---

U.S. SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549    FORM 10-QSB QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE
SECURITIES EXCHANGE ACT OF 1934 For Quarter Ended
     
     September 30, 2005Commission File Number
     
     1-31070  Derma Sciences, Inc.(Exact name of small business issuer as specified in its charter) Pennsylvania
     23-2328753(State or other jurisdiction of
     incorporation or organization)
     (I.R.S. Employer Identification
     No.)  214 Carnegie Center, Suite 100Princeton, New Jersey
08540(609) 514-4744(Address including zip code and
telephonenumber, of principal executive offices)


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

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

|Date: September 30, 2005 | Class: Common Stock, par value $.01 per share
|------------------------ | ---------------------------------------------
|                         | Shares Outstanding: 12,285,768               

Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act).    Yes [  ]   No [X]

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

---



Part IDERMA SCIENCES,
INC.FORM 10-QSBINDEX

Description
     
     PagePart I - Condensed Financial Information

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

Item 1.
     Legal Proceedings
     40Item 6.
     Exhibits
     40Forward Looking Statements

This document includes certain "forward-looking statements" within the
meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations
and are subject to uncertainty and changes in circumstances. Actual results may differ materially from these expectations due to
changes in political, economic, business, competitive, market and regulatory factors.
1



Index

Part I - Financial Information

Item 1.  CONDENSED FINANCIAL STATEMENTS

2
Index
DERMA SCIENCES, INC. AND SUBSIDIARIESConsolidated Balance Sheets


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

Current Assets
  Cash and cash equivalents                                            $    624,221     $     46,508
  Accounts receivable, net                                                1,695,053        2,601,092
  Inventories                                                             3,899,766        4,932,232
  Prepaid expenses and other current assets                                 269,782          181,201
------------------------------------------------------------------------------------------------------
Total current assets                                                      6,488,822        7,761,033
Equipment and improvements, net                                           3,467,232        3,662,557
Goodwill                                                                  1,110,967        1,110,967
Other intangible assets, net                                                320,807          383,911
Other assets, net                                                           314,539          132,464
------------------------------------------------------------------------------------------------------
Total Assets                                                           $ 11,702,367     $ 13,050,932
------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------------------------------------------------------------------------
Current Liabilities
  Line of credit borrowings                                            $  1,361,772     $  2,820,284
  Current maturities of long-term debt                                      285,161          247,306
  Accounts payable                                                        1,095,907        1,249,409
  Accrued expenses and other current liabilities                            483,996          594,438
------------------------------------------------------------------------------------------------------
Total current liabilities                                                 3,226,836        4,911,437
Long-term debt                                                              461,233          867,539
Other long-term liabilities                                                  91,522           53,207
------------------------------------------------------------------------------------------------------
Total Liabilities                                                         3,779,591        5,832,183
------------------------------------------------------------------------------------------------------
Commitments
Shareholders' Equity
Convertible preferred stock, $.01 par value; 11,750,000 shares
  authorized; issued and outstanding: 2,280,407 shares at September 30,
  2005 and December 31, 2004 (liquidation preference of $4,210,231 at
  September 30, 2005 and December 31, 2004)                                  22,804           22,804
Common stock, $.01 par value, 30,000,000 shares authorized;
  issued and outstanding: 12,285,768 shares at September 30, 2005 and
  11,079,007 shares at December 31, 2004                                    122,858          110,790
Additional paid-in capital                                               19,881,964       19,371,225
Accumulated other comprehensive income -
  cumulative translation adjustments                                        892,943          699,960
Accumulated deficit                                                     (12,997,793)     (12,986,030)
------------------------------------------------------------------------------------------------------
Total Shareholders' Equity                                                7,922,776        7,218,749
------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity                             $ 11,702,367     $ 13,050,932
======================================================================================================


See accompanying consolidated notes.

3



Index

DERMA SCIENCES, INC. AND SUBSIDIARIESConsolidated Statements of Operations (Unaudited)


======================================================================================================
                                                                            Three months ended
                                                                                September 30,
                                                                            2005             2004
------------------------------------------------------------------------------------------------------
Net sales                                                              $  5,712,457     $  4,969,824
Cost of sales                                                             3,750,384        3,768,367
------------------------------------------------------------------------------------------------------
Gross Profit                                                              1,962,073        1,201,457
------------------------------------------------------------------------------------------------------
Operating expenses                                                        1,831,780        1,393,822
Interest expense, net                                                        75,929           61,242
Other expense (income), net                                                  11,259          (10,252)
------------------------------------------------------------------------------------------------------
Total Expenses                                                            1,918,968        1,444,812
------------------------------------------------------------------------------------------------------
Income (loss) before provision for income taxes                              43,105         (243,355)
Provision for income taxes                                                    -                -
------------------------------------------------------------------------------------------------------
Net Income (Loss)                                                      $     43,105     $   (243,355)
------------------------------------------------------------------------------------------------------
Income (loss) per common share - basic and fully diluted                      $0.00           $(0.03)
------------------------------------------------------------------------------------------------------
Shares used in computing income (loss) per common share - basic          12,285,768        9,524,007
------------------------------------------------------------------------------------------------------
Shares used in computing income (loss) per common share - fully diluted  15,804,912        9,524,007
======================================================================================================


See accompanying consolidated notes.

4



Index

DERMA SCIENCES, INC. AND SUBSIDIARIESConsolidated Statements of Operations (Unaudited)


======================================================================================================
                                                                             Nine months ended
                                                                                September 30,
                                                                            2005             2004
------------------------------------------------------------------------------------------------------
Net sales                                                              $ 17,540,122     $ 14,913,257
Cost of sales                                                            12,018,056       10,885,070
------------------------------------------------------------------------------------------------------
Gross Profit                                                              5,522,066        4,028,187
------------------------------------------------------------------------------------------------------
Operating expenses                                                        5,412,992        5,317,681
Interest expense, net                                                       255,782          159,388
Other (income) expense, net                                                (134,945)         101,238
------------------------------------------------------------------------------------------------------
Total Expenses                                                            5,533,829        5,578,307
------------------------------------------------------------------------------------------------------
Loss before provision for income taxes                                      (11,763)      (1,550,120)
Provision for income taxes                                                     -                -
------------------------------------------------------------------------------------------------------
Net Loss                                                               $    (11,763)    $ (1,550,120)
------------------------------------------------------------------------------------------------------
Loss per common share - basic and fully diluted                               $0.00           $(0.17)
------------------------------------------------------------------------------------------------------
Shares used in computing loss per common share - basic and fully diluted 12,193,816        9,285,722
======================================================================================================


See accompanying consolidated notes.

5



Index

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


======================================================================================================
                                                                             Nine months ended
                                                                                September 30,
                                                                            2005             2004
------------------------------------------------------------------------------------------------------
Operating Activities
  Net loss                                                             $    (11,763)    $ (1,550,120)
  Adjustments to reconcile net loss to
   net cash provided by (used in) operating activities:
     Depreciation of equipment and improvements                             376,994          213,896
     Amortization of intangible assets                                       63,105          138,155
     Amortization of deferred financing costs                                53,791            -
     Provision for bad debts and rebates                                  1,200,909           38,613
     Provision for inventory obsolescence                                    71,918          106,279
     Loss on disposal of equipment                                           14,927          108,121
     Deferred rent expense                                                   30,575            -
     Employee stock options                                                   1,000            -
     Changes in operating assets and liabilities:
       Accounts receivable                                                 (269,664)         243,932
       Inventories                                                          995,571       (1,052,987)
       Prepaid expenses and other current assets                           (121,414)          63,111
       Other assets                                                        (131,031)          11,317
       Accounts payable                                                    (157,107)         549,250
       Accrued expenses and other current liabilities                      (114,912)         176,787
       Other long-term liabilities                                            7,365           37,305
------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities                       2,010,264         (916,341)
------------------------------------------------------------------------------------------------------
Investing Activities
  Cash paid for wound care business                                           -             (376,797)
  Purchase of equipment and improvements                                   (136,001)        (961,866)
  Proceeds from sale of equipment                                            35,629            -
  Short-term investments, restricted                                          -           (1,004,010)
------------------------------------------------------------------------------------------------------
Net cash used in investing activities                                      (100,372)      (2,342,673)
------------------------------------------------------------------------------------------------------
Financing Activities
  Net change in bank lines of credit                                     (1,433,934)       1,122,704
  Deferred financing costs                                                 (116,590)         (60,617)
  Long-term debt repayments                                                (377,449)        (149,946)
  Proceeds from issuance of stock, net of issuance costs                    539,307        1,961,798
------------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities                      (1,388,666)       2,873,939
------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash                                      56,487           (3,631)
------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents                        577,713         (388,706)

Cash and cash equivalents
  Beginning of period                                                        46,508          439,837
------------------------------------------------------------------------------------------------------
  End of period                                                        $    624,221     $     51,131
------------------------------------------------------------------------------------------------------

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


See accompanying consolidated notes.


6



Index

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

1.    Organization and
Summary of Significant Accounting Policies


Derma
Sciences, Inc. and its subsidiaries (the Company) are full line providers of
wound care, wound closure-fastener 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 function is performed by a third party. 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 and
nine month periods ended September 30, 2005, are not necessarily indicative of the results that may be expected for the year
ending December 31, 2005. Information included in the condensed balance sheet as of December 31, 2004 has been derived from the
consolidated financial statements and footnotes thereto for the year ended December 31, 2004, included in Form 10-KSB previously
filed with the Securities and Exchange Commission. For further information, refer to that Form 10-KSB.



Summary
of Significant Accounting Policies:


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


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


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


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


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


7
Index

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

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


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


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


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


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


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


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


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


8
Index

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

Pro
forma information regarding net income (loss) and net income (loss) per share is required
by SFAS No. 123, which also requires that the information be determined as if the Company
has accounted for its stock options granted to employees under the fair value method of
that Statement. The fair value for these options was estimated at the date of grant using
a Black-Scholes option pricing model with the following weighted-average assumptions for
2005 and 2004: risk-free interest rate of 4.25% for the three months ended March 31, 2005
and 3.90% for the three months ended June 30, 2005 and September 30, 2005, respectively,
and 4.0% for 2004; dividend yield of 0%; a volatility factor of the expected market price
of the Companys Common Stock of 1.376, 1.353, and 1.326 for the three months ended
March 31, 2005, June 30, 2005 and September 30, 2005, respectively, and 1.463 for 2004;
and an expected option life of 5 years.


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


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


Three Months Ended           Nine Months Ended
                                                    ------------------           -----------------
                                                       September 30,               September 30,
                                                       -------------               -------------
                                                    2005          2004          2005            2004
                                                    ----          ----          ----            ----

   Net income (loss) as reported                 $  43,105     $(243,355)    $  (11,763)    $(1,550,120)
   Pro forma compensation expense - net of tax    (111,153)     (173,736)      (583,541)       (708,084)
                                                 ----------    ----------    -----------    ------------

   Pro forma net loss                            $ (68,048)    $(417,091)     $(595,304)    $(2,258,204)
                                                 ==========    ==========     ==========    ============

   Income (loss) per common share - basic
         As reported                                 $0.00        $(0.03)        $ 0.00          $(0.17)
         Pro forma                                   $0.00        $(0.04)        $(0.05)         $(0.24)

   Income (loss) per common share - diluted
         As reported                                 $0.00        $(0.03)        $ 0.00          $(0.17)
         Pro forma                                   $0.00        $(0.04)        $(0.05)         $(0.24)



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


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


9
Index

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

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


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


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


Three Months Ended             Nine Months Ended
                                                  ------------------             -----------------
                                                     September 30,                 September 30,
                                                     -------------                 -------------
                                                   2005          2004           2005           2004
                                                   ----          ----           ----           ----
   Weighted average common shares
     outstanding - Basic                        12,285,768     9,524,007     12,193,816      9,285,722
                                                ----------    ----------     ----------     ----------

   Potentially dilutive shares:
     Preferred stock                             2,280,407     2,280,407      2,280,407      2,281,659
     Warrants                                      185,373       651,431         63,317        680,309
     Stock options                               1,053,364       912,706        574,683      1,017,484
                                                ----------    ----------     ----------     ----------

       Sub-total potentially dilutive shares     3,519,144     3,844,544      2,918,407      3,979,452
                                                ----------    ----------     ----------     ----------

       Weighted average common
         shares outstanding - Dilutive          15,804,912    13,368,551     15,112,223     13,265,174
                                                ==========    ==========     ==========     ==========



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



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


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


10
Index

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

Kimberly-Clark
manufactured wound care products, for the account of the Company, at its facility through
April 9, 2004 to meet current customer demand and to build sufficient inventory to cover
the period during which production at the Kimberly-Clark facility was discontinued and the
equipment was transferred to the Companys facility in Toronto, Canada. Upon
cessation of manufacturing at Kimberly-Clarks facility, the Company purchased, in
accordance with a pre-determined formula, inventory consisting of raw and packaging
materials and up to four months supply of finished goods. The purchase price of this
inventory was approximately $550,000. Cash on hand and borrowings against available credit
lines were used to pay for this inventory.


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



3.    Accounts Receivable


Accounts
receivable include the following:

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     Trade accounts receivable                   $3,101,017       $2,774,293
     Less:  Allowance for doubtful accounts         (54,242)         (57,090)
            Allowance for trade rebates          (1,443,068)        (164,000)
                                                  ----------       ----------
          Net trade receivables                   1,603,707        2,553,203
     Other receivables                               91,346           47,889
                                                  ----------       ----------

          Total receivables                      $1,695,053       $2,601,092
                                                  ==========       ==========

4.    Inventories

Inventories include the
following:


September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     Finished goods                              $2,561,791       $3,531,095
     Work in process                                 47,251           71,423
     Packaging materials                            483,094          461,052
     Raw materials                                  807,630          868,662
                                                  ----------       ----------

          Total inventories                      $3,899,766       $4,932,232
                                                  ==========       ==========


11
Index

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


5.    Equipment and
Improvements, net


Equipment
and improvements include the following:

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     Machinery and equipment                     $3,473,972       $3,407,073
     Furniture and fixtures                         242,324          196,506
     Leasehold improvements                         737,226          714,992
                                                  ----------       ----------
        Gross equipment and improvements          4,453,522        4,318,571
     Less: accumulated depreciation                (986,290)        (656,014)
                                                  ----------       ----------

        Total equipment and improvements, net    $3,467,232       $3,662,557
                                                  ==========       ==========

Included
in equipment and improvements at September 30, 2005 and December 31, 2004 were machinery
and equipment with a cost of $221,518 and $228,518 and accumulated amortization of $46,361
and $22,989, respectively, attributable to leased equipment. Amortization of assets under
capital leases is included in depreciation expense.



6.    Other Intangible
Assets, net

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

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

          Gross other intangible assets             786,864          786,864
          Less: accumulated amortization           (466,057)        (402,953)
                                                  ----------       ----------

          Other intangible assets, net            $ 320,807        $ 383,911
                                                  ==========       ==========

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



7.    Other Assets, net


Other
assets, net include the following:

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     Deferred financing costs, net                 $110,362        $  60,728
     Deposits                                        67,809           71,736
     Long-term receivable                           100,375             -
     Other                                           35,993             -
                                                  ----------       ----------

          Total other assets, net                  $314,539         $132,464
                                                  ==========       ==========

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


12
Index

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


8.    Line of Credit
Borrowings

Short-term borrowings include
the following:

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     U.S. line of credit                         $1,361,772       $1,312,756
     Canadian line of credit                           -           1,507,528
                                                  ----------       ----------

        Total line of credit borrowings          $1,361,772       $2,820,284
                                                  ==========       ==========



U.S.
Line of Credit


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


The
Company may request advances under the New Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.5%, but not less than 7.5% per annum. At September 30, 2005 the effective interest rate
was 9.10%. In addition, the Company pays a monthly collateral management fee at the rate
of 1.5% per annum upon the daily average amount of advances outstanding and a monthly
unused line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the new U.S. lender its guarantee of payment together
with a second lien security interest in the assets of the Companys wholly owned
Canadian subsidiary. The new U.S. lender has agreed not to exercise its rights under its
second lien security interest and guarantee against the Canadian assets without the
Canadian lenders approval.


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


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


13
Index

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

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


On
January 13, 2005 in connection with the refinancing of the U.S. line of credit, the
Company paid off and cancelled the outstanding irrevocable standby letter of credit issued
by the former U.S. lender in the amount of $200,000 held by the Companys Canadian
lender as additional security for its credit facility. The $200,000 paid to the Canadian
lender was applied as a permanent principal reduction against the principal amount due in
2007 associated with the Companys outstanding term loan with the Canadian lender
(see Note 10). Subsequently, on January 31, 2005 the Canadian lender agreed as part of
refinancing of the U.S. line of credit to retain its second lien security interest and
guarantee position against the Companys U.S. assets and not to exercise its rights
under its second lien security interest and guarantee against the U.S. assets without the
U.S. lenders approval.



Canadian
Line of Credit


As of September 30, 2005, the
Company was in the midst of renewing its revolving credit facility with its Canadian lender (the Canadian Agreement).
Management expects that the renewal will be finalized in the near future. In light of the favorable impact of the new distribution
agreement (see Note 17) on the borrowing requirements of the Company's wholly owned Canadian subsidiary, Derma Sciences Canada
Inc., the maximum principal amount of the credit facility will be reduced to $653,000 ($800,000 Canadian) in line with its
prospective maximum borrowing capacity. No other significant changes to the terms of the Canadian Agreement are expected.


In
September 2004, the Company finalized the annual renewal of the Canadian Agreement for a
maximum principal amount of $1,892,000 ($2,200,000 Canadian). 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 $946,000 ($1,100,000 Canadian) or 40% of eligible inventory (as defined), less
priority claims. Interest on outstanding advances is payable monthly in arrears at prime
rate (as defined) plus 1.0%, or 5.50% for Canadian dollar advances and 8.25% for U.S.
dollar denominated advances at September 30, 2005. Outstanding advances are secured by all
tangible and intangible assets of Derma Sciences Canada Inc. In addition, the Company has
accorded the Canadian lender its guarantee of payment together with a second lien security
interest in the Companys assets located in the U.S.


Over
the term of the Canadian Agreement, the Company has agreed to comply with a number of
financial covenants governing minimum working capital, current ratios, tangible net worth,
interest coverage, total indebtedness to tangible net worth and total indebtedness to
adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $430,000 ($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.


14
Index

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


9.    Accrued Expenses and
Other Current Liabilities


Accrued
expenses and other current liabilities include the following:

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     Accrued compensation and related taxes        $125,884          $218,037
     Accrued sales, goods and services taxes         92,546           197,984
     Accrued administrative fees                    200,411           107,916
     Accrued closure costs                           32,810                 -
     Other                                           32,345            70,501
                                                  ----------       ----------

        Total accrued expenses and other
          current liabilities                      $483,996          $594,438
                                                  ==========       ==========



10.    Long-Term Debt


Long-term
debt includes the following:

September 30,      December 31,
                                                     2005             2004
                                                     ----             ----

     Canadian term loan                            $593,291       $   916,805
     Capital lease obligations                      153,103           198,040
                                                  ----------       ----------

          Total debt                                746,394         1,114,845
     Less:  current maturities                      285,161           247,306
                                                  ----------       ----------

          Long-term debt                           $461,233       $   867,539
                                                  ==========       ==========


In
connection with the acquisition of substantially all the assets of Dumex Medical Inc. in
August 2002, the Company entered into a five-year term loan agreement with a Canadian
Bank. The loan is repayable in monthly payments consisting of principal and interest.
Interest on the outstanding principal balance is payable monthly at the banks prime
rate (as defined) plus 1.25%, or 5.75% at September 30, 2005. The term loan is secured by
all tangible and intangible assets of Derma Canada and is subject to the same financial
covenants applicable to the Canadian operating line of credit (see Note 8).


The
Company has three capital lease obligations for certain distribution and computer
equipment totaling $153,103. The capital leases bear interest at annual rates ranging from
3.9% to 10.2% with the longest lease term expiring in April 2009.



11.    Shareholders
Equity



Preferred
Stock


There
are 150,003 shares of series A convertible preferred stock outstanding at September 30,
2005. The series A preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $4.00 per share, votes as
a class on matters affecting the series A preferred stock and maintains voting rights
identical to the common stock on all other matters.


There
are 440,003 shares of series B convertible preferred stock outstanding at September 30,
2005. The series B preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $6.00 per share, votes as
a class on matters affecting the series B preferred stock and maintains voting rights
identical to the common stock on all other matters.


15
Index

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

There
are 619,055 shares of series C convertible preferred stock outstanding at September 30,
2005. The series C preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.70 per share,
votes as a class on matters affecting the series C preferred stock and maintains voting
rights identical to the common stock on all other matters.


There
are 1,071,346 shares of series D convertible preferred stock outstanding at September 30,
2005. The series D preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.50 per share,
votes as a class on matters affecting the series D preferred stock and maintains voting
rights identical to the common stock on all other matters.



Common
Stock


On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,666, net of $159,334 in offering expenses, were used for
working capital. The offering commenced prior to December 31, 2004. During 2005, the
Company sold 1,205,000 units at $0.50 per unit and received total offering proceeds of
$539,307, net of $80,693 in offering expenses. As of December 31, 2004, the Company had
sold 1,555,000 units at $0.50 per unit and received total offering proceeds of $681,359,
net of $78,641 in offering expenses.



Stock
Options


During
the three and nine months ended September 30, 2005, the Company granted stock options at
fair market value as follows:

Number of       Per Share
                                                    Granted Stock      Exercise
                                                      Options           Price
                                                      -------           -----

     Three months ended March 31, 2005                1,021,000         $0.50
     Three months ended June 30, 2005                   465,000         $0.42
     Three months ended September 30, 2005               40,000         $0.67
                                                      ---------

     Total for nine months ended September 30, 2005   1,526,000
                                                      =========


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



Stock
Purchase Warrants


During
the three months ended March 31, 2005, the Company issued 1,205,000 series G warrants in
conjunction with the private offering discussed above. The Companys 1,870,007 series
E warrants expired unexercised on July 18, 2005.


At
September 30, 2005, 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


16
Index

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


Shares
Reserved for Future Issuance


At
September 30, 2005, the Company had reserved the following shares of common stock for
future issuance:

Convertible preferred shares (series A - D)                 2,280,407
    Common stock options outstanding                            5,990,655
    Common stock options available for grant                      246,000
    Common stock warrants (series F - G)                        4,069,441
                                                                ---------

    Total common stock shares reserved                         12,586,503
                                                               ==========



12.    Comprehensive Income
(Loss)


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


Three Months Ended          Nine Months Ended
                                                    ------------------          -----------------
                                                       September 30,              September 30,
                                                       -------------              -------------
                                                     2005         2004         2005            2004
                                                     ----         ----         ----            ----

    Net income (loss) as reported                  $ 43,105    $(243,355)    $(11,763)    $(1,550,120)
    Other comprehensive (loss) income:
        Foreign currency translation adjustment     259,721      227,270      192,983         206,448
                                                    -------     ---------     --------     -----------

    Comprehensive income (loss)                    $302,826    $ (16,085)    $181,220     $(1,343,672)
                                                    =======     =========     ========     ===========




13.    Operating Segments


The Company
consists of three operating segments: wound care, wound closure-fasteners and skin care.
Products in the wound care segment consist of basic and advanced dressings, ointments and
sprays designed to treat wounds. Wound closure-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 advanced wound care wound closure-fastener products and skin care products
are primarily outsourced. Basic wound care products are manufactured in-house. Internally,
the segments are managed at the gross profit level. The aggregation or allocation of other
costs by segment is not practical.


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


17
Index

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

Three Months Ended September 30, 2005
                                 -------------------------------------
                                        Wound
                                       Closure-                                         Total
                        Wound Care     Fasteners     Skin Care     Other Costs         Company
                        ----------     ---------     ---------     -----------         -------

Net sales               $4,684,049    $  657,471    $  370,937            -          $ 5,712,457
                         ---------     ---------     ---------      -----------       -----------

Gross profit             1,606,267       333,916        21,890            -            1,962,073
Total expenses             -               -              -        $(1,918,968)       (1,918,968)
                                                                                      -----------

Net income                                                                           $    43,105
                                                                                      ===========

Net long-lived assets   $3,453,218         -        $1,203,288     $   242,500      $ 4,899,006
                         =========     =========     =========      ===========       ===========



                                 Three Months Ended September 30, 2004
                                 -------------------------------------
                                        Wound
                                       Closure-                                         Total
                        Wound Care     Fasteners     Skin Care     Other Costs         Company
                        ----------     ---------     ---------     -----------         -------

Net sales               $3,733,166    $  725,930    $  510,728            -          $ 4,969,824
                         ---------     ---------     ---------      -----------       -----------

Gross profit               705,303       368,217       127,937            -            1,201,457
Total expenses               -             -              -        $(1,444,812)       (1,444,812)
                                                                                      -----------

Net loss                                                                             $   (243,355)
                                                                                      ===========

Net long-lived assets   $3,644,730         -        $1,344,394     $   271,222       $ 5,260,346
                         =========     =========     =========      ===========       ===========



                                  Nine Months Ended September 30, 2005
                                  -------------------------------------
                                        Wound
                                       Closure-                                         Total
                        Wound Care     Fasteners     Skin Care     Other Costs         Company
                        ----------     ---------     ---------     -----------         -------

Net sales              $14,435,532    $1,955,742    $1,148,848            -          $17,540,122
                         ---------     ---------     ---------      -----------       -----------

Gross profit (loss)      4,597,081       997,178       (72,193)           -            5,522,066
Total expenses             -               -              -        $(5,533,829)      $(5,533,829)
                                                                                      -----------

Net loss                                                                             $   (11,763)
                                                                                      ===========

Net long-lived assets   $3,453,218         -         $1,203,288    $   242,500       $ 4,899,006
                         =========     =========      ==========    ===========       ===========


18
Index

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

Nine Months Ended September 30, 2004
                                  -------------------------------------
                                        Wound
                                       Closure-                                         Total
                        Wound Care     Fasteners     Skin Care     Other Costs         Company
                        ----------     ---------     ---------     -----------         -------

Net sales              $10,798,118    $2,624,198    $1,490,941            -          $14,913,257
                        ----------     ---------     ---------      -----------       -----------

Gross profit             2,398,221     1,304,621       325,345            -            4,028,187
Total expenses                -            -              -        $(5,578,307)       (5,578,307)
                                                                                      -----------

Net loss                                                                             $(1,550,120)
                                                                                      ===========
Net long-lived assets   $3,644,730         -         $1,344,394    $   271,222       $  5,260,346
                         =========     =========      ==========    ===========       ===========



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


For
the nine months ended September 30, 2005 the skin care segment gross profit (loss)
includes a $106,000 charge for closure of the Companys soap and lotion manufacturing
facility in St. Louis, Missouri.


The
following table presents net sales by geographic region.

Three Months Ended      Nine Months Ended
                   ------------------      -----------------
                      September 30,          September 30,
                      -------------          -------------
                      2005     2004          2005     2004
                      ----     ----          ----     ----

    United States      46%      51%           42%      53%
    Canada             51%      46%           54%      43%
    Other               3%       3%            4%       4%


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


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

September 30,    September 30,
                         -------------    -------------
                             2005             2004
                             ----             ----
    United States         $1,779,843       $2,060,025
    Canada                 3,094,001        3,162,588
    Other                     25,162           37,733
                           ---------        ---------

          Total           $4,899,006       $5,260,346
                           =========        =========


19
Index

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


14.    Income Taxes


The provision
for income taxes has been offset during the third quarter of 2005 and 2004 and the nine
months ended September 30, 2005 and 2004 by the utilization of the Companys net
operating losses. No benefit has been recorded as the realization of the net operating
losses is not assured.


At
December 31, 2004, the Company has net operating loss carryforwards of approximately
$8,300,000 for federal income tax purposes that expire in years 2012 through 2024. For
state income tax purposes, the Company has net operating loss carryforwards in a number of
jurisdictions in varying amounts and with varying expiration dates. The most significant
net operating loss is in New Jersey, site of the Companys domicile. This state
presently has a moratorium on the use of net operating losses. As of December 31, 2004,
the Company has foreign (primarily Canadian) net operating loss carryforwards of
approximately $1,065,000 which begin to expire in 2009. The timing in which the Company
can utilize its U.S. net operating loss carryforwards in any year or in total may be
limited under the Internal Revenue Code section 382 regarding changes in ownership of
corporations. Due to uncertainties surrounding the Companys ability to use its net
operating loss carryforwards, a full valuation allowance has been provided for all periods
presented.



15.    Distribution
Agreement Upset Fee


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

Three Months Ended           Nine Months Ended
                           ------------------           -----------------
                             September 30,                September 30,
                             -------------                -------------
                          2005         2004            2005         2004
                          ----         ----            ----         ----

    Sales                $18,000     $148,000        $113,300     $772,200
    Gross profit          $9,700      $68,000         $55,900     $350,500


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



16.    Employee Termination
Costs


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


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


20
Index

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


17.    Appointment of
Canadian Distributor


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


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


With
respect to sales made by the distributor to the Companys contract customers in its
capacity as a servicing agent, the Company will pay the distributor an agreed upon
distribution fee and a specified incentive for growth (as achieved). The Company will
reimburse the distributor for the difference between the price paid by the distributor and
the Companys contract price with its customer upon submission by the distributor of
an agreed upon rebate report. With respect to sales made by the distributor to its
customers, the distributors compensation will consist solely of the excess of the
proceeds over the cost of the product and the Company will not be responsible for payment
of any distribution fee. Further, the agreement requires the distributor to meet specified
minimum sales growth targets of 15%, 12%, 12% and 12% in the first four years and private
label product purchase targets failing which the Company may cancel the agreement. The
Company believes that the agreement will provide better service to its customers
throughout Canada and greater opportunity for sales growth.


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

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

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

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


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


21
Index



Item 2.
     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
     CONDITION AND RESULTS OF OPERATIONSQuarter Ended September 30, 2005
Compared to Quarter Ended September 30, 2004.


Results of Operations



Overview


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


The
Company engages in the manufacture, marketing and sale of three dermatological product
lines consisting of wound care, wound closure and fasteners and skin care. The wound care
line is composed of basic and advanced wound care products. Basic wound care consists of
gauze dressings, 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 and fastener line consists of wound closure strips
and a variety of catheter fasteners. The skin care line consists of bath sponges, skin
cleansers, soaps, hair and body washes and moisturizers.


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


Quarter Ended September 30,
                                       ---------------------------
                                          2005           2004               Variance
                                          ----           ----       ---------------------

Gross Sales                           $6,825,971     $5,254,203     $1,571,768      29.9%
Adjustments                           (1,113,514)      (284,379)      (829,135)    291.6%
                                       ---------      ---------      ---------

Net sales                              5,712,457      4,969,824        742,633      14.9%
Cost of sales                          3,750,384      3,768,367        (17,983)     (0.5%)
                                       ---------      ---------      ---------

Gross profit                           1,962,073      1,201,457        760,616      63.3%
Gross profit percentage                     34.3%          24.2%
Operating expenses                     1,831,780      1,393,822        437,958      31.4%
Interest expense, net                     75,929         61,242         14,687      24.0%
Other expense (income), net               11,259        (10,252)        21,511       -
                                       ---------      ---------      ---------

Total expenses                         1,918,968      1,444,812        474,156      32.8%
Income (loss) before income taxes         43,105       (243,355)       286,460
Provision for income taxes                  -              -              -          -
                                       ---------      ---------      ---------

Net income (loss)                     $   43,105     $ (243,355)    $  286,460       -
                                       =========      =========      =========




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 at
September 30, 2005, the trade rebate reserve would be overstated by approximately
$165,000. If the normal rebate cycle were two months at September 30, 2005, the trade
rebate reserve would be understated by approximately $330,000. To minimize its cash
outflow invested in rebates, distributors generally strive to optimize the rebate credit
submission process.


22
Index




Given
the nature of the Companys products and business, there is no external information
available to further validate the reasonableness of the trade rebate accrual balance.
Historical trends of sales subject to rebate and rebates received are evaluated monthly,
by distributor, on a 3 month, 6 month and 12 month rolling basis to update the continued
reasonableness of the assumptions used to quantify the accrual trade rebate balance.
Deviations in the trends resulting, among other causes, from distributors not submitting
their rebates on a timely basis are analyzed and factored in determining the required
accrual balance.


Medicaid
rebates are accrued monthly based upon recent historical activity and reconciled quarterly
based upon receipt of rebate reports from participating state agencies. Returns and
allowances and cash discounts have historically been accounted for on a cash basis, which
approximates accrual based accounting given the month-to- month consistency of these
charges.


Gross
to net sales adjustments comprise the following:

Quarter Ended September 30,
                                              ---------------------------
                                                  2005             2004
                                                  ----             ----
Gross Sales                                  $6,825,971       $5,254,203
                                              ---------        ---------

Trade rebates                                (1,053,717)        (223,796)
Medicaid rebates                                 (8,717)         (12,511)
Returns and allowances                          (11,640)         (10,896)
Cash discounts                                  (39,440)         (37,176)
                                              ---------        ---------

Total adjustments                            (1,113,514)        (284,379)
                                              ---------        ---------

Net sales                                    $5,712,457       $4,969,824
                                              =========        =========


Trade rebates
increased significantly in the third quarter 2005 versus 2004 due to the Companys
implementing an exclusive third party distribution agreement in the second quarter 2005
for its Canadian business, continuing growth of rebate intensive U.S. private label sales
and a general increase in the level of sales subject to rebate (contract
business) in other areas of the Companys business. Implementing the third
party distribution agreement was responsible for approximately $780,000 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 comparable period to
period and on balance reflect a normal level of activity. The slight 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 September 30, 2005 and 2004 is
outlined below:

Quarter Ended September 30,
                                              ---------------------------
                                                  2005             2004
                                                  ----             ----

Beginning balance - July 1                   $1,363,463         $168,000
Rebates paid                                   (965,657)        (190,747)
Rebates accrued                               1,047,754          219,103
                                              ---------          -------

Ending balance - September 30                $1,445,560         $196,356
                                              =========          =======

The
$82,097 increase in the third quarter 2005 trade rebate reserve reflects a $159,745
increase to $1,131,813 in the reserve associated with the commencement of the
Companys third party distribution agreement in Canada during the second quarter 2005
partially offset by a higher level of scheduled U.S. private label rebate payments during
the third quarter 2005 which served to significantly reduce the outstanding balance owed.
There has been no other discernable change in the nature of the Companys business as
it relates to the accrual and subsequent payment of rebates, nor has there been any
material prior period related adjustments to the trade rebate accrual in the third quarter
2005. The $28,356 increase in the third quarter 2004 trade rebate reserve reflects the
continued growth of the rebate intensive U.S. private label business coupled with the
commencement of extended payment terms with two large customers, partially offset by the
work down of a higher than normal trade rebate accrual balance due to significant sales of
product subject to rebate earlier in the year.


23
Index





Net Sales and Gross Margin


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

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

Wound care                     $4,684,049      $3,733,166     $950,883       25.5%
Wound closure and fasteners       657,471         725,930      (68,459)      (9.4%)
Skin care                         370,937         510,728     (139,791)     (27.4%)
                                ---------       ---------     --------

    Total                      $5,712,457      $4,969,824     $742,633       14.9%
                                =========       =========      =======

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

Wound care                     $1,606,267      $  705,303     $900,964      127.7%
Wound closure and fasteners       333,916         368,217      (34,301)      (9.3%)
Skin care                          21,890         127,937     (106,047)     (82.9%)
                                ---------       ---------     --------

    Total                      $1,962,073      $1,201,457     $760,616       63.3%
                                =========       =========      =======

Wound
care sales increased $950,883, or 25.5%, to $4,684,049 in 2005 from $3,733,166 in 2004.
The increase is attributable to a basic wound care increase of $606,742, or 21.9%. This
increase was driven by an increase in Canadian basic wound care sales of $595,385
comprised of growth of $390,945 and favorable exchange of $204,440 (reflecting a 8.2%
strengthening of the Canadian dollar) while U.S. sales increased $11,357, or 2.4%. The
Canadian sales growth was driven by the exclusive distribution agreement that commenced in
the second quarter 2005. The U.S. sales performance reflects the relatively stable demand
for these products. Advanced wound care sales increased $344,142, or 35.8%, to $1,305,803
in 2005 from $961,661 in 2004. This increase was principally driven by continued growth of
the Companys private label sales to U.S. customers together with higher Dermagran
and former Kimberly-Clark product sales. This increase was partially offset by lower
silver advanced wound care product sales which, while improving in the third quarter 2005,
were $85,077 less than sales in the third quarter 2004.


Wound
care gross profit increased $900,964, or 127.7%, to $1,606,267 in 2005 from $705,303 in
2004. Gross profit margin increased to 34.3% in 2005 from 18.9% in 2004. The margin dollar
increase and improved gross margin percentage are due to the increase in sales and the
flow through of lower basic wound care costs negotiated in 2004, lower silver dressing
costs associated with sourcing from a new supplier, lower advanced wound care costs
associated with manufacturing the former Kimberly-Clark products in-house versus the
acquisition related negotiated costing used in 2004 and the non-recurrence of one-time
Kimberly-Clark equipment transfer, start-up and product validation costs incurred in the
third quarter 2004. Also contributing was the transfer of approximately $90,000 of freight
costs to distribution expense. Excluding the benefit of the freight expense
reclassification, wound care margins would have been 32.4%. In connection with the
implementation of the exclusive distribution agreement for the Companys products in
Canada in the second quarter 2005, the distributor took over responsibility for all
distribution costs. Outbound freight costs previously recorded as part of cost of sales
are now being absorbed by the distributor and charged back to the Company as part of its
overall distribution fee which is recorded in distribution expense.


Wound
closure and fastener sales decreased $68,459, or 9.4%, to $657,471 in 2005 from $725,930
in 2004. A reduction of approximately $124,000 in sales of certain catheter fasteners in
2005 versus 2004 associated with the loss of the Companys exclusive distribution
agreement for the sale of these products in August 2004 is primarily responsible for the
decrease. Higher suture strip and catheter fastener sales due to improving demand served
to partially mitigate the decrease.


24
Index




Wound
closure-fastener gross profit decreased $34,301, or 9.3%, to $333,916 in 2005 from
$368,217 in 2004. Gross profit margins were essentially unchanged at 50.8% in 2005 versus
50.7% in 2004. The decrease in margin dollars is consistent with the sales shortfall.


Skin
care sales decreased $139,791, or 27.4%, to $370,937 in 2005 from $510,728 in 2004 due to
continuing competitive pressure and the loss of several key customers. Skin care gross
profit decreased $106,047 to $21,890 in 2005 from $127,937 in 2004. 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
and percentage experienced during the quarter reflect continuation of high cost
manufacturing for half the quarter coupled with a number of one-time costs associated with
the closure. Skin care margins are expected to improve going forward once the Company
works through its higher cost inventory on hand and begins to realize the full benefit of
the facilitys closure.



Operating Expense


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

Quarter Ended September 30,
                                  ---------------------------
                                      2005           2004                Variance
                                      ----           ----         ---------------------

     Distribution                $  389,807     $  243,232        $146,575        60.3%
     Marketing                       90,700         57,785          32,915        57.0%
     Sales                          458,569        444,852          13,717         3.1%
     General administrative         892,704        647,953         244,751        37.8%
                                  ---------      ---------         -------

         Total                   $1,831,780     $1,393,822        $437,958        31.4%
                                  =========      =========         =======

Operating
expense increased $437,958, or 31.4%, to $1,831,780 in 2005 from $1,393,822 in 2004
including an increase of $36,339, or 2.6%, attributable to exchange associated with an
8.2% strengthening of the Canadian dollar on the Canadian operations.


Distribution
expense increased $146,575, or 60.3%, in 2005 versus 2004. Expenses in Canada increased
$167,026 (including $8,487 expense related to exchange) while expenses in the U.S
decreased $20,451. The increase in Canada was attributable to implementation of the new
distribution agreement. Effective June 1, 2005 the new distributor assumed responsibility
for customer service, product delivery and inventory maintenance and warehousing while, to
the extent possible, the Company eliminated its internal costs for these services. The
distributor charges the Company a distribution fee each month based on a fixed percentage
of eligible distributor net sales of the Companys product to end users. The $158,539
increase (excluding exchange) is attributable to an estimated $108,000 of freight and
customer service costs being included in the distribution fee and recorded as distribution
expense that the Company previously recorded (when it internally provided distribution
services) as cost of sales (freight) and general and administrative expense (customer
service). The balance of approximately $50,500 represents the cost of maintaining a
temporary distribution warehouse until such time as these activities can be integrated
into existing leased manufacturing space estimated at $33,000 together with slightly
higher overall distributor fees versus the Companys previous internal costs. The
U.S. decrease was attributable to lower compensation costs associated with running the new
U.S. distribution facility opened in March 2004 more cost effectively in 2005 and the
absence in 2005 of start up related costs incurred in 2004 associated with bringing the
new U.S distribution center on line.


Marketing
expense increased $32,915, or 57.0%, in 2005 versus 2004. The increase is principally
attributable to higher literature, promotion and product development expense in support of
the Companys growth initiatives.


25
Index




Sales
expense increased $13,717, or 3.1%, in 2005 versus 2004. Expenses in Canada increased
$8,211 (including $7,913 expense related to exchange) while expenses in the U.S. increased
$5,506. The slight increase in Canada (excluding exchange) is attributable to a higher
level of sales support activities consisting principally of travel, convention attendance
and sampling to expand market visibility and improve contract compliance 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 attributable to higher
compensation and commissions of $12,500 associated with hiring two new sales
representatives (one replacement and one new position), one-time recruiting fees of
$28,000 and higher travel costs of $7,000. Partially offsetting these increases were
savings of $20,000 related to the elimination of a sales database consultant and related
expenses, lower sample costs of $12,000 and lower manufacturers representative
commissions of $10,000 due to the discontinuance of manufacturers representatives in
the second quarter of 2005.


General
administrative expense increased $244,751, or 37.8%, in 2005 versus 2004. Expenses in
Canada increased $201,467 (including $7,393 expense related to exchange) while expenses in
the U.S. increased $43,284. The increase in Canada reflects the non-recurrence of a
$123,600 employee termination settlement gain recognized in the third quarter 2004
(original settlement expense was recorded in the first quarter 2004) coupled with higher
compensation costs related to the hiring of a director of materials and logistics in the
second quarter 2005 together with higher travel, computer and professional services
expenses. Partially offsetting these increases was an estimated benefit of $18,000 related
to the elimination of the customer service department in the second quarter 2005 in
connection with commencement of the new exclusive distribution agreement. The U.S.
increase principally reflects board of directors fees initiated in January 2005, increased
compensation associated with the retention of an employee formerly part of the skin care
manufacturing team (facility closed in August 2005) to serve as supervisor of materials
and logistics and higher benefit, travel and professional service expenses.



Interest Expense


Interest
expense increased $14,687, or 24.0%, to $75,929 in 2005 from $61,242 in 2004. Interest
expense in Canada decreased $17,944 (net of $2,865 expense related to exchange) while
interest expense in the U.S. increased $32,631. The decrease in Canada reflects lower
outstanding line of credit and term loan balances in 2005, partially offset by slightly
higher interest rates and fees. Canadas outstanding line of credit balance was
significantly reduced beginning in mid-May 2005 and reached zero by the end of June 2005
through use of the initial one-time positive cash flow generated by implementation of the
new distribution agreement. Canadas term loan was significantly reduced in January
2005 as a result of the pay off of an outstanding irrevocable standby letter of credit
issued by the U.S. lender in the amount of $200,000 held by the Canadian lender as
additional security for its credit facility. The $200,000 payment was applied to the term
loan as a permanent principal reduction against the principal amount due in 2007. The U.S.
increase is due to higher outstanding line of credit balances, higher interest rates and
higher line of credit fees in 2005 versus 2004. In January 2005, the U.S. operation
refinanced its line of credit at a higher overall cost.



Other Income/Expense


Other
expense increased $21,511 to $11,259 expense in 2005 from $10,252 income in 2004. The
increase is primarily driven by losses on fixed asset disposals related to the closure of
the skin care manufacturing facility and higher storage and demurrage charges associated
with a truckers strike in Canada in 2005 compared to 2004 that included a favorable
exchange gain partially offset by higher state taxes.



Income Taxes


The
Companys provision for income taxes in the third quarter 2005 and 2004 was offset by
the utilization of net operating losses.



Net Income (Loss)


The
Company generated net income of $43,105, or $0.00 per share (basic and diluted) in the
third quarter 2005, compared to a $243,355 loss, or $0.03 loss per share (basic and
diluted) in the third quarter 2004.


26
Index



NINE MONTHS ENDED SEPTEMBER 30, 2005
COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2004.



Results of Operations



Overview


The
following table highlights the nine months ended September 30, 2005 versus 2004 operating
results:

Nine Months Ended September 30,
                               -------------------------------
                                   2005              2004                  Variance
                                   ----              ----         -----------------------

Gross Sales                    $20,273,239       $15,705,084      $ 4,568,155       29.1%
Adjustments                     (2,733,117)         (791,827)      (1,941,290)     245.2%
                                ----------        ----------       ----------

Net sales                       17,540,122        14,913,257        2,626,865       17.6%
Cost of sales                   12,018,056        10,885,070        1,132,986       10.4%
                                ----------        ----------       ----------

Gross profit                     5,522,066         4,028,187        1,493,879       37.1%
Gross profit percentage               31.5%             27.0%
Operating expenses               5,412,992         5,317,681           95,311        1.8%
Interest expense, net              255,782           159,388           96,394       60.5%
Other (income) expense, net       (134,945)          101,238         (236,183)       -
                                ----------        ----------       ----------

Total expenses                   5,533,829         5,578,307          (44,478)       0.8%
Loss before income taxes           (11,763)       (1,550,120)       1,538,357       99.2%
Provision for income taxes             -                -                -           -
                                ----------        ----------       ----------

Net loss                       $   (11,763)      $(1,550,120)     $ 1,538,357       99.2%
                                ==========        ==========       ==========


Gross to Net Sales
Adjustments


Gross
to net sales adjustments comprise the following:

Nine Months Ended September 30,
                                         -------------------------------
                                              2005             2004
                                              ----             ----

      Gross Sales                         $20,273,239      $15,705,084
                                           ----------       ----------

      Trade rebates                        (2,549,451)       (598,428)
      Medicaid rebates                        (22,137)        (36,253)
      Returns and allowances                  (50,134)        (44,145)
      Cash discounts                         (111,395)        (113,001)
                                           ----------       ----------

      Total adjustments                    (2,733,117)       (791,827)
                                           ----------       ----------

      Net sales                           $17,540,122     $14,913,257
                                           ==========      ==========

Trade rebates
increased significantly in the first nine months of 2005 versus 2004 due to the
Companys implementing an exclusive third party distribution agreement in the second
quarter 2005 for its Canadian business, continuing growth of rebate intensive U.S. private
label sales and a general increase in the level of sales subject to rebate (contract
business) in other areas of the Companys business. Implementing the third
party distribution agreement was responsible for approximately $1,752,000 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 comparable period to
period and on balance reflect a normal level of activity. The slight decrease in cash
discounts reflects the Companys efforts to tighten its discount terms while
experiencing a trend in sales growth towards larger customers that routinely take
advantage of available discount terms.


27
Index





Rebate Reserve Roll
Forward


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

Nine Months Ended September 30,
                                            -------------------------------
                                                 2005             2004
                                                 ----             ----

     Beginning balance - January 1          $   235,200         $212,000
     Rebates paid                            (1,318,658)        (589,333)
     Rebates accrued                          2,529,018          573,689
                                              ---------          -------

     Ending balance - September 30           $1,445,560         $196,356
                                              =========          =======

The
$1,210,360 net increase in rebates the first nine months of 2005 reflects a $1,131,000
incremental reserve associated with implementing the third party distribution agreement in
Canada during the second quarter 2005 coupled with lower rebates paid due to extended
rebate payment terms with two large customers. There has been no other discernable change
in the nature of the Companys business as it relates to the accrual and subsequent
payment of rebates, nor has there been any material prior period related adjustments to
the trade rebate accruals in 2005. The $15,644 decrease in the first nine months of 2004
trade rebate reserve reflects the work down of a higher than normal beginning accrual
balance due to significant sales of product subject to rebate in December 2003 and January
2004 coupled with a decrease in the amount of corresponding sales subject to rebate in the
following months as customers worked down their existing inventory levels. This decrease
was partially offset by the commencement of extended rebate payment terms with two large
customers during the first half of 2004.



Net Sales and Gross Margin


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

Nine Months Ended September 30,
                                -------------------------------
                                    2005           2004                  Variance
                                    ----           ----          ----------------------
Product Line Net Sales
----------------------

Wound care                       $14,435,532     $10,798,118     $3,637,414       33.7%
Wound closure and fasteners        1,955,742       2,624,198       (668,456)     (25.5%)
Skin care                          1,148,848       1,490,941       (342,093)     (22.9%)
                                  ----------      ----------      ---------

    Total                        $17,540,122     $14,913,257     $2,626,865       17.6%
                                  ==========      ==========      =========

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

Wound care                       $ 4,597,081     $ 2,398,221     $2,198,860       91.7%
Wound closure and fasteners          997,178       1,304,621       (307,443)     (23.6%)
Skin care                            (72,193)        325,345       (397,538)       -
                                  ----------      ----------      ---------

    Total                        $ 5,522,066     $ 4,028,187     $1,493,879       37.1%
                                  ==========      ==========      =========

Wound
care sales increased $3,637,414, or 33.7%, to $14,435,532 in 2005 from $10,798,118 in
2004. The increase is principally attributable to a basic wound care increase of
$3,158,187, or 41.0%. This increase was driven by a significant increase in Canadian basic
wound care sales of $3,092,462 comprised of growth of $2,574,376 and favorable exchange of
$518,086 (reflecting a 7.5% strengthening of the Canadian dollar) while U.S. sales
increased $65,725, or 5.0%. The Canadian sales growth was driven by a one-time benefit of
approximately $1,740,000 (excluding foreign exchange benefit) related to the sale of
inventory on hand to fill the distribution pipeline in conjunction with the appointment of
an exclusive third party distributor for Canada in the second quarter coupled with normal
growth of $834,376, or 13.5%, due principally to improved contract compliance and the
improved market visibility afforded by the new exclusive distribution agreement effective
June 1, 2005. Advanced wound care sales increased $479,228, or 15.5%, to $3,577,639 in
2005 from $3,098,411 in 2004. This increase was driven by continued growth of the
Companys private label sales to U.S. customers. These increases were partially
offset by lower former Kimberly-Clark private label product sales attributable to
competitive pressure and lower silver product sales which, while improving in the third
quarter 2005, were $170,544 less than in 2004.


28
Index




Wound
care gross profit increased $2,198,860, or 91.7%, to $4,597,081 in 2005 from $2,398,221 in
2004. Gross profit margin increased to 31.8% in 2005 from 22.2% in 2004. Approximately
$600,000 of the increased gross margin dollars relates to the one-time sale of inventory
to fill the new Canadian distributors pipeline. The balance of the margin dollar
increase and improved gross margin percentage are due to the increase in sales and the
flow through of lower basic wound care costs negotiated in 2004, lower silver dressing
costs associated with sourcing from a new supplier, lower advanced wound care costs
associated with manufacturing the former Kimberly-Clark products in-house versus the
acquisition related negotiated costing used in much of 2004, the non-recurrence of
one-time advanced wound care private label manufacturing and Kimberly-Clark equipment
transfer start-up and product validation costs incurred in 2004, and the non-recurrence of
a one-time $59,400 inventory write-off in the first quarter 2004. Also contributing was
the transfer of approximately $120,000 of freight costs out of cost of sales to
distribution expense in 2005. Excluding the benefit of the freight expense
reclassification, 2005 wound care margins would have been 31.0%. In connection with the
implementation of the exclusive distribution agreement for the Companys products in
Canada in the second quarter 2005, the distributor took over responsibility for all
distribution costs. Outbound freight costs previously recorded as part of cost of sales
are now being incurred by the distributor and charged back to the Company as part of its
overall distribution fee.


Wound
closure and fastener sales decreased $668,456, or 25.5%, to $1,955,742 in 2005 from
$2,624,198 in 2004. A reduction of approximately $664,000 in sales of certain catheter
fasteners in 2005 versus 2004 associated with the loss of the Companys exclusive
distribution agreement for the sale of these products in August 2004 is primarily
responsible for the decrease. Lower catheter fastener sales due to competitive pressure
partially offset by a slight increase in suture strip sales is responsible for the balance
of the sales decrease.


Wound
closure and fastener gross profit decreased $307,443, or 23.6%, to $997,178 in 2005 from
$1,304,621 in 2004. Gross profit margins improved to 51.0% in 2005 from 49.7% in 2004. The
decrease in margin dollars is consistent with the sales shortfall. The margin improvement
principally reflects the benefit of the loss of the exclusive catheter fastener business,
which was slightly lower margined than the average for the line.


Skin
care sales decreased $342,093, or 22.9%, to $1,148,848 in 2005 from $1,490,941 in 2004 due
to continuing competitive pressure and the loss of several key customers. Skin care gross
profit decreased $397,538 to a loss of $72,193 in 2005 from a profit of $325,345 in 2004.
The Company completed the closure of its skin care manufacturing operation on schedule at
the end of August 2005 and commenced outsourcing the manufacture of its skin care products
from a third party supplier. Included in the 2005 loss are one-time costs of approximately
$106,000 associated with the closure of the facility. Excluding these one-time costs, the
skin care line generated a positive gross margin of approximately $34,000 for the first
nine months of 2005. Skin care margins are expected to improve going forward once the
Company works through its higher cost inventory on hand and begins to realize the full
benefit of the facilitys closure.



Operating Expense


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

Nine Months Ended September 30,
                               -------------------------------
                                     2005           2004                Variance
                                     ----           ----         -------------------
     Distribution                $  974,494     $  806,681       $167,813      20.8%
     Marketing                      316,002        267,057         48,945      18.3%
     Sales                        1,390,741      1,347,945         42,796       3.2%
     General administrative       2,731,755      2,895,998       (164,243)     (5.7%)
                                  ---------      ---------        -------

         Total                   $5,412,992     $5,317,681       $ 95,311       1.8%
                                  =========      =========        =======


29
Index




Operating
expense increased $95,311, or 1.8%, to $5,412,992 in 2005 from $5,317,681 in 2004
including an increase of $137,266, or 2.6%, attributable to exchange associated with a
7.9% strengthening of the Canadian dollar on the Canadian operations.


Distribution
expense increased $167,813, or 20.8%, in 2005 versus 2004. Expenses in Canada increased
$303,368 (including $24,083 expense related to exchange) while expenses in the U.S.
decreased $135,555. The increase in Canada was attributable to implementation of the new
distribution agreement. Effective June 1, 2005 the new distributor assumed responsibility
for customer service, product delivery and inventory maintenance and warehousing while, to
the extent possible, the Company eliminated its internal cost for these services. 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
$279,285 increase (excluding exchange) is attributable to an estimated $144,000 of freight
and customer service costs being included in the distribution fee and recorded as
distribution expense that the Company previously recorded (when it internally provided
distribution services) as cost of sales (freight) and general and administrative (customer
service). In addition, the Company incurred approximately $52,000 in one-time severance
and other related costs associated with the transition to the new distribution agreement.
The balance of the increase relates to the cost of maintaining a temporary distribution
warehouse until such time that these activities can be integrated into existing leased
manufacturing space, incremental transition related expenses and slightly higher
distributor fees versus the Companys previous internal costs. The U.S. decrease
principally reflects the benefit of closing one of the Companys distribution
facilities in April 2004 and the non-recurrence in 2005 of approximately $60,000 of
one-time costs to close the facility and various incremental start-up related expenses
associated with bringing the new U.S. distribution center which opened in March 2004,
on-line. Partially offsetting these expense reductions were higher lease costs associated
with the new, larger U.S. distribution center.


Marketing
expense increased $48,945, or 18.3%, in 2005 versus 2004. The increase is principally
attributable to higher literature, promotion and product development expense in support of
the Companys growth initiatives.


Sales
expense increased $42,796, or 3.2%, in 2005 versus 2004. Expenses in Canada increased
$101,540 (including $22,516 expense related to exchange) while expenses in the U.S.
decreased $58,744. The increase in Canada is attributable to a higher level of sales
support activities consisting principally of travel, convention attendance and sampling to
expand market visibility and improve contract compliance and one-time severance and travel
costs associated with implementing the new distribution agreement. The U.S. decrease was
attributable to lower compensation of $45,000 associated with lower sales representative
commissions due to timing, lower manufacturers representative commissions due to the
decision to discontinue the use of manufacturers representatives in the second
quarter 2005 partially offset by the addition of a new sales representative in September
2005, elimination of a sales database consultant and related expenses in early 2005
generated savings of $50,000 and lower sampling expense of $10,000, also contributed.
Partially offsetting these decreases were higher recruiting expenses of $28,000 and travel
costs of $17,000.


General
and administrative expense decreased $164,243, or 5.7%, in 2005 versus 2004. Expenses in
Canada decreased $184,333 (net of $90,667 expense related to exchange) while expenses in
the U.S. increased $20,090. The $275,000 decrease (excluding exchange) in Canada
principally reflects the non-recurrence in 2005 of a $326,400 charge for employee
termination costs, a benefit of $24,000 related to the elimination of the customer service
department in the second quarter 2005 in connection with the commencement of the new
distribution agreement and generally lower miscellaneous spending in an effort to contain
costs. Partially offsetting these decreases were one-time costs of $41,700 for severance
and other costs associated with implementing the new distribution agreement together with
higher compensation costs of $46,000 associated with the hiring of a director of materials
and logistics in the second quarter 2005. The increase in the U.S. reflects board of
directors fees of $50,000 initiated in 2005, higher information technology costs of
$18,000 associated with an upgrade of the Companys hardware and overall systems
capabilities, incremental Sarbanes Oxley related fees of $30,000 and travel of $10,000,
partially offset by the non-recurrence in 2005 of a $42,600 bad debt write-off taken in
the first quarter 2004 coupled with lower public relations, legal and regulatory costs due
to cost containment efforts.


30
Index





Interest Expense


Interest
expense increased $96,394, or 60.5%, to $255,782 in 2005 from $159,388 in 2004. Interest
expense in Canada decreased $20,369 (net of $8,071 expense related to exchange) while
interest expense in the U.S. increased $116,763. The $28,440 decrease in Canada (excluding
exchange) reflects lower outstanding line of credit and term loan balances in 2005,
partially offset by slightly higher interest rates and fees. Canadas outstanding
line of credit balance was significantly reduced beginning in mid-May 2005 to zero by the
end of June 2005 through the use of the initial one-time positive cash flow generated by
implementation of the new distribution agreement. Canadas term loan was
significantly reduced in January 2005 as a result of the pay off of an outstanding
irrevocable standby letter of credit issued by the U.S. lender in the amount of $200,000
held by the Canadian lender as additional security for its credit facility. The $200,000
payment was applied to the term loan as a permanent principal reduction against the
principal amount due in 2007. The increase in the U.S. is due to higher outstanding line
of credit balances, higher interest rates and higher line of credit fees in 2005 versus
2004. In January 2005, the U.S. refinanced its line of credit at a higher overall cost. In
addition, in 2004 the U.S. operation did not move into a net borrowing position until June
2004.



Other Income/Expense


Other
income increased $236,183 to $134,945 income in 2005 from $101,238 expense in 2004. The
2005 net income was comprised of a gain plus interest of $176,000 related to a
distribution agreement upset fee recorded in the first quarter 2005 and license fee income
of $14,000 less unfavorable exchange of $22,000, fixed asset write-offs of $22,000 and
miscellaneous net expense of $11,000. The 2004 net expense was comprised of fixed asset
write-offs of $83,000, reversal of a prior year gain on sale of $14,000 and miscellaneous
net expense of $4,000.



Income Taxes


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



Net Loss


The
Company incurred a net loss of $11,763, or $0.00 loss per share (basic and diluted), in
the first nine months of 2005 compared to a $1,550,120 loss, or $0.17 loss per share
(basic and diluted), in the first nine months of 2004.



Liquidity and Capital
Resources



Operational Overview


In
the first nine months of 2005, overall sales have not met expectations. Adjusted for
one-time items, lost business and foreign exchange, period-to-period sales growth was
approximately 6%. Sales in Canada have exceeded 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 in the U.S. are essentially flat period to period. Growth in the
private label area has effectively been offset by softness in the skin care area of the
business, while Dermagran, basic wound care and wound closure-fastener sales have remained
relatively stable.


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


31
Index




As
expected, the Company has realized the benefit of its major manufacturing and sourcing
initiatives completed in 2004. Notwithstanding the impact of sales pricing and mix on
margins, the Company has realized an improvement in its overall gross margin percentage in
2005 stemming from lower product costs.


In
an effort to enhance manufacturing efficiency and competitiveness, the Company decided to
shut down its skin care manufacturing facility and outsource the manufacture of these
products. An agreement was signed in July 2005 to cost effectively outsource the
manufacture of the Companys skin care products. The Company completed the closure of
the skin care manufacturing facility on schedule at the end of August 2005. Excluding
one-time costs, the skin care line generated a modest positive gross margin through the
first nine months of 2005. Skin care gross margins are expected to improve going forward
as the Company works through its existing higher cost inventory on hand and begins to
realize the full benefit of the facilitys closure.


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


Excluding
a one-time gain of $164,300 related to a distribution agreement upset fee, the first
quarter 2005 net loss was $377,352. Excluding the one-time gain of $495,000 associated
with the implementation of the new distribution agreement and the $98,000 expense
associated with the closure of the skin care manufacturing facility, the second quarter
2005 net loss was $238,816. In the third quarter 2005, excluding additional skin care
manufacturing costs of $8,000, the Company generated a profit of $51,105. Adjusting for
these one-time items, the loss for the first nine months of 2005 was $565,063 versus
$11,763, as reported. Notwithstanding the benefit of improving quarterly performance and
the Canadian distribution agreement on liquidity, this performance continues to put
pressure on the Companys overall liquidity. In response, the Company will continue
to focus on, and take the steps necessary to accelerate, sales growth while properly
aligning operating expenses with expected revenues.


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


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


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


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


32
Index




On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,666, net of $159,334 in offering expenses, were used for
working capital. The offering was initiated in December 2004. In 2004, the Company sold
1,555,000 units and received offering proceeds of $681,359, net of $78,641 in offering
expenses. In 2005, the Company sold 1,205,000 units and received offering proceeds of
$539,307, net of $80,693 in offering expenses.


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


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


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

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

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

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


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


33
Index




In
June 2005, the Company announced its intention to close its skin care manufacturing
facility in St. Louis, Missouri and outsource the facilitys production with a view
to reducing overhead and improving cost competitiveness. The Company recorded a charge of
$98,000 for estimated severance and lease costs associated with the closure. The facility
was closed on schedule at the end of August 2005. One-time closure related costs of
approximately $118,000 consisting of severance, lease costs, inventory write-offs and
fixed asset write-offs were incurred. Ongoing estimated monthly lease and facility
maintenance costs of $7,500, net of existing committed lease cost and estimated sub-lease
income through lease expiration on January 31, 2007, will be expensed as incurred.


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



Cash Flow


At
September 30, 2005 and December 31, 2004, the Company had cash and cash equivalents on
hand of $624,221 and $46,508, respectively. The $577,713 increase represents a timing
difference that results from net cash provided by operating activities of $2,010,264
partially offset by net cash used in financing activities of $1,388,666, net cash used in
investing activities of $100,372 and cash provided as a result of exchange rate changes of
$56,487. Subject to constraints surrounding the movement of cash between legal 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 provided by operating activities stems from an estimated $2,705,000 positive cash
infusion associated with implementation of the Canadian distribution agreement in the
second quarter 2005 partially offset by estimated cash used in ongoing operations of
$704,000 (exclusive of a one-time distribution upset fee gain of $164,300 and the $118,000
estimated cost of closing the skin care manufacturing facility). Of the estimated $704,000
cash used in operations, approximately $217,000 represented cash provided (net losses less
non cash items) and the balance of approximately $921,000 represented cash used from the
net change in operating assets and liabilities. Higher receivables, replenishment of lower
than normal inventory levels for several key products and the pay down of outstanding
payables and accrued liabilities afforded by the improved cash flow were the major drivers
behind the net change in ongoing operating assets and liabilities. Cash provided by
operations of approximately $23,000 related to pay down of the distribution upset fee and
cash outflows associated with the skin care manufacturing closure also contributed.


Net
cash used in financing activities principally reflects the use of the funds generated from
operating activities to pay down the Companys outstanding line of credit balance by
$1,433,934. Other uses pertain to the debt repayment of $377,449, including, in addition
to normal scheduled payments, a one-time payment of $200,000 in January 2005 related to
the payoff of the outstanding standby letter of credit issued by the U.S. lender in favor
of the Companys Canadian lender as additional security for the Companys credit
facility and deferred financing costs of $116,590 related to refinancing the U.S. line of
credit in January 2005. Partially offsetting these cash uses were net proceeds of $539,307
from the sale of common stock in the first quarter 2005.


Net
cash used in investing activities of $100,372 reflects modest capital investment of
$136,001 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, less proceeds from the sale of excess equipment.



Working Capital


Working
capital increased $412,390, or 14.5%, at September 30, 2005 to $3,261,986 from $2,849,596
at December 31, 2004. The increase reflects the net impact of the cash inflows and
outflows outlined in the Cash Flow section above.


34
Index





Financing Arrangements
 United States


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


The
Company may request advances under the New Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.5%, but not less than 7.5% per annum. At September 30, 2005, the effective interest rate
was 9.10%. In addition, the Company pays a monthly collateral management fee at the rate
of 1.5% per annum upon the daily average amount of advances outstanding and a monthly
unused line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the new U.S. lender its guarantee of payment together
with a second lien security interest in the assets of the Companys wholly owned
Canadian subsidiary. The new U.S. lender has agreed not to exercise its rights under its
second lien security interest and guarantee against the Canadian assets without the
Canadian lenders approval.


Maximum
potential advances under the New Agreement at September 30, 2005 were $1,800,000. Advances
outstanding against the line were $1,361,772 at September 30, 2005, leaving an additional
$438,228 available for borrowing.


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


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


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


35
Index




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


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


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


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



Financing Arrangements
 Canada


The
Company is in the midst of renewing its revolving credit facility with its Canadian lender
(the Canadian Agreement). It is expected that the renewal will be finalized in
the near future. In light of the favorable impact of the new distribution agreement on
Derma Sciences Canada Inc. borrowing requirements, the maximum principal amount of the
line will be reduced to $653,000 ($800,000 Canadian) in line with its prospective maximum
borrowing capacity. No other significant changes to the terms of the Canadian Agreement
are expected.


In
September 2004, the Company finalized the annual renewal of the Canadian Agreement for a
maximum principal amount of $1,795,000 ($2,200,000 Canadian). The Companys wholly
owned Canadian subsidiary, Derma Sciences Canada Inc., may request advances under the
Canadian Agreement up to the value of 75% of eligible receivables (as defined) plus the
lesser of $946,000 ($1,100,000 Canadian) or 40% of eligible inventory (as defined), less
priority claims. Interest on outstanding advances is payable monthly in arrears at prime
rate (as defined) plus 1.0%, or 5.50% for Canadian dollar advances and 8.25% for U.S.
dollar denominated advances at September 30, 2005. Outstanding advances are secured by all
tangible and intangible assets of Derma Sciences Canada Inc. In addition, the Company has
accorded the Canadian lender its guarantee of payment together with a second lien security
interest in the Companys assets located in the U.S. Maximum potential advances under
the Canadian Agreement at September 30, 2005 were $520,000. Advances outstanding against
the Canadian Agreement were zero at September 30, 2005, leaving an additional $520,000
available for borrowing.


36
Index




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 $430,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default.


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


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



Prospective Assessment


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


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


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


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


37
Index





Additional Financial
Information



Forward Looking Statements


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



Critical Accounting
Policies


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



Revenue Recognition and
Adjustments to Revenue


Revenue
is recognized when product is shipped and title passes to the customer and collectability
is reasonably assured. When the Company recognizes revenue from the sale of its products,
it simultaneously adjusts revenue for estimated trade rebates. A trade rebate represents
the difference between the invoice price to the wholesaler and the indirect
customers contract price. These rebates are estimated based on historical
experience, estimated future trends, estimated customer inventory levels, current contract
sales terms with wholesale and indirect customers and other competitive factors. If the
assumptions used to calculate these rebates do not appropriately reflect future activity,
the Companys financial position, results of operations and cash flows could be
impacted. The Company continually monitors the factors that influence these rebates and
make adjustments as necessary.



Goodwill


At
September 30, 2005, the Companys skin care segment had $1,110,967 of goodwill. The
Company tests goodwill for impairment in the fourth quarter of each year or when
impairment indicators are present. The process of evaluating the potential impairment of
goodwill is highly subjective and requires significant judgments and assumptions in
estimating future cash flows to determine the fair value of the reporting unit. These
assumptions include future growth rates, discount factors, future tax rates and other
factors. The Companys cash flow forecasts are based on assumptions that are
consistent with the plans and estimates used to manage the underlying business. In
addition, the Company makes certain judgments about allocating shared assets to the
balance sheet for this segment. If the expected cash flows are not realized, impairment
losses may be recorded in the future.



Inventory


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


38
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 September 30, 2005. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective for gathering, analyzing
and disclosing the information the Company is required to disclose in the reports it files
under the Securities Exchange Act of 1934, within the time periods specified in the
SECs rules and forms.


During
the three months ended September 30, 2005, there was no change in the Companys
internal controls over financial reporting that materially affected, or is reasonably
likely to materially affect, the Companys internal controls over financial
reporting.


39
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, 2005, are incorporated
herein by reference.

Exhibit    Description
-------    -----------

31.1       Certification of the Principal Executive Officer pursuant to Section 302 of
           the Sarbanes-Oxley Act of 2002
31.2       Certification of the Principal Financial Officer pursuant to Section 302 of
           the Sarbanes-Oxley Act of 2002
32.1       Certification of 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: November 11, 2005 |  | By:/s/ John E.
     Yetter
         John E. Yetter, CPA
         Chief Financial
     Officer

40

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