---

UNITED STATESSECURITIES 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, 2006Commission 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 [  ]

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

Yes [  ]    
No [X]

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

|                  |        |                                       
|----------------- | ------ | --------------------------------------
|Date: May 1, 2006 | Class: | Common Stock, par value $.01 per share
|                  |        | Shares Outstanding: 22,906,160        

Transitional Small Business Disclosure Format (check one):
   Yes [  ]     No [X]

---



Part IDERMA SCIENCES,
INC.FORM 10-QSBINDEX

|                                         |         |                                                                                                                         |   
|---------------------------------------- | ------- | ----------------------------------------------------------------------------------------------------------------------- | --
|Description                              | Page   
|Part I - Condensed Financial Information
|                                         | Item 1. | Condensed Consolidated Financial Statements                                                                             |   
|                                         |         | Condensed Consolidated Balance
     Sheets - March 31, 2006 Unaudited and December 31, 2005                             | 3 
|                                         |         | Condensed Consolidated Statements of
     Operations - Three months ended March 31, 2006 and March 31, 2005 (Unaudited) | 4 
|                                         |         | Condensed Consolidated Statements of
     Cash Flows - Three months ended March 31, 2006 and March 31, 2005 (Unaudited) | 5 
|                                         |         | Notes to Condensed Consolidated Financial
     Statements                                                               | 6 
|                                         | Item 2. | Management's Discussion and
     Analysis or Plan of Operation                                                          | 16
|                                         | Item 3. | Controls and
     Procedures                                                                                            | 27
|Part II - Other Information             
|                                         | Item 1. | Legal
     Proceedings                                                                                                  | 28
|                                         | Item 6. | Exhibits                                                                                                                | 28

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 CONSOLIDATED FINANCIAL STATEMENTS

2

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

| |                                                                     |                                                                             |                          |   |             |                          |   | 
| | ------------------------------------------------------------------- | --------------------------------------------------------------------------- | ------------------------ | - | ----------- | ------------------------ | - | 
| | Condensed Consolidated
     Balance Sheets                         
| |                                                                     |                                                                             | March 31,2006(Unaudited) |   |             | December 31,2005(Note 1) |   | 
| | ASSETS                                                             
| | Current Assets                                                     
| |                                                                     | Cash and cash equivalents                                                   | $        68,246          |   |             | $  1,105,330             |   | 
| |                                                                     | Accounts receivable, net                                                    | 1,303,068                |   |             | 1,225,639                |   | 
| |                                                                     | Inventories                                                                 | 4,740,795                |   |             | 3,868,663                |   | 
| |                                                                     | Prepaid expenses and other
     current assets                              | 341,302                  |   |             | 210,288                  |   | 
| | Total current assets                                                | 6,453,411                                                                   |                          |   | 6,409,920   |                          |  
| | Equipment and improvements, net                                     | 3,312,597                                                                   |                          |   | 3,385,862   |                          |  
| | Goodwill                                                            | 200,000                                                                     |                          |   | 200,000     |                          |  
| | Other intangible assets, net                                        | 278,779                                                                     |                          |   | 299,776     |                          |  
| | Other assets, net                                                   | 323,811                                                                     |                          |   | 299,688     |                          |  
| | Total Assets                                                        | $10,568,598                                                                 |                          |   | $10,595,246 |                          |  
| | LIABILITIES AND
     SHAREHOLDERS' EQUITY                          
| | Current Liabilities                                                
| |                                                                     | Line of credit borrowings                                                   | $     854,144            |   |             | $  1,080,561             |   | 
| |                                                                     | Current maturities of long-term debt                                        | 289,227                  |   |             | 285,945                  |   | 
| |                                                                     | Accounts payable                                                            | 1,497,754                |   |             | 1,197,062                |   | 
| |                                                                     | Accrued expenses and other
     current liabilities                         | 386,683                  |   |             | 491,559                  |   | 
| | Total current liabilities                                           | 3,027,808                                                                   |                          |   | 3,055,127   |                          |  
| | Long-term debt, net of current portion                              | 311,131                                                                     |                          |   | 388,473     |                          |  
| | Other long-term
     liabilities                                    | 105,925                                                                     |                          |   | 99,982      |                          |  
| | Total Liabilities                                                   | 3,444,864                                                                   |                          |   | 3,543,582   |                          |  
| | Commitments                                                        
| | Shareholders' Equity                                               
| | Convertible preferred stock, $.01 par value; 11,750,000
     shares
| |                                                                     | authorized; issued and outstanding: 2,280,407 shares at March
     31, 2006
| |                                                                     | and December 31, 2005 (liquidation preference of $4,210,231
     at        
| |                                                                     | March 31, 2006 and December 31, 2005)                                       | 22,804                   |   |             | 22,804                   |   | 
| | Common stock, $.01 par value, 30,000,000 shares
     authorized;   
| |                                                                     | issued and outstanding: 12,285,768 shares at March 31, 2006
     and       
| |                                                                     | December 31, 2005                                                           | 122,858                  |   |             | 122,858                  |   | 
| |                                                                     | Additional paid-in capital                                                  | 19,943,684               |   |             | 19,905,059               |   | 
| |                                                                     | Accumulated other comprehensive income                                      | 871,802                  |   |             | 896,077                  |   | 
| |                                                                     | Accumulated deficit                                                         | (13,837,414              | ) |             | (13,895,134              | ) | 
| |                                                                     | Total Shareholders' Equity                                                  | 7,123,734                |   |             | 7,051,664                |   | 
| |                                                                     | Total Liabilities and Shareholders'
     Equity                             | $10,568,598              |   |             | $10,595,246              |   | 

See accompanying notes to
condensed consolidated financial statements.

3

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

| |                                                                              |                             |   |  |             |   | 
| | ---------------------------------------------------------------------------- | --------------------------- | - |  | ----------- | - | 
| | Condensed Consolidated
     Statements of Operations (Unaudited)            
| |                                                                              | Three months endedMarch 31, |  
| |                                                                              | 2006                        |   |  | 2005        |   | 
| | Net sales                                                                    | $ 5,756,914                 |   |  | $ 4,893,447 |   | 
| | Cost of sales                                                                | 3,564,913                   |   |  | 3,422,603   |   | 
| | Gross Profit                                                                 | 2,192,001                   |   |  | 1,470,844   |   | 
| | Operating expenses                                                           | 2,121,752                   |   |  | 1,764,513   |   | 
| | Interest expense, net                                                        | 82,050                      |   |  | 84,584      |   | 
| | Other income, net                                                            | (69,521                     | ) |  | (165,201    | ) | 
| | Total Expenses                                                               | 2,134,281                   |   |  | 1,683,896   |   | 
| | Income (loss) before provision for income taxes                              | $     57,720                |   |  | $ (213,052  | ) | 
| | Provision for income taxes                                                   |                            |   |  |            |   | 
| | Net Income (Loss)                                                            | $     57,720                |   |  | $ (213,052  | ) | 
| | Income (loss) per common share
     - basic                                  | $0.00                       |   |  | $(0.02      | ) | 
| | Income (loss) per common share
     - fully diluted                          | $0.00                       |   |  | $(0.02      | ) | 
| | Shares used in computing income
     (loss) per common share - basic         | 12,285,768                  |   |  | 12,011,674  |   | 
| | Shares used in computing income
     (loss) per common share - fully diluted | 15,659,185                  |   |  | 12,011,674  |   | 

See accompanying notes to
condensed consolidated financial statements.

4

---



Index

DERMA SCIENCES, INC. AND SUBSIDIARIES

| |                                                                  |                                                             |                                              |                                                     |                             |              |         |          |   | 
| | ---------------------------------------------------------------- | ----------------------------------------------------------- | -------------------------------------------- | --------------------------------------------------- | --------------------------- | ------------ | ------- | -------- | - | 
| | Condensed Consolidated
     Statements of Cash Flows (Unaudited)
| |                                                                  |                                                             |                                              |                                                     | Three months endedMarch 31, |             
| |                                                                  |                                                             |                                              |                                                     | 2006                        |              |         | 2005     |   | 
| | Operating Activities                                            
| |                                                                  | Net income (loss)                                           | $        57,720                              |                                                     |                             | $  (213,052) |         |         
| |                                                                  | Adjustments to reconcile net income (loss)                 
| |                                                                  | to net cash used in operating
     activities:             
| |                                                                  |                                                             | Depreciation of equipment and improvements   | 138,077                                             |                             |              | 121,885 |          |  
| |                                                                  |                                                             | Amortization of intangible assets            | 20,997                                              |                             |              | 21,032  |          |  
| |                                                                  |                                                             | Amortization of deferred financing costs     | 18,161                                              |                             |              | 16,869  |          |  
| |                                                                  |                                                             | Provision for bad debts and rebates          | 270,472                                             |                             |              | 40,221  |          |  
| |                                                                  |                                                             | Provision for inventory obsolescence         | 24,489                                              |                             |              | 27,519  |          |  
| |                                                                  |                                                             | Deferred rent expense                        | 5,976                                               |                             |              | 13,651  |          |  
| |                                                                  |                                                             | Share based compensation expense             | 38,625                                              |                             |              |        |          |  
| |                                                                  |                                                             | Gain on settlement of accounts payable       | (64,971                                             | )                           |              |        |          |  
| |                                                                  |                                                             | Changes in operating assets and liabilities:
| |                                                                  |                                                             |                                              | Accounts receivable                                 | (349,587                    | )            |         | (124,259 | ) | 
| |                                                                  |                                                             |                                              | Inventories                                         | (911,176                    | )            |         | (87,500  | ) | 
| |                                                                  |                                                             |                                              | Prepaid expenses and other current assets           | (132,049                    | )            |         | (52,817  | ) | 
| |                                                                  |                                                             |                                              | Other assets                                        | 10,769                      |              |         | (120,470 | ) | 
| |                                                                  |                                                             |                                              | Accounts payable                                    | 369,496                     |              |         | 145,365  |   | 
| |                                                                  |                                                             |                                              | Accrued expenses and other
     current liabilities | (104,431                    | )            |         | (193,999 | ) | 
| | Net cash used in
     operating activities                       | (607,432                                                    | )                                            |                                                     | (405,555                    | )            |        
| | Investing Activities                                            
| |                                                                  | Business acquisition costs related to Western Medical, Inc. | (51,352                                      | )                                                   |                             |             |         |         
| |                                                                  | Purchases of
     equipment and improvements                | (76,908                                      | )                                                   |                             | (25,480      | )       |         
| | Net cash used in
     investing activities                       | (128,260                                                    | )                                            |                                                     | (25,480                     | )            |        
| | Financing Activities                                            
| |                                                                  | Net change in bank lines of credit                          | (226,417                                     | )                                                   |                             | 277,161      |         |         
| |                                                                  | Deferred financing costs                                    |                                             |                                                     |                             | (108,804     | )       |         
| |                                                                  | Long-term debt repayments                                   | (72,820                                      | )                                                   |                             | (255,229     | )       |         
| |                                                                  | Proceeds from
     issuance of stock, net of issuance costs |                                             |                                                     |                             | 547,797      |         |         
| | Net cash (used in)
     provided by financing activities         | (299,237                                                    | )                                            |                                                     | 460,925                     |              |        
| | Effect of exchange
     rate changes on cash                     | (2,155                                                      | )                                            |                                                     | 180                         |              |        
| | Net (decrease) increase in cash and cash equivalents             | (1,037,084                                                  | )                                            |                                                     | 30,070                      |              |        
|
| | Cash and cash equivalents                                       
| | Beginning of period                                              | 1,105,330                                                   |                                              |                                                     | 46,508                      |              |        
| | End of period                                                    | $        68,246                                             |                                              |                                                     | $  76,578                   |              |        

See accompanying notes to
condensed consolidated financial statements.

5

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

1.    Organization and
Summary of Significant Accounting Policies

Derma
Sciences, Inc. and its subsidiaries (the Company) 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 U.S. distribution facility is located in St. Louis, Missouri,
while the Companys Canadian distribution facility is located in Toronto. The Company
has manufacturing facilities in Toronto, Canada and Nantong, China.

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 month period ended March 31, 2006, are not
necessarily indicative of the results that may be expected for the year ending December
31, 2006. Information included in the condensed balance sheet as of December 31, 2005 has
been derived from the consolidated financial statements and footnotes thereto for the year
ended December 31, 2005, included in Form 10-KSB previously filed with the Securities and
Exchange Commission. For further information, refer to that Form 10-KSB.

Summary
of Significant Accounting Policies:

Stock-Based
Compensation  Effective January 1, 2006 the Company adopted Statement of
Financial Accounting Standards No. 123R, Share-Based Payment (SFAS
123R), which revises SFAS 123
Accounting for Stock-Based Compensation (SFAS 123) and supercedes Accounting Principles
Board Opinion 25 Accounting for Stock Issued to Employees. Under APB 25, the Company used the intrinsic
value method for employee stock options and did not record any expense because option exercise prices
equaled the market value at the date of grant. SFAS 123R requires
that new, modified and unvested share-based payment transactions with employees, such as
grants of stock options and restricted stock, be recognized in the financial statements
based on their fair value at the grant date and recognized as compensation expense over their vesting
periods. The Company estimates the fair value of stock options as of the date of grant
using the Black-Scholes pricing model and restricted stock based on the quoted market
price. The Company adopted SFAS 123R using the modified prospective method, and accordingly, prior period
financial statements were not revised.

No
charge is recorded as of the date of grant for performance-based options. An evaluation is
conducted as of the end of each subsequent reporting period through the vesting date to
determine the probability of the satisfaction of the performance criteria underlying the
earning of the performance options being met. If it is determined that achievement of the
underlying performance criteria is not probable as of the reporting date, no charge is
recorded. If it is determined that achievement of the performance criteria is probable,
then a charge is recorded. The charge represents the change in fair value of the option
from the grant date through the reporting date. The charge is remeasured and adjusted each
subsequent reporting period until the final determination as to the vesting of the
performance-based options is made in accordance with the terms of the original grant.

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.

6

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

Potential common stock has not been
included in the computation of diluted loss per share for the three months ended March
31, 2005 as the effect would be anti-dilutive.

Total
dilutive shares that have or would have been used to compute diluted income per common
share for the three months ended March 31, 2006 and 2005 (assuming profitability in all
periods) are outlined below:

| |                                                         |                                       |                              |  |      |            |  | 
| | ------------------------------------------------------- | ------------------------------------- | ---------------------------- |  | ---- | ---------- |  | 
| |                                                         |                                       | Three Months Ended March 31, | 
| |                                                         |                                       | 2006                         |  | 2005 |           
|
| | Weighted average common shares outstanding  basic in  
| |                                                         | 2006 and basic and diluted in 2005    | 12,285,768                   |  |      | 12,011,674 |  | 
|
| | Potentially dilutive shares:                           
| |                                                         | Preferred stock                       | 2,280,407                    |  |      | 2,280,407  |  | 
| |                                                         | Warrants                              | 155,723                      |  |      | 4,578      |  | 
| |                                                         | Stock options                         | 937,287                      |  |      | 489,559    |  | 
|
| |                                                         | Sub-total potentially dilutive shares | 3,373,417                    |  |      | 2,774,544  |  | 
|
| | Weighted average common shares outstanding  diluted in
| |                                                         | 2006 and potentially diluted in 2005  | 15,659,185                   |  |      | 14,786,218 |  | 

Reclassifications
 Certain reclassifications have been made to prior year reported amounts to conform
with the 2006 presentation.

2.    Inventories

Inventories
include the following:

| |                     |                   |                 |  |                    |             |  | 
| | ------------------- | ----------------- | --------------- |  | ------------------ | ----------- |  | 
| |                     |                   | March 31,  2006 |  | December 31,  2005 |            
|
| | Finished goods      | $ 3,241,405       |                 |  | $ 2,516,114        |             | 
| | Work in process     | 69,667            |                 |  | 144,390            |             | 
| | Packaging materials | 531,109           |                 |  | 398,463            |             | 
| | Raw materials       | 898,614           |                 |  | 809,696            |             | 
|
| |                     | Total inventories | $ 4,740,795     |  |                    | $ 3,868,663 |  | 

3.    Line of Credit
Borrowings

Short-term
borrowings include the following:

| |                     |          |                 |  |                    |  |  | 
| | ------------------- | -------- | --------------- |  | ------------------ |  |  | 
| |                     |          | March 31,  2006 |  | December 31,  2005 | 
|
| | U.S. line of credit | $854,144 |                 |  | $ 1,080,561        |  | 

U.S.
Line of Credit

On
January 31, 2005, the Company entered into a three year revolving credit facility
agreement (the Agreement) with a new U.S. lender for a maximum principal
amount of $2,000,000. The Agreement replaces a $2,000,000 revolving credit facility that
expired on January 31, 2005. Advances will be utilized to fund strategic

7

---



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

initiatives and general working
capital requirements. The Company incurred loan origination and legal fees of $147,300 in
connection with the implementation of the Agreement. These fees have been deferred and
are being amortized to interest expense over the three year term of the Agreement.

The
Company may request advances under the 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 March 31, 2006 the effective interest rate was
10.25%. 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 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 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 Agreement, the Company has agreed to comply with financial covenants
governing minimum EBITDA (earnings before interest, taxes, depreciation and amortization)
and its fixed charge ratio (EBITDA divided by the sum of debt service, capital
expenditures, income taxes and dividends), measured at the end of each month for the
average of the three most recent calendar months based upon its consolidated operating
results. As it pertains to the Companys U.S. operations, cash collections may not be
less than a defined amount each calendar month. In addition, at all times the
Companys cash on hand (including unused borrowing capacity under the 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 Agreement.

Based
upon consolidated operating results for October 2005 through February 2006, the Company
was out of compliance with its EBITDA and fixed charge ratio covenants as amended
effective June 30, 2005. For a fee of $20,000, the U.S. lender agreed to waive these
covenant violations and to work with the Company to amend the existing covenants going
forward. On April 18, 2006, the Company amended its financial covenants effective March 31, 2006 in
connection with the amendment to the Agreement as part of the Western Medical, Inc. asset purchase
(see Note 10). As of March 31, 2006, the Company was in compliance with its amended
covenants.

The
Company may terminate the Agreement at any time 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 Agreement divided by 12.

Canadian
Line of Credit

In
November 2005, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $685,000 ($800,000
Canadian) with its Canadian lender. In light of the favorable impact of the new
distribution agreement on the borrowing requirements of the Companys
wholly owned Canadian subsidiary, Derma Sciences Canada Inc., the maximum principal amount
of the credit facility was reduced in line with the subsidiarys prospective maximum
borrowing capacity. The next annual review is expected to be completed in the second
quarter, 2006. 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
$342,000 ($400,000 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 6.5% for Canadian dollar advances and 9.25% for U.S. dollar
denominated advances at March 31, 2006. 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.

8

---



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

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 $428,000 ($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.

4.    Long-Term Debt

Long-term
debt includes the following:

| |                           |                |                 |  |                    |           |  | 
| | ------------------------- | -------------- | --------------- |  | ------------------ | --------- |  | 
| |                           |                | March 31,  2006 |  | December 31,  2005 |          
|
| | Canadian term loan        | $ 472,448      |                 |  | $ 533,809          |           | 
| | Capital lease obligations | 127,910        |                 |  | 140,609            |           | 
|
| |                           | Total debt     | 600,358         |  |                    | 674,418   |  | 
| | Less: current maturities  | 289,227        |                 |  | 285,945            |           | 
|
| |                           | Long-term debt | $ 311,131       |  |                    | $ 388,473 |  | 

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 its Canadian
lender. 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 6.75% at March 31, 2006. 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 3).

The
Company has three capital lease obligations for certain distribution and computer
equipment totaling $127,910 as of March 31, 2006. The capital leases bear interest at annual rates ranging from
3.9% to 10.2% with the longest lease term expiring in April 2009.

5.    Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at March 31, 2006.
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 March 31, 2006.
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 March 31, 2006.
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 March 31,
2006. The series D preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a

9

---



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

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.

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 $1,246,656, net of $133,344 in offering expenses, were
received. The offering commenced prior to December 31, 2004. In 2005, the Company sold
1,205,000 units at $0.50 per unit and received total offering proceeds of $547,797, net of
$54,703 in offering expenses. Proceeds from the offering were used for working capital.

Stock
Options

The
Company adopted the Stock Option Plan (the Plan) July 18, 1991 and amended the
Plan January 14, 1994, May 22, 1996, July 14, 1998, February 6, 2003 and February 24,
2004. The number of shares of Common Stock reserved for issuance pursuant to the Plan is
3,500,000 shares. The Plan authorizes the Company to grant two types of equity incentives:
(i) options intended to qualify as incentive stock options (ISOs)
as defined in Section 422 of the Internal Revenue Code of 1986, as amended, and (ii)
nonqualified stock options (NQSOs). The Plan authorizes options to be granted
to directors, officers, key employees and consultants of the Company, except that ISOs may
be granted only to employees. The Plan is administered by a committee of disinterested
directors designated by the Board of Directors (the Compensation Committee).
Subject to the provisions of the Plan, the Compensation Committee determines who is
eligible to receive stock options, together with the nature, amount, timing, exercise
price, vesting schedule and all other terms and conditions of the options to be granted.

Under
the Plan, ISOs and NQSOs may have a term of up to ten years. Stock options are not
assignable or transferable except by will or the laws of descent and distribution. Stock
options granted under the Plan which have lapsed or terminated revert to the status of
unissued and become available for reissuance. Stock options granted generally
vest 25% at the date of grant and 25% on each anniversary date of grant until fully
vested. The option exercise price is invariably established at the fair market value of
the common stock on the date of grant.

At
March 31, 2006, options to purchase 3,426,625 shares of the Companys Common Stock at
prices in the range of $0.37 to $5.00 per share were issued and outstanding under the
Plan. In addition to options granted under the Plan, at March 31, 2006 there are 2,736,655
options granted outside the Plan that were not approved by shareholders.

During
the three months ended March 31, 2006 and 2005, the Company issued stock options as
outlined below:

| |                                |         |                              |  |           |      |  | 
| | ------------------------------ | ------- | ---------------------------- |  | --------- | ---- |  | 
| |                                |         | Three Months Ended March 31, |  |          
| |                                |         | 2006                         |  |           | 2005 |  | 
|
| | Number of stock options issued | 390,000 |                              |  | 1,021,000 |      | 
| | Average exercise price         | $0.70   |                              |  | $0.50     |      | 

10

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

The
fair value of each option award is estimated at the date of grant using the Black-Scholes
option pricing model. The weighted-average assumptions for the three months ended March 31,
2006 and 2005 were as follows:

| |                              |       |                              |  |       |      |  | 
| | ---------------------------- | ----- | ---------------------------- |  | ----- | ---- |  | 
| |                              |       | Three Months Ended March 31, |  |      
| |                              |       | 2006                         |  |       | 2005 |  | 
|
| | Risk-free interest rate      | 4.60% |                              |  | 4.25% |      | 
| | Volatility factor            | .675  |                              |  | 1.376 |      | 
| | Dividend yield               | 0%    |                              |  | 0%    |      | 
| | Expected option life (years) | 5     |                              |  | 5     |      | 
| | Contractual life (years)     | 10    |                              |  | 10    |      | 

The
risk-free rate utilized represents the five year U.S. Treasury yield curve rate at the
time of grant and coincides with the expected option life. The three months ended March
31, 2006 volatility factor is calculated based on the twenty-four month-end closing prices
of the Companys common stock preceding the month of stock option grant. The
twenty-four month time period was selected since it is representative of the
Companys common stock price volatility. The dividend yield is 0% since the Company
does not anticipate paying dividends in the near future. The expected option life of five
years is one-half of the option contractual life and has been consistently utilized by the
Company.

A
summary of option activity as of March 31, 2006, and changes during the three months then
ended, is presented below:

|                               |  |           |  |                                    |  |                                                       |  |                         
|------------------------------ |  | --------- |  | ---------------------------------- |  | ----------------------------------------------------- |  | ------------------------
|Options                        |  | Shares    |  | WeightedAverageExercise
     Price |  | Weighted AverageRemainingContractualTerm
     (Years) |  | AggregateIntrinsic Value
|                              
|Outstanding at January 1, 2006 |  | 5,773,280 |  | $0.92                              |  |                                                       |  |                         
|Granted                        |  | 390,000   |  | $0.70                              |  |                                                       |  |                         
|Forfeited or expired           |  | -         |  | -                                  |  |                                                       |  |                         
|                              
|Outstanding at March 31, 2006  |  | 6,163,280 |  | $0.90                              |  | 6.7                                                   |  | $267,850                
|                              
|Exercisable at March 31, 2006  |  | 5,889,530 |  | $0.91                              |  | 6.5                                                   |  | $267,850                

The
weighted average grant-date fair values of options granted during the three months ended
March 31, 2006 and 2005 were $163,800, or $0.42 per option, and $170,226, or $0.17 per option, respectively.

As
of March 31, 2006, there was $110,822 of total unrecognized compensation cost related to
nonvested share-based awards granted under the Plan. That cost is expected to be
recognized over the options remaining weighted average vesting period of 2.9 years.

During
the three months ended March 31, 2006, stock option compensation expense was recorded
using the fair value method under SFAS 123R as follows:

| |                                         |          |  |  | 
| | --------------------------------------- | -------- |  |  | 
| | Cost of sales                           | $  6,251 |  | 
| | Distribution                            | 573      |  | 
| | Sales                                   | 5,109    |  | 
| | General and administrative              | 26,692   |  | 
|
| | Total stock option compensation expense | $38,625  |  | 

11

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

For
the three months ended March 31, 2006, no income tax benefit was recognized.

The Companys
net loss and loss per common share and pro forma net loss and loss per common share
assuming compensation expense had been determined for the three months ended March 31,
2005 based on the fair value at the grant date for all awards, using the Black-Scholes
option pricing model consistent with the provisions of SFAS 123 and SFAS 123R, and amortized ratably
over the vesting period, instead of the instrinsic value method under APB 25, are set forth below:

| |                                           |             |                             |  | 
| | ----------------------------------------- | ----------- | --------------------------- |  | 
| |                                           |             | Quarter EndedMarch 31, 2005 | 
|
| | Net loss  as reported                    | $ (213,052  | )                           | 
| | Pro forma compensation expense            | (170,226    | )                           | 
|
| | Pro forma net loss                        | $ (383,278  | )                           | 
|
| | Loss per common share  basic and diluted
| |                                           | As reported | $(0.02)                     |  | 
| |                                           | Pro forma   | $(0.03)                     |  | 

Stock
Purchase Warrants

At
March 31, 2006, the Company had warrants outstanding to purchase 4,069,441 shares of the
Companys common stock as outlined below:

| |        |                    |                |                   | 
| | ------ | ------------------ | -------------- | ----------------- | 
| | Series | Number of Warrants | Exercise Price | Expiration Date   | 
|
| | F      | 1,309,441          | $0.57          | January 6, 2007   | 
| | G      | 2,760,000          | $1.05          | December 31, 2008 | 

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 period.

Shares
Reserved for Future Issuance

At
March 31, 2006, 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            | 6,163,280  |  | 
| | Common stock options available for grant    | 73,375     |  | 
| | Common stock warrants (series F - G)        | 4,069,441  |  | 
|
| | Total common stock shares reserved          | 12,586,503 |  | 

12

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

6.    Comprehensive Income
(Loss)

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

| |                               |                                         |                             |   |           |         |   | 
| | ----------------------------- | --------------------------------------- | --------------------------- | - | --------- | ------- | - | 
| |                               |                                         | Three Months EndedMarch 31, |  
| |                               |                                         | 2006                        |   | 2005      |        
|
| | Net income (loss) as reported | $57,720                                 |                             |   | $(213,052 | )       |  
| | Other comprehensive loss:    
| |                               | Foreign currency translation adjustment | (24,275                     | ) |           | (27,188 | ) | 
|
| | Comprehensive income (loss)   | $33,445                                 |                             |   | $(240,240 | )       |  

7.    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-fastener 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 basic and advanced wound care products, along with wound closure-fastener
products, are performed both internally and outsourced, while the manufacture of skin care
products is totally outsourced. 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 ended March 31, 2006 and 2005 were as
follows:

|                    |  |                                   |  |                         |  |           |   |             |   |              |  
|------------------- |  | --------------------------------- |  | ----------------------- |  | --------- | - | ----------- | - | ------------ | -
|                    |  | Three Months Ended March 31, 2006 |  |                         | 
|                   
|                    |  | Wound Care                        |  | Wound Closure-Fasteners |  | Skin Care |   | Other Costs |   | TotalCompany |  
|                   
|Net sales           |  | $4,884,556                        |  | $593,237                |  | $279,121  |   | -           |   | $5,756,914   |  
|                   
|Gross profit (loss) |  | 1,901,451                         |  | 292,317                 |  | (1,767    | ) | -           |   | 2,192,001    |  
|Total expenses      |  | -                                 |  | -                       |  | -         |   | $(2,134,281 | ) | (2,134,281   | )
|                   
|Net income          |  | $      57,720                     | 

13

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

|               |  |                                   |  |                         |  |           |  |             |   |              |  
|-------------- |  | --------------------------------- |  | ----------------------- |  | --------- |  | ----------- | - | ------------ | -
|               |  | Three Months Ended March 31, 2005 |  |                         | 
|              
|               |  | Wound Care                        |  | Wound Closure-Fasteners |  | Skin Care |  | Other Costs |   | TotalCompany |  
|              
|Net sales      |  | $3,871,130                        |  | $628,298                |  | 394,019   |  | -           |   | $4,893,447   |  
|              
|Gross profit   |  | 1,139,409                         |  | 326,173                 |  | 5,262     |  | -           |   | 1,470,844    |  
|Total expenses |  | -                                 |  | -                       |  | -         |  | $(1,683,896 | ) | (1,683,896   | )
|              
|Net loss       |  | $    (213,052)                    | 

The
following table presents net sales by geographic region.

| |               |     |                              |  |     |      |  | 
| | ------------- | --- | ---------------------------- |  | --- | ---- |  | 
| |               |     | Three Months Ended March 31, |  |    
| |               |     | 2006                         |  |     | 2005 |  | 
|
| | United States | 44% |                              |  | 49% |      | 
| | Canada        | 52% |                              |  | 47% |      | 
| | Other         | 4%  |                              |  | 4%  |      | 

8.    Income Taxes

The Company
did not record any provision for income taxes in the first quarter of 2006 due to available
net operating loss carryforwards or in 2005 given the net operating loss for the quarter.
No benefit has been recorded as the realization of the net operating losses is not
assured.

9.    Comvita Licensing,
Manufacturing and Sales Agreement

On
February 13, 2006 the Company entered into an exclusive five year licensing, manufacturing
and sales agreement (the Agreement) with Comvita New Zealand Limited, whereby
the Company will manufacture and sell a line of Manuka Honey based wound care products
developed by Comvita. These products are supported by proprietary intellectual property
that will serve to provide a competitive advantage in the market place. Access to this
technology and these products represents a significant milestone in the Companys
strategy to build a larger presence in the advanced wound care market segment. Under the
Agreement, the Company receives exclusive rights to manufacture and sell its branded
products throughout North and South America within the professional medical-surgical
marketplace (i.e. extended care, acute care, home care, etc). Comvita retains the right to
these products in the consumer marketplace and has the option to purchase its branded
consumer product requirements from the Company at agreed upon pricing.

In
accordance with the Agreement, the Company will purchase its requirements for active honey
from Comvita at agreed upon pricing. As consideration for the grant of the license, the
Company will pay Comvita a royalty based on sales. The Agreement calls for the Company to
spend a minimum of either $200,000 or 8% of sales per year on Advertising and Promotion in
support of these products. Further, the Agreement calls for minimum sales achievement
targets beginning in the second year of the Agreement and each year thereafter to maintain
exclusivity. The agreement will commence upon regulatory approval of the first product.
Approval is expected in the fourth quarter 2006.

14

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

10.    Subsequent Event

Western
Medical, Inc. Asset Purchase

On
April 18, 2006, the Company acquired certain assets and assumed the trade payables of
Western Medical, Inc. (Western Medical) for $6,500,000 of which $6,000,000 was
paid in cash and $500,000 was paid via a three-year promissory note issued to Western
Medical by the Company. The purchase price represents approximately five times adjusted
EBITDA which the Company believes is consistent with market valuation for companies of
this size and type based on managements judgment and that of the Companys
investment banker acting as an advisor on the transaction. In accordance with the purchase
agreement, Western Medical was required to transfer to the Company a minimum of $1,200,000 of
working capital (receivables and inventory, less trade payables, as defined) as of the
date of sale. The purchased assets consist of receivables, inventory, equipment, other
intangibles and goodwill. The Company anticipates transaction expenses of $1,000,000
related to the purchase. The Company is presently conducting a valuation analysis to
determine the allocation of the $6,500,000 purchase price to the underlying assets
acquired.

Western
Medical is a privately held manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. In 2005, Western Medical
reported unaudited sales of $6,600,000, gross margin of $2,600,000 and pre-tax income of
$700,000. Western Medicals product line is complementary to and will serve to expand
the Companys existing basic wound care line. The Company anticipates being able to
leverage cross selling opportunities presented by the purchase to grow sales. In addition,
the Company expects to absorb Western Medicals business within its existing
operating infrastructure incurring only modest cost increases. Both of these initiatives
are expected to increase the contribution of the business going forward.

In
connection with the acquisition, the Company raised $5,901,825 (net of $470,411 in
commission and other offering expenses) from the sale of 2,655,098 units (10,620,392
shares) at $2.40 per unit, each unit consisting of four shares of the Companys
common stock and one five-year warrant (2,655,098 warrants in total) to purchase one share
of common stock at the price of $1.00. In addition, the placement agent received 754,806
five-year warrants to purchase one share of common stock at $0.72. Total common shares
outstanding increased from 12,285,768 before the transaction to 22,906,160 afterwards. The
Company also received $1,000,000 in proceeds from a new term loan secured from its U.S.
lender through an amendment to its existing three year revolving credit facility. The
amendment required the Company to utilize the $1,000,000 in the acquisition of
substantially all of the assets of Western Medical. The term loan bears interest at prime
plus 5% for which purpose prime may not be lower than 7.75%. On the first day of each
month from May 1, 2006 through September 1, 2006, payments of interest only are required
on the term loan. Commencing October 1, 2006 and on the first day of the 28 months
thereafter, payments of accrued interest and principal amortized at the rate of 1/36th of
the principal balance of the term loan ($27,777) are required. On April 1, 2009, payment
of all principal and accrued interest of the term loan is required. In addition, the
amendment amends and restates various loan covenants of the revolving credit facility
effective March 31, 2006 and increases the revolving credit facility cap from $2,000,000
to $3,500,000.

The
Company will retain certain Western Medical personnel through May 31, 2006 to perform
sales and marketing transition services with respect to the products acquired from Western
Medical. The Company will reimburse Western Medical for all salaries and benefits of the
subject employees in addition to a maximum of $7,500 per month in employee related
overhead costs. Also, the Company entered into a one year sales and marketing agreement
with an affiliate of Western Medical to provide sales and marketing consulting services
relative to the products acquired by the Company. The sales and marketing agreement
requires payments of $15,000 monthly for the first four months and $7,500 for the last
eight months of the agreements term.

15

---



Index

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
OPERATION

QUARTER ENDED MARCH 31, 2006 COMPARED
TO QUARTER ENDED MARCH 31, 2005.

Results of Operations

Overview

The
2006 and 2005 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-fasteners and skin care. The wound care line
is composed of basic and advanced wound care products. Basic wound care consists of gauze
dressings, packing strips, impregnated gauze dressings, abdominal pads, laparotomy
sponges, burn dressings and bandages. Advanced wound care products consist of ointments,
silver dressings, calcium alginate dressings, hydrogel dressings, hydrocolloid dressings
and foam dressings. The wound closure-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 March 31, 2006 versus 2005 operating
results:

| |                                   |                              |   |      |              |          |  |             |   |  |        | 
| | --------------------------------- | ---------------------------- | - | ---- | ------------ | -------- |  | ----------- | - |  | ------ | 
| |                                   | Quarter Ended March
     31, |  
| |                                   | 2006                         |   | 2005 |              | Variance | 
|
| | Gross Sales                       | $6,764,766                   |   |      | $5,237,037   |          |  | $1,527,729  |   |  | 29.2%  | 
| | Sales adjustments                 | (1,007,852                   | ) |      | (343,590     | )        |  | (664,262    | ) |  | 193.3% | 
|
| | Net sales                         | 5,756,914                    |   |      | 4,893,447    |          |  | 863,467     |   |  | 17.6%  | 
| | Cost of sales                     | 3,564,913                    |   |      | 3,422,603    |          |  | 142,310     |   |  | 4.2%   | 
|
| | Gross profit                      | 2,192,001                    |   |      | 1,470,844    |          |  | 721,157     |   |  | 49.0%  | 
| | Gross profit percentage           | 38.1%                        |   |      | 30.1%        |          |  |             |   |  |        | 
| | Operating expenses                | 2,121,752                    |   |      | 1,764,513    |          |  | 357,239     |   |  | 20.2%  | 
| | Interest expense, net             | 82,050                       |   |      | 84,584       |          |  | (2,534)     |   |  | (3.0%) | 
| | Other income, net                 | (69,521                      | ) |      | (165,201     | )        |  | 95,680      |   |  | 57.9%  | 
|
| | Total expenses                    | 2,134,281                    |   |      | 1,683,896    |          |  | 450,385     |   |  | 26.7%  | 
| | Income (loss) before income taxes | 57,720                       |   |      | (213,052)    |          |  | 270,772     |   |  | -      | 
| | Provision for income taxes        | -                            |   |      | -            |          |  | -           |   |  | -      | 
|
| | Net income (loss)                 | $    57,720                  |   |      | $  (213,052) |          |  | $   270,772 |   |  | -      | 

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 from distributors. 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
less than estimated at March 31, 2006, the trade rebate reserve would be overstated by
approximately $139,000. If the normal rebate cycle were one month greater than estimated
at March 31, 2006, the trade rebate reserve would be understated by approximately
$278,000. To minimize its cash outflow invested in rebates, distributors generally strive
to optimize the rebate credit submission process.

16

---



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 as incurred.

Gross
to net sales adjustments comprise the following:

| |                        |            |                         |  |            |      |  | 
| | ---------------------- | ---------- | ----------------------- |  | ---------- | ---- |  | 
| |                        |            | Quarter Ended March 31, |  |           
| |                        |            | 2006                    |  |            | 2005 |  | 
|
| | Gross Sales            | $6,764,766 |                         |  | $5,237,037 |      | 
|
| | Trade rebates          | (953,047   | )                       |  | (273,184   | )    | 
| | Medicaid rebates       | (6,450     | )                       |  | (7,420     | )    | 
| | Returns and allowances | (12,255    | )                       |  | (31,582    | )    | 
| | Cash discounts         | (36,100    | )                       |  | (31,404    | )    | 
|
| | Total adjustments      | (1,007,852 | )                       |  | (343,590   | )    | 
|
| | Net sales              | $5,756,914 |                         |  | $4,893,447 |      | 

Trade rebates
increased significantly in the first quarter 2006 versus 2005 due to the Companys
implementing an exclusive third party distribution agreement in the second quarter 2005
for its Canadian business and continuing growth of rebate intensive U.S. private label
sales partially offset by a decrease 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 $738,140 of the
increase as the majority of the Canadian sales represent contract business subject to
rebate. A continuing trend towards lower levels of Medicaid reimbursed sales is
responsible for the lower level of Medicaid rebates. Sales returns and allowances were
down period to period as 2005 activity was unusually high due to an increase in the level
of shipping errors associated with upgrading the Companys supply chain information
technology systems. The increase in cash discounts 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 March 31, 2006 and 2005 is outlined
below:

| |                               |            |                         |  |          |      |  | 
| | ----------------------------- | ---------- | ----------------------- |  | -------- | ---- |  | 
| |                               |            | Quarter Ended March 31, |  |         
| |                               |            | 2006                    |  |          | 2005 |  | 
|
| | Beginning balance - January 1 | $1,600,172 |                         |  | $253,815 |      | 
| | Rebates paid                  | (717,989   | )                       |  | (196,659 | )    | 
| | Rebates accrued               | 953,047    |                         |  | 273,184  |      | 
|
| | Ending balance - March 31     | $1,835,230 |                         |  | $330,340 |      | 

The
$235,058 increase in the first quarter 2006 trade rebate reserve reflects a $172,209
increase to $1,329,699 in the reserve associated with the commencement of the
Companys third party distribution agreement in Canada during the second quarter 2005
coupled with lower rebates paid due to extended payment terms with one large customer,
less a reduction of $42,300 due to a change in estimate to a prior period amount due.
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. The $76,525 increase in the
first quarter 2005 trade rebate reserve reflects the continued growth

17

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Index

of the rebate
intensive U.S. private label business coupled with the continuation of extended payment
terms with two large customers.

The
March 31st ending balance consists of accrued rebates and third party deductions accrued
by and paid by the Company that are recorded in accrued liabilities. The ending balance at
March 31, 2006 and 2005 consist of the following:

| |                                 |            |                         |  |          |          |  | 
| | ------------------------------- | ---------- | ----------------------- |  | -------- | -------- |  | 
| |                                 |            | Quarter Ended March 31, |  |         
| |                                 |            | 2006                    |  |          | 2005     |  | 
|
| | Accrued rebates                 | $1,665,045 |                         |  | $211,721 |          | 
| | Third party deductions recorded | 170,185    |                         |  | 118,619  |          | 
| | in accrued liabilities         
|
| |                                 | Total      | $1,835,230              |  |          | $330,340 |  | 

Net Sales and Gross Margin

The
following table highlights the March 31, 2006 versus 2005 product line net sales and gross
profit:

| |                           |                              |   |      |            |          |  |            |   |  |         |  
| | ------------------------- | ---------------------------- | - | ---- | ---------- | -------- |  | ---------- | - |  | ------- | -
| |                           | Quarter Ended March
     31, |  
| |                           | 2006                         |   | 2005 |            | Variance | 
|
| | Product Line Net Sales   
|
| | Wound care                | $4,884,556                   |   |      | $3,871,130 |          |  | $1,013,426 |   |  | 26.2%   |  
| | Wound closure-fasteners   | 593,237                      |   |      | 628,298    |          |  | (35,061    | ) |  | (5.6%   | )
| | Skin care                 | 279,121                      |   |      | 394,019    |          |  | (114,898   | ) |  | (29.2%  | )
|
| | Total                     | $5,756,914                   |   |      | $4,893,447 |          |  | $  863,467 |   |  | 17.6%   |  
|
| | Product Line Gross Profit
|
| | Wound care                | $1,901,451                   |   |      | $1,139,409 |          |  | $762,042   |   |  | 66.9%   |  
| | Wound closure-fasteners   | 292,317                      |   |      | 326,173    |          |  | (33,856)   |   |  | (10.4%) |  
| | Skin care                 | (1,767                       | ) |      | 5,262      |          |  | (7,029     | ) |  | -       |  
|
| | Total                     | $2,192,001                   |   |      | $1,470,844 |          |  | $  721,157 |   |  | 49.0%   |  

Company
net sales increased $863,467, or 17.6%, to $5,756,914 in 2006 from $4,893,447 in 2005.
Canadian net sales increased $725,372, or 31.7%, to $3,011,500 in 2006 from $2,286,128 in
2005. This increase was driven by growth of $582,939 and favorable exchange of $142,433
associated with a 5.9% strengthening of the Canadian dollar. U.S. net sales increased
$138,095, or 5.3%, to $2,745,414 in 2006 from $2,607,319 in 2005. The increase was largely
driven by continued growth of the private label business partially offset by continuing
skin care competitive pressure and softening demand for basic wound care.

Company
gross profit increased $721,157, or 49.0% to $2,192,001 in 2006 from $1,470,844 in 2005.
Company gross profit margin percentage increased to 38.1% in 2006 from 30.1% in 2005.
Canadian gross profit increased $586,560, or 99.6%, to $1,175,735 in 2006 from $589,175 in
2005. Canadian gross profit margin increased to 39.0% in 2006 from 25.8% in 2005. The
significant improvement in Canadian 2006 gross profit dollars and margin percentage
reflects the combined impact of higher sales, continuing improvement in manufacturing
performance, higher unit volume throughput thru the Toronto plant and the benefit of lower
negotiated basic wound care costs. U.S. gross profit increased $134,597, or 15.3%, to
$1,016,266 in 2006 from $881,669 in 2005. Gross profit margin increased to 37.0% in 2006
from 33.8% in 2005. The improvement in U.S. gross margin dollars and margin percentage
reflects the combined impact of higher sales, favorable product mix and the benefit of
lower product costs from Canada and third party skin care product costs associated with
outsourcing the line in the third quarter 2005.

18

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Index

Wound
care sales increased $1,013,426, or 26.2%, to $4,884,556 in 2006 from $3,871,130 in 2005.
The increase is attributable to a basic wound care increase of $649,509, or 23.4%. This
increase was driven by an increase in Canadian basic wound care sales of $725,372, or
31.7%, comprised of growth of $582,939 and favorable exchange of $142,433 while U.S. sales
decreased $75,863, or 15.4%. The Canadian sales growth was driven by the exclusive
distribution agreement that commenced in the second quarter 2005. The U.S. sales
performance reflects a softening of demand for these products. Advanced wound care sales
increased $363,917, or 33.3%, to $1,456,748 in 2006 from $1,092,831 in 2005. This increase
was principally driven by continued growth of the Companys private label sales to
U.S. customers together with improving silver product sales.

Wound
care gross profit increased $762,042, or 66.9%, to $1,901,451 in 2006 from $1,139,409 in
2005. Gross profit margin increased to 38.9% in 2006 from 29.4% in 2005. The margin dollar
increase and improved gross margin percentage are due to the increase in sales and the
flow through of lower products costs as a result of continued improvement in the Toronto
manufacturing operations and the benefit of lower basic wound care and silver product
purchase prices.

Wound
closure and fastener sales decreased $35,061, or 5.6%, to $593,237 in 2006 from $628,298
in 2005. The non-recurrence of approximately $38,000 in residual sales of certain catheter
fasteners in 2005 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. Sales for the balance of the line were essentially flat period to period.

Wound
closure-fastener gross profit decreased $33,856, or 10.4%, to $292,317 in 2006 from
$326,173 in 2005. Gross profit margin decreased to 49.3% in 2006 from 51.9% in 2005. The
decrease in margin dollars reflects the lower sales and margin deterioration. The margin
deterioration is due principally to the combined impact of pricing pressure and higher
product costs.

Skin
care sales decreased $114,898, or 29.2%, to $279,121 in 2006 from $394,019 in 2005 due to
continuing competitive pressure. Skin care gross profit decreased $7,029 to a $1,767 loss
in 2006 from a $5,262 profit in 2005. The Company completed the closure of its skin care
manufacturing operation at the end of August 2005 and commenced outsourcing these products
to a third party supplier. The lower margin dollars in 2006 principally reflects the sales
loss, a large percentage of which came from generally higher margined small customers.

Operating Expense

The
following table highlights March 31, 2006 versus 2005 operating expenses by type:

| |                        |                              |  |      |             |          |  |             |  |  |       | 
| | ---------------------- | ---------------------------- |  | ---- | ----------- | -------- |  | ----------- |  |  | ----- | 
| |                        | Quarter Ended March
     31, | 
| |                        | 2006                         |  | 2005 |             | Variance | 
|
| | Distribution           | $   416,418                  |  |      | $   348,501 |          |  | $    67,917 |  |  | 19.5% | 
| | Marketing              | 141,621                      |  |      | 96,795      |          |  | 44,826      |  |  | 46.3% | 
| | Sales                  | 505,422                      |  |      | 455,214     |          |  | 50,208      |  |  | 11.0% | 
| | General administrative | 1,058,291                    |  |      | 864,003     |          |  | 194,288     |  |  | 22.5% | 
|
| | Total                  | $2,121,752                   |  |      | $1,764,513  |          |  | $357,239    |  |  | 20.2% | 

Operating
expense increased $357,239, or 20.2%, to $2,121,752 in 2006 from $1,764,513 in 2005
including an increase of $35,314, or 6.2%, attributable to exchange associated with a 5.9%
strengthening of the Canadian dollar on the Canadian operations.

Distribution
expense increased $67,917, or 19.5%, in 2006 versus 2005. Expenses in Canada increased
$87,936 (including $13,176 expense related to exchange) while expenses in the U.S
decreased $20,019. The increase in Canada was principally attributable to higher
distribution fees associated with higher distributor sales to the Companys customers
in 2006 versus 2005. In accordance with the exclusive distribution agreement effective
June 2005, the distributor charges the Company a distribution fee each month based on a
fixed percentage of eligible distributor net sales of the Companys products to end
users. The U.S. decrease was attributable to the elimination of compensation related
occupancy costs in the third quarter 2005 in connection with the reorganization of the St.

19

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Index

Louis manufacturing and distribution operations in connection with the closure of the skin
care manufacturing facility in August 2005.

Marketing
expense increased $44,826, or 46.3%, in 2006 versus 2005. The increase was principally
attributable to higher promotion and product development expense in support of the
Companys growth initiatives. Higher compensation (associated with an employee
promotion) and travel, also contributed.

Sales
expense increased $50,208, or 11.0%, in 2006 versus 2005. Expenses in Canada increased
$25,882 (including $7,076 expense related to exchange) while expenses in the U.S.
increased $24,326. The increase in Canada was attributable to higher compensation and
commission expense, a higher level of sales support activities, consisting principally of
travel, convention attendance and sampling to expand market visibility and improve
contract compliance, and higher sales related administrative and bid fees, partially
offset by elimination of one sales position and related expenses in the second quarter
2005 as a result of the new distribution agreement. The U.S. increase was principally
attributable to higher compensation and commissions associated with hiring two new sales
representatives (one replacement and one new position) in the third quarter 2005,
partially offset by lower sample expense.

General
administrative expense increased $194,288, or 22.5%, in 2006 versus 2005. Expenses in
Canada increased $87,501 (including $15,062 expense related to exchange) while expenses in
the U.S. increased $11,345. The increase in Canada reflects higher compensation and
benefit costs (a large portion of which relates to filling a new director of materials and
logistics position in the second quarter 2005), higher travel costs principally to China
and in support of new private label business opportunities, stock option expense of
$14,000 and higher audit and insurance costs. The U.S. increase of $119,768 principally
reflects higher accounting expense, along with higher compensation, legal, bad debt and
stock option ($13,000) expenses, partially offset by lower recruiting, travel, information
technology and insurance costs.

Interest Expense

Interest
expense, net decreased $2,534, or 3.0%, to $82,050 in 2006 from $84,584 in 2005. Interest
expense in Canada decreased $19,737 (net of $2,102 expense related to exchange) while
interest expense in the U.S. increased $17,203. The decrease in Canada reflects lower
outstanding line of credit and term loan balances in 2006 versus 2005 partially offset by
higher interest rates. Canadas outstanding line of credit balance was reduced to
zero by the end of June 2005 through use of the one-time positive cash flow generated by
implementation of the new distribution agreement. The U.S. increase is due to a one-time
fee of $20,000 paid in March 2006 for loan covenant violation waivers and higher overall
interest rates partially offset by lower outstanding line of credit balances due to
improved cash flow in the U.S. associated with the implementation of an expense
reimbursement and management fee policy with Derma Canada.

Other Income/Expense

Other
income, net decreased $95,680 to $69,521 income in 2006 from $165,201 income in 2005. The main
driver for the decrease was the non-recurrence of a $164,300 gain recorded in 2005
associated with a one-time distribution agreement upset fee, partially offset by the
favorable settlement of a supplier liability of $65,000. Higher exchange and other
miscellaneous expense in 2006, partially offset by higher profit sharing income, also
contributed.

Income Taxes

The
Company did not record any income taxes in the first quarter of 2006 due to available net
operating loss carryforwards or in 2005 given the net operating loss reported for the
quarter.

Net Income (Loss)

The
Company generated net income of $57,720, or $0.00 per share (basic and diluted), in the
first quarter 2006 compared to a $213,052 loss, or $0.02 loss per share (basic and
diluted), in the first quarter 2005.

20

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Index

Liquidity and Capital
Resources

Operational Overview

Net
sales increased 17.6% (14.7% excluding foreign exchange) in the first quarter 2006 over
2005. This growth was driven by a sales increase in Canada of 31.7% (25.5% adjusted for
foreign exchange) and a sales increase of 5.3% in the U.S. Sales in Canada have met
expectations as the Company has focused on contract compliance, exploring opportunities in
other market segments (other than its traditional strength in the acute care segment) and
working closely with its new exclusive distributor to capitalize on sales growth
opportunities presented by this new relationship. Sales growth in the U.S. is for the most
part being driven by private label growth. The existing private label business is growing
and the Company made its first sale to a potentially large new private label customer in
the quarter. Overall, with the exception of skin care sales, U.S. core product sales have
remained relatively stable period to period with strength in some areas offsetting
softness in others. Skin care sales continue to deteriorate in the face of significant
competitive pressure.

As
expected, the Company continues to realize the benefit of its major manufacturing and
sourcing initiatives implemented over the past eighteen months. Incremental unit volume
throughput associated with commencement of manufacturing for several new private label
customers is contributing to improved efficiencies in the Companys manufacturing
operations. Notwithstanding the impact of sales pricing and mix on margins, the Company
has realized a significant improvement in gross profit dollars and margin percentage in
2006 stemming from lower product costs.

Operating
expenses increased 20.2% (18.2% adjusted for foreign exchange) in the first quarter 2006
over 2005. Much of the increase relates to distribution costs in Canada that are directly
tied to sales growth and to planned increases in Marketing and Sales expenses in support
of the Companys growth initiatives. Excluding these costs and non cash stock option
expense incurred beginning in 2006, growth in the balance of operating expenses is in line
with inflation and continues to be closely monitored.

The
Company has reported profitability in its last four quarters. While core sales in the U.S.
remain sluggish, sales performance in Canada and expected growth of the private label
business in the U.S. coupled with ongoing manufacturing cost reduction initiatives and
operating expense management, the Company expects to continue this trend going forward.

On
April 18, 2006, the Company acquired certain assets and assumed the trade payables of
Western Medical for $6,500,000 of which $6,000,000 was paid in cash and $500,000 was paid
via a three-year promissory note issued to Western Medical by the Company. In accordance
with the purchase agreement, Western Medical was required to transfer to the Company a
minimum $1,200,000 of working capital (receivables and inventory, less trade payables, as
defined) as of the date of sale. The Company anticipates transaction expenses of
$1,000,000 related to the purchase.

Western
Medical is a privately held manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. In 2005, Western Medical
reported unaudited sales of $6,500,000, gross margin of $2,600,000 and pre-tax income of
$700,000. Western Medicals product line is complementary to and will serve to expand
the Companys existing basic wound care line. The Company anticipates being able to
leverage cross selling opportunities presented by the purchase to grow sales. In addition,
the Company expects to absorb Western Medicals business within its existing
operating infrastructure incurring only modest cost increases. Both of these initiatives
are expected to increase the contribution of the business going forward.

In
connection with the acquisition, the Company raised $5,901,825 (net of $470,411 in
commission and other offering expenses) from the sale of 2,655,098 units (10,620,392
shares) at $2.40 per unit, each unit consisting of four shares of the Companys
common stock and one five-year warrant (2,655,098 warrants in total) to purchase one share
of common stock at the price of $1.00. In addition, the placement agent received 754,806
five year warrants to purchase one share of common stock at $0.72. Total common shares
outstanding increased from 12,285,768 before the acquisition to 22,906,160 afterwards. The
Company also received $1,000,000 in proceeds from a new term loan secured from its U.S.
lender through an amendment to its existing three year revolving credit

21

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Index

facility. The term loan bears
interest at prime plus 5% for which purpose prime may not be lower than 7.75%. On the
first day of each month from May 1, 2006 through September 1, 2006, payments of interest
only are required on the term loan. Commencing October 1, 2006 and on the first day of
the 28 months thereafter, payments of accrued interest and principal amortized at the
rate of 1/36th of the principal balance of the term loan ($27,777) are required. On April
1, 2009, payment of all principal and accrued interest of the term loan is required. In
addition, the amendment amends and restates various loan covenants of the revolving
credit facility effective March 31, 2006 and increases the revolving credit facility cap
from $2,000,000 to $3,500,000.

Cash Flow and Working
Capital

At
March 31, 2006 and December 31, 2005, the Company had cash and cash equivalents on hand of
$68,246 and $1,105,330, respectively. The $1,037,084 decrease principally represents a
timing difference that results from net cash used by operating activities of $607,432, net
cash used in financing activities of $299,237, net cash used in investing activities of
$128,260 and cash used as a result of exchange rate changes of $2,155. The timing
difference relative to cash used by operating activities reflects receipt of a large
Canadian receivable payment at year-end 2005. Subject to lender and tax authority
constraints surrounding the movement of cash between affiliated entities, the
Companys objective is to maintain minimum cash balances on hand while using
available funds to pay down its outstanding line of credit balances.

Net
cash used in operating activities of $607,432 stems from $1,116,978 cash used from the net
change in operating assets and liabilities partially offset by $509,546 cash provided from
operations (net income plus non cash items). Higher receivables, inventory and prepaids
partially offset by an increase in accounts payable were the major drivers behind the net
change in ongoing operating assets and liabilities. The increase in receivables reflects
the flow through of the large payment received at year-end 2005 and the absence of a
corresponding payment at the end of the first quarter 2006. The increase in inventory
reflects incremental investment in raw and packaging materials in support of several new
private label customers and bringing the manufacture of the wound closure and fastener
line of products in-house. The Company also made a significant investment in inventory
during the first quarter to replenish low levels of third party sourced product and to
better balance its inventory to improve customer service. The increase in prepaids in the
first quarter reflects the payment of insurance and certain service fees that are
subsequently amortized to expense as earned or when the activity takes place. The increase
in payables principally reflects the increase in the level of inventory spending.

Net
cash used in financing activities of $299,237 principally reflects the use of available
funds to pay down the Companys outstanding line of credit balance by $226,417 and
make normally scheduled long-term debt repayments of $72,820.

Net
cash used in investing activities of $128,260 reflects modest capital investment of
$76,908 consistent with the Companys plan to limit capital expenditures to that
necessary to continue running the business or generate an above average return until
operational performance improves together with $51,352 of deferred business acquisition
costs associated with the Western Medical acquisition.

Working
capital increased $70,810, or 2.1%, at March 31, 2006 to $3,425,603 from $3,354,793 at
December 31, 2005. Working capital of this magnitude is considered sufficient to support
ongoing operations.

Financing Arrangements
 United States

On
January 31, 2005, the Company entered into a three-year revolving credit facility
agreement (the Agreement) with a new U.S. lender for a maximum principal
amount of $2,000,000. The Company may request advances under the 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. 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 based upon
the difference between the daily average amount of advances outstanding and $2,000,000.

22

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Index

Maximum
potential advances under the Agreement at March 31, 2006 were $1,800,000. Advances
outstanding against the line were $854,144 at March 31, 2006, leaving an additional
$945,856 available for borrowing.

The
Company may terminate the Agreement at any time 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 Agreement divided by 12.

Financing Arrangements
 Canada

In
November 2005, the Company finalized the annual renewal of its Canadian Agreement for a
maximum principal amount of $685,000 ($800,000 Canadian) with its Canadian lender. In
light of the favorable impact of the new distribution agreement on the borrowing
requirements of the Companys wholly owned subsidiary, Derma Sciences Canada Inc.,
the maximum principal amount of the credit facility was reduced in line with the
subsidiarys prospective maximum borrowing capacity. 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 $342,000 ($400,000 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%.

Maximum
potential advances under the Canadian Agreement at March 31, 2006 were $412,000. Advances
outstanding against the Canadian Agreement were zero at March 31, 2006, leaving an
additional $412,000 available for borrowing.

In
the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $428,000 ($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.

In
addition, the Canadian lender has granted Derma Sciences Canada Inc. a $428,000 ($500,000
Canadian) non-revolving term line of credit to finance equipment purchases, equipment
upgrades and/or leasehold improvements to Derma Sciences Canada Inc.s manufacturing
facility in Toronto, Canada. Advances against the line are limited to 75% of the actual
cost of the capital expenditure. Interest on outstanding advances is payable monthly in
arrears at prime (as defined), plus 1.25%. Each advance shall be amortized and repaid over
sixty months. As of March 31, 2006, outstanding advances against the line was zero.

Prospective Assessment

The
Companys objective is to continue to grow sales and gross profit and return to
profitability in 2006. Growth of the Companys existing private label business is
expected to accelerate in 2006 as existing business continues to grow and new customers
are brought on board. Plans are in place to better leverage existing opportunities in the
Companys basic and advanced wound care lines in the U.S. by working more closely
with several key existing and potential new customers to increase business. The recent
acquisition of Western Medical, Inc. is expected to have a positive impact on the
Companys U.S. business. In Canada, the exclusive distribution agreement represents
an opportunity for sales growth in the near to intermediate future. In 2005, the Company
expanded its product development initiatives. As a result of these efforts, the Company
expects to launch two new products in 2006.

The
Company plans to build upon its success in 2005 in the area of product cost savings.
Higher throughput and improved operational efficiencies are expected to lower the
Companys overall internal cost of manufacturing going forward. Plans are in place to
bring the manufacture of the Companys wound closure and fastener line in house
during 2006 at a significant savings versus existing third party sourcing. The Company
expects to realize savings when it begins sterilizing its China source products in China
in the second half of 2006. Subject to commodity driven cotton prices and foreign exchange
changes, which are outside of the Companys

23

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Index

control, the Company expects to continue
building on its successful relationships in China to keep its basic wound care costs
competitive.

The
Company believes its existing infrastructure is adequate to support its growth plans for
the foreseeable future except in the area of information technology where the Company is
presently is in the midst of a two to three year program to upgrade its capabilities. In
addition, as a small business filer (as defined by the SEC), the Company is required to be
in compliance with Sarbanes-Oxley regulations as of December 31, 2007. The Company is
closely monitoring its requirements under Sarbanes-Oxley and expects to incur significant
one-time costs to comply beginning in the second half 2006 through the first quarter 2008
with modest ongoing incremental cost thereafter. Steps will continue to be taken to
monitor operating expenses and to limit spending in this area to that necessary to support
existing operations.

Going
forward, capital expenditures will continue to be limited to those projects capable of
generating an acceptable level of return and those necessary to support ongoing
operations. The Company plans to continue to closely monitor inventory levels with the
objective of properly balancing customer service requirements while minimizing 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
through at least December 31, 2006. 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 near future.

Update of Factors
Affecting Future Prospects

The
following factors affecting future prospects update the related factors set forth in the
Companys annual report on Form 10-KSB filed with the Securities and Exchange
Commission on March 31, 2006:

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

As
of April 30, 2006, 15,923,032 shares of the Companys common stock were issuable upon
the conversion or exercise of outstanding convertible preferred stock, warrants and
options (derivative securities). The shares of common stock issuable upon
conversion or exercise of derivative securities are substantial compared to the 22,906,160
shares of common stock currently outstanding.

Earnings
per share relative to the Companys common stock, as and when generated, will be
calculated assuming the conversion or exercise of all dilutive derivative securities.
Earnings per share of common stock would be substantially diluted by the existence of
these derivative securities regardless of whether they are converted or exercised. This
dilution of earnings per share could have a depressive effect upon the market value of the
Companys common stock.

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

The
Company earned net income of $57,720 (unaudited) in the first quarter of 2006, $22,241 in
2003, $61,368 in 2002 and $192,398 in 2001 and incurred losses of $909,104 in 2005,
$2,338,693 in 2004, $2,581,337 in 2000 and $2,998,919 in 1999. At
March 31, 2006, the Company had an accumulated deficit of $13,837,414 (unaudited).
Although the Company achieved nominal profitability in the first quarter of 2006, in
2003, 2002 and 2001, the Company cannot offer any assurance that it will be able to
generate sustained or significant earnings.

24

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Index

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

Historically,
the market price of the Companys common stock has been volatile. The high and low
prices for the years 2001 through 2005 and the first four months of 2006 are set forth in
the table below:

Derma Sciences
                        Trading Range - Common Stock

           Year                     Low           High
           ----                     ---           ----

           2001                     $0.22         $0.80
           2002                     $0.35         $0.85
           2003                     $0.35         $2.30
           2004                     $0.43         $1.90
           2005                     $0.42         $0.78
           2006(*)                  $0.45         $0.97
            _______________
            (*) January 1 through April 30.


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

| |   |                                                                                       
| | - | --------------------------------------------------------------------------------------
| |  | Quarter to quarter variations in its operating results;                               
| |  | Changes in earnings estimates by securities analysts;                                 
| |  | Changes in interest rates or other general economic conditions;                       
| |  | Changes in market conditions in the wound care and skin care
     industries;         
| |  | The introduction of new products either by the Company or by its
     competitors; and
| |  | The loss of a major customer.                                                         

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

Additional Financial
Information

Forward Looking Statements

Statements
that are not historical facts, including statements about the Companys confidence,
strategies, expectations about new or existing products, technologies, opportunities,
market demand or acceptance of new or existing products are forward-looking statements
that involve risks and uncertainties. These uncertainties include, but are not limited to,
product demand and market acceptance risk, impact of competitive products and prices,
product development, commercialization or technological delays or difficulties, 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

25

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Index

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

Goodwill

At
March 31, 2006, the Companys skin care segment had $200,000 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.

Stock-Based Compensation

Effective
January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment
(SFAS 123R) which revises SFAS 123 Accounting for Stock-Based Compensation,
(SFAS 123) and supercedes Accounting Principles Board Opinion 25 Accounting for Stock Issued to Employees.
Under APB 25, the Company used the "intrinsic value" method for employee stock options and did not record any expense
because option exercise prices equaled the market value at the date of grant. SFAS 123R requires that new,
modified and unvested share-based payment transactions with employees, such as grants of stock options
and restricted stock, be recognized in the financial statements based on their fair value at the grant date and
recognized as compsensation expense over their vesting periods. The Company estimates the fair value of
stock options as of the date of grant using the Black-Scholes pricing model and restricted stock based on
the quoted market price. The Company adopted SFAS 123R using the modified prospective method
and, accordingly, prior period financial statements were not revised. The Company recognized stock-based
employee compensation of $38,625 in the three months ended March 31, 2006 under SFAS 123R and no compensation
under APB 25 in the first three months ended March 31, 2005. Assuming compensation expense had been determined
for the three months ended March 31, 2005 based on the fair value at the grant date for all awards to employees,
using the Black-Scholes option pricing model consistent with the provisions of SFAS 123 and SFAS 123R, and
amortized ratably over the vesting period, instead of the intrinsic value method under APB 25, the Company would
have recorded compensation expense of approximately $170,000.

26

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Index

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 March 31, 2006. 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 March 31, 2006, 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.

27

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Index

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, 2006, are incorporated
herein by reference.

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

Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has caused this
report to be signed on its behalf by the undersigned thereunto duly authorized.

|                    |                                                                                              
|------------------- | ---------------------------------------------------------------------------------------------
|                    | DERMA SCIENCES, INC.                                                                         
|                    |                                                                                              
|                    |                                                                                              
|Dated: May 15, 2006 | By:/s/ John E.
     Yetter
         John E. Yetter, CPA
         Chief Financial
     Officer

28

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Index

EXHIBIT INDEX

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