.

Over
the term of the Dumex 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. These covenants are measured at the end of each month.
Additional covenants governing permitted indebtedness, liens, payments of dividends and
protection of collateral are included in the Dumex Agreement. In the event of a margin
deficiency (as defined) or covenant violation, the Company is required to advance up to an
additional $380,000 of working capital to Dumex Medical 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.

As
security for indebtedness of the Companys subsidiary, Dumex Medical Canada Inc., the
Company has accorded a Canadian bank its guarantee of payment together with a second lien
security interest in the Companys assets located in the U.S. In connection with the
Dumex Agreement and in return for a standby letter of credit in the amount of $200,000
against the Companys U.S. line of credit, the Canadian bank has agreed not to
exercise its rights under its second lien security interest and guarantee against the
Companys U.S. assets without the U.S. lenders approval.

A
$450,000 charge for employee termination costs resulted in Dumex being out of compliance
with certain of its loan covenants at March 31, 2004. The Canadian bank agreed to waive
the covenant violations at March 31, 2004 and adjust the covenants prospectively. The
Company anticipates that it will be able to comply with the adjusted covenants for the
foreseeable future.

9. Long-Term Debt

Long-term debt includes the
following:

`March 31, 2004   December 31, 2003
                                                     --------------   -----------------

        Canadian term loan                             $   970,792       $1,025,839
        Capital lease obligations                          160,888            2,862
                                                       ------------      -----------

             Total debt                                  1,131,680        1,028,701
        Less:  current maturities                          202,486          178,720
                                                       ------------      -----------

             Long-term debt                            $   929,194       $  849,981
                                                       ============      ===========`

12

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

In
connection with the acquisition of substantially all the assets of Dumex Medical Inc. in
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 5.25% at March 31, 2004. The term loan is secured by all tangible
and intangible assets of Dumex Medical Canada Inc. and subject to the same financial
covenants applicable to the operating line of credit (See Note 8).

The
Company has two capital lease obligations for certain distribution equipment totaling
$159,097 and manufacturing equipment for $1,791. The distribution and manufacturing
equipment capital leases bear interest at annual rates of 8.2% and 10.75%, respectively,
and expire in April 2009 and August 2004, respectively.

10. Shareholders Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding. 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. 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. 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. 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.

Stock
Purchase Warrants

At
March 31, 2004, the Company had warrants outstanding to purchase 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`

Other
Equity Transactions

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 of $1,979,761, net of $180,239 in
offering expenses, will be used to fund strategic initiatives and for general working
capital purposes.

13

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

In
June 2003, the Company closed a private offering of 4,000,000 shares of its common stock
at a price of $0.50 per share. Total offering proceeds of $1,879,810, net of $120,190 in
offering expenses, were used to fund strategic initiatives and for general working capital
purposes.

In
March 2004, 4,167 shares of series B preferred stock were converted into 4,167 shares of
common stock. In July 2003, a total of 241,668 shares of series B, C and D preferred stock
were converted into 241,668 shares of common stock.

11. Comprehensive (Loss) Income

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

`Quarter Ended March 31,
                                                           -----------------------
                                                             2004             2003
                                                           --------        --------

         Net (loss) income - as reported               $  (976,466)      $    8,070
         Other comprehensive (loss) income:
             Foreign currency translation adjustment       (27,241)         106,167
                                                       ------------      -----------

         Comprehensive (loss) income                   $(1,003,707)      $  114,237
                                                       ============      ===========`

12. 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.

14

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Segment
sales and gross profit for the three months ended March 31, 2004 and 2003 are as follows:

`Three Months Ended March 31, 2004
                                    ---------------------------------

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

Net sales                $3,609,348     $958,269    $  461,805           -         $ 5,029,422
                         ----------     --------    ----------    ------------     ------------

Gross profit                880,975      469,451        99,383           -           1,449,809
Total expenses                 -            -             -       $(2,426,275)      (2,426,275)
                                                                                    -----------
Net loss                                                                           $  (976,466)
                                                                                   ============
Net long-lived assets    $2,818,342         -       $1,338,848    $   226,650      $ 4,383,839
                         ==========     ========    ==========    ============     ============



                                    Three Months Ended March 31, 2003
                                    ---------------------------------

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

Net sales                $2,810,985     $845,256      $559,998           -         $ 4,216,239
                         ----------     --------    ----------    ------------     ------------

Gross profit                965,121      394,434       167,455           -           1,527,010
Total expenses                 -            -             -       $(1,518,940)      (1,518,940)
                                                                                    -----------
Net income                                                                         $     8,070
                                                                                   ============
Net long-lived assets    $  970,946         -       $1,274,758    $   35,732       $ 2,281,436
                         ==========     ========    ==========    ============     ============`

Long-lived
assets consist of property and equipment, patents and trademarks, other intangible assets
and goodwill. Wound care long-lived assets consist principally of Dumex Medical Canada
Inc., property and equipment and other intangible assets acquired in the 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 property and equipment associated therewith. Corporate headquarters and
the Companys U.S. distribution center property and equipment are included in the
other costs column since they service all three business segments.

The
following table presents net sales by geographic region.

`Three Months Ended March 31,
                                                    ----------------------------
                                                       2004            2003
                                                     --------        --------

                      United States                     56%             46%
                      Canada                            40%             49%
                      Rest of world                      4%              5%`

13. Income Taxes

No
provision for income taxes has been made in either the first quarter 2004 and 2003 given
the Companys loss in 2004 and the available net operating loss carryforwards. A
benefit has not been recorded as the realization of the net operating losses is not
assured.

15

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Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

At
December 31, 2003, the Company has net operating loss carryforwards of approximately
$6,750,000 for federal income tax purposes that begin to expire in years 2012 through
2020. For state income tax purposes, the Company has net operating loss carryforwards of
approximately $6,750,000 that expire in years 2004 through 2010. As of December 31, 2003,
the Company has foreign net operating loss carryforwards of approximately $157,000 which
begin to expire in 2009. The timing in which the Company can utilize its 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.

14. Distribution Agreement

As
of November 23, 1999 the Company entered into a 4 year agreement to serve as the exclusive
distributor in the United States for certain catheter fasteners. The manufacturer of the
fasteners has given the Company the required nine months notice of its intention not to
renew the agreement in its present form. Accordingly, the Companys rights under the
current agreement will terminate on August 23, 2004. The parties are presently engaged in
negotiations with a view to executing a new agreement. However, no assurance can be given
that these negotiations will prove successful. Annual sales of catheter fasteners under
the current agreement aggregate approximately $750,000.

15. Employee Termination Costs

On
March 9, 2004 the Company terminated the employment of its Executive Vice President and
President of its Dumex Medical Canada Inc. subsidiary. The Company has 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. Given that the payout (if any) will be made over a period of
up to twenty-four months, the liability has been 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. The Company is presently investigating possible defenses to the payment
of such severance and costs.

16

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Index

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

Quarter Ended March 31, 2004
Compared to Quarter Ended March 31, 2003.

Results of Operations

The
first quarter 2004 and 2003 operating results include the financial results of Derma
Sciences, Inc. and its subsidiaries. Unless otherwise indicated by the context, the term
Dumex is used throughout this discussion in reference to the operations of Dumex Medical
Canada Inc. and the term Derma is used throughout this discussion in reference to the
operations of the Company excluding Dumex.

The
following table highlights the 2004 and 2003 operating results:

`Quarter Ended March 31,
                                               -----------------------
                                                 2004          2003             Variance
                                                 ----          ----             --------

     Net sales                               $5,029,422    $4,216,239      $ 813,183    19%
     Gross profit                             1,449,809     1,527,010        (77,201)   (5%)
     Operating expenses                       2,261,958     1,455,097        806,861    55%
     Interest expense, net                       46,667       113,439        (66,772)   59%
     Other (income) expense, net                117,650       (49,596)       167,246     -
                                             -----------   -----------     ----------
     Total expenses                           2,426,275     1,518,940        907,335    60%
     (Loss) income before income taxes         (976,466)        8,070       (984,536)    -
     Provision for income taxes                    -             -              -        -
                                             -----------   -----------     ----------

     Net (loss) income                       $ (976,466)   $    8,070      $(984,536)    -
                                             ===========   ===========     ==========`

Net sales
increased $813,183, or 19%, to $5,029,422 in the first quarter 2004 from $4,216,239 in the
first quarter 2003. The increase in first quarter 2004 versus 2003 net sales is primarily
attributable to Kimberly-Clark Corporations wound care product sales, commencement
of private label sales to distributors and strong growth of the recently introduced
Silverlon product line. In addition, the first quarter 2004 versus 2003 benefited from
higher sales in the United States of Dumex products in the United States, partially offset
by lower sales of the Derma and Sunshine product lines. The increase in Dumex and private
label wound care sales is a result of the Companys decision to focus a significant
portion of its sales and marketing resources on expanding the U.S. business of these
product lines. The decrease in Derma wound care sales in the first quarter of 2004 was
principally attributable to an aggressive sales incentive program at the end of 2003
resulting in reduced sales of these products in the first quarter 2004. Sunshine product
line sales decreased as a result of continuing market pressures.

Dumex
Canada first quarter 2004 versus 2003 sales decreased 5% on a local currency basis. Dumex
Canada wound care sales increased 10%, as a result of increased sales to hospital buying
groups. The Dumex Canada private label line decreased 96% due to a loss of this business
in early 2003 and a cessation of narcotics sales (versus $26,655 in 2003) due to the sale
of this product line in December 2003. On a U.S. dollar basis, the first quarter 2004
Dumex Canada sales increased 9% to $1,995,253 from $1,833,741. This increase is primarily
attributable to the strengthening of the Canadian versus the U. S. dollar comparing the
first quarter 2004 versus 2003 quarterly average exchange rates.

Gross
profit in the first quarter 2004 versus 2003 decreased $77,201, or 5%, to $1,449,809
versus $1,527,010. Overall gross profit percentages were 29% and 36% in 2004 and 2003,
respectively. The decrease in the gross profit percentage is attributable to the
increasingly higher percentage of lower margin Dumex and private label sales, a decrease
in sales of the higher margin Derma product line (due to higher than normal customer
inventory levels as a result of customer purchases associated with the 2003 year-end
incentive program), higher traditional wound care costs and a $60,000 write-off of
unsaleable inventory.

With
respect to the Derma product lines, first quarter 2004 versus 2003 gross profit margins
declined 19% in the Derma wound care line due to unfavorable product mix and a $60,000
write-off of unsaleable inventory and decreased 8% in the skin care product line due to
the adverse impact of lower sales volume on operational efficiency and fixed overhead
absorption. The Kimberly-Clark wound care product sales generated a first quarter 2004
gross margin of 24%.

17

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Index

The
Dumex product line gross margin improved in the first quarter of 2004 to 24% from 21% in
2003. This improvement is attributable to the strengthening of the Canadian versus United
States dollar which favorably impacted sales and resulted in cost savings on U.S. dollar
denominated inventory purchases which constitute a significant percentage of total Dumex
product inventory cost.

Operating
expenses increased $806,861, or 55%, to $2,261,958 in the first quarter of 2004 from
$1,455,097 in the first quarter of 2003. Derma warehouse expenses increased 130% in 2004
primarily attributable to a one-time $50,000 expense provision to close the Old Forge,
Pennsylvania distribution center effective March 31, 2004, and start-up costs for the new
Fenton, Missouri distribution center that became operational in early March 2004.

Derma
marketing expenses increased 88% in 2004 versus 2003 as a result of the hiring of a
marketing director, along with increased trade show and promotional activities. In 2004,
Derma selling expenses increased 19% primarily reflecting higher compensation relating to
the annualized impact of 2003 staff additions and higher sampling costs. Derma general and
administrative expenses increased 25% in 2004 versus 2003 primarily reflecting higher
insurance, legal, public relations and recruitment costs.

Dumex
operating expenses increased 100% principally as a result of a $450,000 provision for
severance, benefits and other costs associated with the discharge of the former Dumex
President. Excluding this charge, first quarter 2004 versus 2003 expenses declined 11% on
a local currency basis and increased 1% on a U.S. dollar basis. The first quarter 2004
decline in operating expenses on a local currency basis reflects closure of Dumexs
U.S. distribution facility in June 2003 as part of the U.S. distribution rationalization
and a reduction in customer service costs as resources dedicated to support the U.S.
business were eliminated in the second quarter 2003 in connection with the transfer of
this responsibility to the U.S. These savings were partially offset by higher selling
expenses to more aggressively promote Dumexs product in the Canadian market.

Interest
expense, net decreased $66,772 to $46,667 in the first quarter of 2004 from $113,439 in
2003. The decrease is principally attributable to the February 2003 termination of the
Companys existing U.S. line of credit facility resulting in the write-off of $66,342
of deferred financing costs.

Other
expense, net increased $167,246 to $117,650 in the first quarter 2004 from $49,596 income
in the first quarter 2003. The change is primarily attributable to the incurrence in 2004
of a $94,428 loss on disposal of fixed assets. The first quarter 2003 other income was
driven by one-time items relating primarily to an IRS payroll tax settlement and
slow-moving inventory sales that were not repeated in 2004.

Given
available net operating loss carryforwards, no provision for income taxes has been made in
the first quarters of 2004 and 2003. A benefit has not been recorded as the realization of
the net operating losses is not assured.

The
Company incurred a $976,466 loss or ($0.11) per share (basic and diluted) in the first
quarter 2004, compared to net income of $8,070 or $0.00 per share (basic and diluted) in
the first quarter 2003.

Liquidity
and Capital Resources

At
March 31, 2004 and December 31, 2003, the Company had cash and cash equivalents of
$184,918 and $439,837, respectively. The $254,919 decrease in cash resulted from net cash
used in operating activities of $1,319,517 and net cash used in investing activities of
$512,390, partially offset by net cash provided by financing activities of $1,582,564.
Excluding $1,001,125 of restricted cash set aside to collateralize the Kimberly-Clark note
payable, net cash used in operating activities was $318,392. This net use of cash stems
principally from the net loss experienced in the first quarter, offset by non-cash charges
and cash generated from the net change in operating assets and liabilities.

18

---

Index

A
planned increase in inventory to support sales growth, partially offset by a corresponding
increase in accounts payable, were the major factors behind the favorable change in
operating assets and liabilities. The $450,000 charge for employee termination costs
recorded as an accrued liability also contributed to the quarters loss. Net cash
used in investing activities relates to $376,510 cash paid during the quarter incident to
acquisition of the Kimberly-Clark Corporation wound care assets and $135,880 for purchases
of property and equipment. Net cash provided by financing activities consisted of net
proceeds of $1,979,761 from the sale of common stock during the quarter, offset by line of
credit and term loan debt repayment of $336,580 and deferred financing costs of $60,617
related to annual fees associated with the U.S. line of credit and outstanding letters of
credit.

Working
capital decreased $737,222 at March 31, 2004 to $4,099,746 from $4,836,968 at December 31,
2003. Coupled with the overall decrease in cash, the main factors behind the decrease in
working capital are the $1,566,000 seller financed Kimberly-Clark Corporation note payable
due on or before December 31, 2004 offset by the increase in restricted cash of $1,001,125
which has been set aside to pay this note.

The
Company renewed its revolving credit facility agreement to fund Dumexs day-to-day
operations on December 31, 2003. Maximum potential advances under the agreement at March
31, 2004 were $1,462,000. Advances outstanding against the credit facility were $1,051,024
at March 31, 2004, leaving an additional $410,976 available for borrowing. The $450,000
charge for employee termination costs resulted in Dumex being out of compliance with
certain of its loan covenants. The Canadian bank agreed to waive the covenant violations
at March 31, 2004 and adjust the covenants prospectively. The Company anticipates that it
will be able to comply with the adjusted covenants for the foreseeable future.

On
January 9, 2004, the Company purchased the Kimberly-Clark Corporation wound care assets
for total consideration to date of $1,942,510. The consideration consisted of cash of
$376,510 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
$76,410 for acquisition related costs. Future acquisition related costs are not expected
to be significant. The equipment purchased will be transferred and installed in the
Companys manufacturing facility in Toronto, Canada in the second quarter 2004.
Estimated costs, the majority of which will be capitalized, to complete the transfer,
installation and validation of the equipment are $560,000.

Kimberly-Clark
Corporation 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 is
discontinued and the equipment is transferred to the Companys facility in Toronto,
Canada. Upon cessation of manufacturing at Kimberly-Clarks facility, the Company
plans to purchase inventory consisting of specified raw and packaging materials and up to
four months supply of finished goods. The purchase price of this inventory is estimated to
be $600,000.

On
January 30, 2004 the Company entered into a new one year line of credit agreement with its
U.S. lender. The maximum principal amount of the line increased to $4,000,000 from
$3,000,000. Estimated maximum potential advances under the agreement are 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 extended by the lender on the Companys behalf up
to $1,000,000, less the aggregate of any outstanding letters of credit issued by the
lender. All other items and conditions of the agreement remained unchanged. In connection
with entering into the new line of credit agreement, the Company deposited cash in the
amount of $1,000,000 in a restricted account with the U.S. lender and the 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. Total letters of credit
outstanding at March 31, 2004 were $1,766,000.

Estimated
maximum potential advances under the new line of credit agreement at March 31, 2004 were
$1,120,000. There are presently no advances outstanding against the line of credit.
Advances will be utilized for general working capital purposes and to fund capital
improvements. The restricted cash of $1,000,000, together with cash on hand or available
line borrowing capacity, will be utilized to pay the $1,566,000 Kimberly-Clark Corporation
promissory note due December 31, 2004.

19

---

Index

The
first quarter 2004 operating loss resulted in the Company being out of compliance with
certain U.S. line of credit covenants at March 31, 2004. The U.S. lender agreed to waive
the covenant violations at March 31, 2004 and adjust the covenants prospectively. The
Company anticipates that it will be able to comply with the adjusted covenants for the
foreseeable future.

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 will be used to fund the
acquisition of the Kimberly-Clark Corporation wound care assets and for general working
capital purposes. Offering proceeds of $1,979,761, net of offering expenses of $180,239,
have been received.

On
March 9, 2004 the Company terminated the employment of its Executive Vice President and
President of its Dumex Medical Canada, Inc subsidiary. The Company has recorded an
estimated charge of $450,000 representing severance, benefits and other costs associated
with this termination. The Company is presently investigating possible defenses to the
payment of such severance and costs. Payout (if any) will be made over a period of up to
twenty-four months.

During
the first quarter 2004, the Company entered into capital and operating leases totaling
$290,300 with terms ranging from three to five years for equipment at the new distribution
center that opened in March 2004 and upgrades to the Company-wide telecommunications and
information technology equipment.

Prospectively,
the Company seeks to increase sales and return to profitability by, among other
initiatives, completing the integration of the Kimberly-Clark Corporation wound care
assets in to the Companys operations, increasing the sale of contracted private
label products to distributors, increasing in-house manufacture of selected products
presently purchased from third parties, continuing growth of Dumex product line sales in
the U.S. and focusing on organic growth of its core product lines in the U.S. and Canada.
Incremental capital will be required to support planned sales growth and the upgrade of
the Companys manufacturing capabilities and cost effectiveness.

Sales
and profitability are projected to improve over the balance of the year. Operating
expenses will be closely monitored and balanced with gross margin growth.

Among
the sources of capital the Company expects to utilize to finance its growth plans are
improved profitability, close management of working capital requirements and prudent
utilization of available lines of credit and leasing. Strategically, the Companys
plan is to stay focused on its base business while evaluating external opportunities to
leverage its core capabilities for growth. The Company believes that available funds from
operations coupled with its available lines of credit will be sufficient to satisfy the
Companys capital requirements for the foreseeable future.

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 near 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.

20

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Index

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 us, there may also be
other reasonable estimates or assumptions. We believe, however, that given current facts
and circumstances, it is unlikely that applying any such other reasonable judgment would
cause a material adverse effect on our consolidated results of operations, financial
position or cash flows for the periods represented in this section. Our 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. When we recognize
revenue from the sale of our products, we simultaneously adjust revenue for estimated
trade rebates. A trade rebate represents the difference between our 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 our wholesale and indirect customers and other
competitive factors. If the assumptions we used to calculate these rebates do not
appropriately reflect future activity, our financial position, results of operations and
cash flows could be impacted. We continually monitor the factors that influence these
rebates and make adjustments as necessary.

Goodwill

At
March 31, 2004, 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.

21

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Index

Item 3.  CONTROLS AND PROCEDURES

The
Companys management, including the Chief Executive Officer and Chief Financial
Officer, have conducted an evaluation of the effectiveness of disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based on the evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the disclosure controls and
procedures are effective in ensuring that all material information required to be filed in
this quarterly report has been made known to them in a timely fashion. There have been no
significant changes in internal controls, or in factors that could significantly affect
internal controls, subsequent to the date the Chief Executive Officer and Chief Financial
Officer completed their evaluation.

22

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Index

Part II  Other
Information

Item 1. Legal Proceedings

None

Item 6. Exhibits and Reports on Form
8-K

(a)  
          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, 2004, 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

(b)     
Reports on Form 8-K. Form 8-K was filed on January 23, 2004, and amended on January 26, 2004, February 6, 2004 and March 23,
2004, relative to the Registrants acquisition of the wound care assets of Kimberly-Clark Corporation. Form 8-K was filed on
March 8, 2004, relative to the Registrants consummation of a private placement of its securities.

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: May 14, 2004 |  | By:/s/ John E.
     Yetter
         John E. Yetter, CPA
         Chief Financial
     Officer

23

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