---

U.S. SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549  FORM 10-QSB  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE
SECURITIES EXCHANGE ACT OF 1934   For Quarter Ended
     
     March 31, 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: March 31, 2005 | Class: Common Stock, par value $.01 per share
|-------------------- | ---------------------------------------------
|                     | Shares Outstanding: 12,284,007               

---

DERMA SCIENCES, INC.FORM
10-QSBINDEX

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

Part I - Condensed Financial Information

|Item 1. | Condensed Consolidated Financial Statements                                                                |   
|------- | ---------------------------------------------------------------------------------------------------------- | --
|        |                                                                                                            |   
|        | Condensed Consolidated Balance
     Sheets - March 31, 2005 and December 31, 2004                          | 3 
|        |                                                                                                            |   
|        | Condensed Consolidated Statements of
     Operations - Three months ended March 31, 2005and March 31, 2004 | 4 
|        |                                                                                                            |   
|        | Condensed Consolidated Statements of
     Cash Flows - Three months ended March 31, 2005and March 31, 2004 | 5 
|        |                                                                                                            |   
|        | Notes to Condensed Consolidated Financial
     Statements                                                  | 6 
|        |                                                                                                            |   
|Item 2. | Management's Discussion and Analysis of
     Financial Condition and Results of Operations                 | 19
|        |                                                                                                            |   
|Item 3. | Controls and Procedures                                                                                    | 29

Part II - Other Information

|Item 1. | Legal Proceedings | 30
|------- | ----------------- | --
|        |                   |   
|Item 6. | Exhibits          | 30
|        |                   |   

Forward Looking Statements

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

1

---

Index

Part I - Financial Information

Item 1. CONDENSED FINANCIAL STATEMENTS

2

---

DERMA SCIENCES, INC.Consolidated Balance Sheets

`===================================================================================================
                                                                         March 31,     December 31,
                                                                           2005            2004
                                                                       (Unaudited)
ASSETS
---------------------------------------------------------------------------------------------------

Current Assets
Cash and cash equivalents                                             $     76,578    $     46,508
Accounts receivable, net                                                 2,675,154       2,601,092
Inventories                                                              4,984,889       4,932,232
Prepaid expenses and other current assets                                  243,059         181,201
---------------------------------------------------------------------------------------------------
Total current assets                                                     7,979,680       7,761,033
Equipment and improvements, net                                          3,545,261       3,662,557
Goodwill                                                                 1,110,967       1,110,967
Other intangible assets, net                                               362,879         383,911
Other assets, net                                                          333,862         132,464
---------------------------------------------------------------------------------------------------
Total Assets                                                          $ 13,332,649    $ 13,050,932
---------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
---------------------------------------------------------------------------------------------------
Current Liabilities
Line of credit borrowings                                             $  3,091,204    $  2,820,284
Current maturities of long-term debt                                       256,829         247,306
Accounts payable                                                         1,390,004       1,249,409
Accrued expenses and other current liabilities                             408,132         594,438
---------------------------------------------------------------------------------------------------
Total current liabilities                                                5,146,169       4,911,437
Long-term debt                                                             593,315         867,539
Other long-term liabilities                                                 66,858          53,207
---------------------------------------------------------------------------------------------------
Total Liabilities                                                        5,806,342       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 March 31, 2005
and December 31, 2004 (liquidation preference of $4,210,231 at March
31, 2005 and December 31, 2004)                                             22,804          22,804
Common stock, $.01 par value, 30,000,000 shares authorized;
issued and outstanding: 12,284,007 shares at March 31, 2005 and
11,079,007 shares at December 31, 2004                                     122,840         110,790
Additional paid-in capital                                              19,906,973      19,371,225
Accumulated other comprehensive income -
cumulative translation adjustments                                         672,772         699,960
Accumulated deficit                                                    (13,199,082)    (12,986,030)
---------------------------------------------------------------------------------------------------
Total Shareholders' Equity                                               7,526,307       7,218,749
---------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity                            $ 13,332,649    $ 13,050,932
===================================================================================================`

See accompanying consolidated notes.

3

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Index

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

`===================================================================================================
                                                                           Three months ended
                                                                                March 31,
                                                                           2005           2004
---------------------------------------------------------------------------------------------------
Net sales                                                               $4,893,447      $5,029,422
Cost of sales                                                            3,506,061       3,596,516
---------------------------------------------------------------------------------------------------
Gross Profit                                                             1,387,386       1,432,906
---------------------------------------------------------------------------------------------------
Operating expenses                                                       1,681,055       2,245,055
Interest expense                                                            84,584          46,667
Other (income) expense, net                                               (165,201)        117,650
---------------------------------------------------------------------------------------------------
Total Expenses                                                           1,600,438       2,409,372
---------------------------------------------------------------------------------------------------
Loss before provision for income taxes                                    (213,052)       (976,466)
Provision for income taxes                                                   -               -
---------------------------------------------------------------------------------------------------
Net Loss                                                                $ (213,052)     $ (976,466)
---------------------------------------------------------------------------------------------------
Loss per common share - basic and diluted                                   ($0.02)         ($0.11)
---------------------------------------------------------------------------------------------------
Shares used in computing loss per common share - basic and diluted      12,011,674       8,809,151
===================================================================================================`

See accompanying consolidated notes.

4

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Index

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

`===================================================================================================
                                                                             Three months ended
                                                                                 March 31,
                                                                           2005            2004
---------------------------------------------------------------------------------------------------
Operating Activities
    Net loss                                                             $(213,052)    $  (976,466)
    Adjustments to reconcile net loss to
      net cash used in operating activities:
       Depreciation of equipment and improvements                          121,885          73,917
       Amortization of intangible assets                                    21,032          22,761
       Amortization of deferred financing costs                             16,869          21,447
       Provision for bad debts and rebates                                  40,221          53,492
       Provision for inventory obsolescence                                 27,519          77,400
       Loss on disposal of equipment and improvements                        -              94,428
       Deferred rent expense                                                13,651           -
       Changes in operating assets and liabilities:
           Restricted cash                                                   -          (1,001,125)
           Accounts receivable                                            (141,759)        124,104
           Inventories                                                     (87,500)       (822,688)
           Prepaid expenses and other current assets                       (52,817)        (30,871)
           Other assets                                                   (120,470)          9,430
           Accounts payable                                                145,365         648,367
           Accrued expenses and other current liabilities                 (193,999)        160,443
           Long-term liabilities                                             -             225,844
---------------------------------------------------------------------------------------------------
Net cash used in operating activities                                     (423,055)     (1,319,517)
---------------------------------------------------------------------------------------------------
Investing Activities
    Purchase of equipment and improvements                                 (25,480)       (135,880)
    Cash paid for wound care business                                        -            (376,510)
---------------------------------------------------------------------------------------------------
Net cash used in investing activities                                      (25,480)       (512,390)
---------------------------------------------------------------------------------------------------
Financing Activities
    Net change in bank line of credit                                      277,161        (292,497)
    Deferred financing costs                                              (108,804)        (60,617)
    Long-term debt repayments                                             (255,229)        (44,083)
    Proceeds from issuance of stock, net of issuance costs                 565,297       1,979,761
---------------------------------------------------------------------------------------------------
Net cash provided by financing activities                                  478,425       1,582,564
---------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash                                        180          (5,576)
---------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents                        30,070        (254,919)

Cash and cash equivalents
  Beginning of period                                                       46,508         439,837
---------------------------------------------------------------------------------------------------
  End of period                                                          $  76,578     $   184,918
---------------------------------------------------------------------------------------------------

Supplemental disclosure of non cash investing and financing activities
  Note payable for acquisition of Kimberly-Clark wound care assets           -         $ 1,566,000
  Equipment obtained  with capital lease                                     -         $   159,097
===================================================================================================`

See accompanying consolidated notes.

5

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Index

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

---

1. Organization and
Summary of Significant Accounting Policies

Derma
Sciences, Inc. and its subsidiaries (the Company) are full line providers of
wound care, wound closure-fasteners and skin care products. The Company markets its
products principally through independent distributors servicing the long-term care, home
health and acute care markets in the United States, Canada and other select international
markets. The Companys principal manufacturing and distribution facilities are
located in St. Louis, Missouri and Toronto, Canada. The Company also has a manufacturing
facility in Nantong, China.

Basis
of Presentation

The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-QSB and Item 310(b)
of Regulation S-B. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States of America for
complete financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three month period ended March 31, 2005, are not
necessarily indicative of the results that may be expected for the year ending December
31, 2005. For further information, refer to the consolidated financial statements and
footnotes thereto for the year ended December 31, 2004, included in Form 10-KSB previously
filed with the Securities and Exchange Commission.

Summary
of Significant Accounting Policies:

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

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

Foreign
Currency Translation  Assets and liabilities are translated using the exchange rates
in effect at the balance sheet date, while income and expenses are translated using
average rates. Translation adjustments are reported as a 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 purchased with an
original maturity of three months or less.

Concentration
of Credit Risk  Financial instruments that subject the Company to a concentration of
credit risk consist principally of cash and cash equivalents and accounts receivable. The
Company maintains cash and cash equivalents with various financial institutions 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.

6

---

Index

DERMA SCIENCES, INC.
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 are 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.

7

---

Index

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

---

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

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

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

`Quarter Ended March 31,
                                                       -----------------------
                                                         2005            2004
                                                      ----------    ------------

     Net loss - as reported                           $(213,052)    $  (976,466)
     Pro forma compensation expense                    (170,226)       (181,906)
                                                       ---------     -----------
     Pro forma net loss                               $(383,278)    $(1,158,372)
                                                       =========     ===========

     Loss per common share - basic and diluted
         As reported                                     $(0.02)         $(0.11)
         Pro forma                                       $(0.03)         $(0.13)`

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.

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

8

---

Index

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

---

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
as the effect would be anti-dilutive.

Total dilutive shares
that would have been used to compute income per common share on a fully diluted basis for the three months
ended March 31, 2005 and 2004 (assuming profitability) are outlined below:

`March 31,      March 31,
                                                          2005           2004
                                                          ----           ----

     Common shares                                     12,011,674      8,809,151
                                                       ----------     ----------

     Dilutive shares:
        Preferred stock                                 2,280,407      2,284,162
        Warrants                                            4,578      1,389,496
        Stock options                                     489,559      1,742,943
                                                       ----------     ----------

            Sub-total dilutive shares                   2,774,544      5,416,601
                                                       ----------     ----------

            Total dilutive shares                      14,786,218     14,225,752
                                                       ==========     ==========`

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 January 1, 2004, and the purchase
price was allocated to equipment in the amount of $1,600,000 and intangible assets (see
Note 6) in the amount of $342,797 based upon the estimated fair values of the assets
acquired. The promissory note was paid in full on December 30, 2004.

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

9

---

Index

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

---

3. Accounts Receivable

Accounts
receivable include the following:

`March 31,      December 31,
                                                           2005           2004
                                                           ----           ----

     Trade accounts receivable                         $2,868,760     $2,774,293
     Less:  Allowance for doubtful accounts               (67,149)       (57,090)
            Allowance for trade rebates                  (211,721)      (164,000)
                                                        ----------     ----------
          Net trade receivables                         2,589,890      2,553,203
     Other receivables                                     85,264         47,889
                                                        ----------     ----------

          Total receivables                            $2,675,154     $2,601,092
                                                        ==========     ==========`

4. Inventories

Inventories
include the following:

`March 31,     December 31,
                                                           2005           2004
                                                           ----           ----

     Finished goods                                    $3,421,385     $3,531,095
     Work in process                                       39,815         71,423
     Packaging materials                                  624,919        461,052
     Raw materials                                        898,770        868,662
                                                        ---------      ---------

          Total inventory                              $4,984,889     $4,932,232
                                                        =========      =========`

5. Equipment and
Improvements, net

Equipment
and improvements include the following:

`March 31,     December 31,
                                                           2005           2004
                                                           ----           ----

     Machinery and equipment                           $3,401,114     $3,407,073
     Furniture and fixtures                               203,499        196,506
     Leasehold improvements                               718,193        714,992
                                                        ----------     ----------
          Gross equipment and improvements              4,322,806      4,318,571
     Less:  accumulated depreciation                     (777,545)      (656,014)
                                                        ----------     ----------

          Total equipment and improvements, net        $3,545,261     $3,662,557
                                                        ==========     ==========`

Included
in equipment and improvements at March 31, 2005 and December 31, 2004 were machinery and
equipment with a cost of $228,518 and accumulated amortization of $31,544 and $22,989,
respectively, attributable to leased equipment. Amortization of assets under capital
leases is included in depreciation expense.

10

---

Index

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

---

6. Other Intangible
Assets, net

`March 31,     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                 (423,985)      (402,953)
                                                        ----------     ----------

          Other intangible assets, net                  $ 362,879      $ 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:

`March 31,     December 31,
                                                           2005           2004
                                                           ----           ----

     Deferred financing costs, net                       $142,564       $ 60,728
     Deposits                                              71,509         71,736
     Long-term receivable                                 119,789           -
                                                          -------        -------

          Total other assets, net                        $333,862       $132,464
                                                          =======        =======`

Deferred
financing costs related to the U.S. credit facility are being amortized over three years.
Deferred financing costs related to the Canadian credit facility are being amortized over
five years. The long-term receivable relates to amounts due in connection with a
distribution agreement upset fee (see Note 15).

8. Line of Credit
Borrowings

Short-term
borrowings include the following:

`March 31,     December 31,
                                                           2005           2004
                                                           ----           ----

     U.S. line of credit                               $1,378,677     $1,312,756
     Canadian line of credit                            1,712,527      1,507,528
                                                        ---------      ---------

          Total line of credit borrowings              $3,091,204     $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 approximately $139,600 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.

11

---

Index

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

---

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 March 31, 2005 the effective interest rate was
8.25%. In addition, the Company pays a monthly collateral management fee at the rate of
1.5% per annum upon the daily average amount of advances outstanding and a monthly unused
line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the 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). 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 2005, the Company was out of compliance with
its EBITDA and fixed charge ratio covenant under the New Agreement at March 31, 2005. The
U.S. lender agreed to waive these covenant violations. The Company expects to, but cannot
ensure that it will, maintain compliance with all applicable loan covenants in the future.

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

On
January 13, 2005 in connection with the refinancing of the U.S. line of credit, the
Company paid off and cancelled the outstanding irrevocable standby letter of credit issued
by the 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.

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 Agreement remained in
full force and effect.

12

---

Index

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

---

Canadian
Line of Credit

In
September 2004, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $1,820,000
($2,200,000 Canadian) with its Canadian lender. The Companys wholly owned Canadian
subsidiary, Derma Sciences Canada Inc., may request advances under the Canadian Agreement
up to the value of 75% of eligible receivables (as defined) plus the lesser of $910,000
($1,100,000 Canadian) or 40% of eligible inventory (as defined), less priority claims.
Interest on outstanding advances is payable monthly in arrears at prime rate (as defined)
plus 1.0%, or 5.25% for Canadian dollar advances and 7.25% for U.S. dollar denominated
advances at March 31, 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 $413,000 ($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.

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.

9. Accrued Expenses and
Other Current Liabilities

Accrued
expenses and other current liabilities include the following:

`March 31,   December 31,
                                                             2005         2004
                                                             ----         ----

   Accrued compensation and related taxes                  $116,384     $218,037
   Accrued sales, goods and services taxes                   42,545      197,984
   Accrued administrative fees                              134,726      107,916
   Other                                                    114,477       70,501
                                                           --------     --------

     Total accrued expenses and other current liabilities  $408,132     $594,438
                                                           ========     ========`

13

---

Index

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

---

10. Long-Term Debt

Long-term
debt includes the following:

`March 31,     December 31,
                                                           2005           2004
                                                           ----           ----

     Canadian term loan                                  $664,534     $  916,805
     Capital lease obligations                            185,610        198,040
                                                          -------      ---------

          Total debt                                      850,144      1,114,845
     Less:  current maturities                            256,829        247,306
                                                          -------      ---------

          Long-term debt                                 $593,315     $  867,539
                                                          =======      =========`

In
connection with the acquisition of substantially all the assets of Dumex Medical Inc. in August 2002, the
Company entered into a five-year term loan agreement with a Canadian Bank. The loan is
repayable in monthly payments consisting of principal and interest. Interest on the
outstanding principal balance is payable monthly at the banks prime rate (as
defined) plus 1.25%, or 5.5% at March 31, 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 operating line of credit (see Note 8).

The
Company has four capital lease obligations for certain distribution equipment and computer
equipment totaling $185,610. 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 March 31, 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 March 31, 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. During the year ended December 31, 2004, 4,167
series B preferred shares were converted into common stock.

There
are 619,055 shares of series C convertible preferred stock outstanding at March 31, 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 March 31,
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.

14

---

Index

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

---

Common
Stock

On February 8, 2005, the
Company closed a private offering of 2,760,000 units at $0.50 per unit, each unit consisting of one share of the Companys
common stock and one four-year series G warrant to purchase one share of common stock at a price of $1.05. Total offering proceeds
of $1,246,656, net of $133,344 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 $565,297, net of
$54,703 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 months ended
March 31, 2005, the Company issued 1,021,000 stock options that are exercisable at $0.50 per share.

Stock
Purchase Warrants

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

At
March 31, 2005, the Company had warrants outstanding to purchase 5,939,448 shares of the
Companys common stock as outlined below:

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

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

Shares
Reserved for Future Issuance

At
March 31, 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                                  5,485,655
     Common stock options available for grant                            751,000
     Common stock warrants (series E - G)                              5,939,448
                                                                      ----------

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

12. Comprehensive Loss

The
Companys comprehensive loss was as follows:

`Quarter Ended March 31,
                                                         -----------------------
                                                          2005            2004
                                                          ----            ----

     Net loss as reported                              $(213,052)    $  (976,466)
     Other comprehensive loss:
         Foreign currency translation adjustment         (27,188)        (27,241)
                                                        ---------     -----------

     Comprehensive loss                                $(240,240)    $(1,003,707)
                                                        =========     ===========`

15

---

Index

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

---

13. Operating Segments

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

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

Segment
sales and gross profit for the three months ended March 31, 2005 and 2004 are as follows:

`Three Months Ended March 31, 2005
                                   ---------------------------------

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

Net sales                $3,871,130     $628,298     $  394,019           -        $ 4,893,447
                          ---------      -------      ---------     ----------      -----------

Gross profit              1,069,385      312,739          5,262           -          1,387,386
Total expenses              -              -               -       $(1,600,438)     (1,600,438)
                                                                                    -----------
Net loss                                                                           $  (213,052)
                                                                                    ===========
Net long-lived assets    $3,417,330        -         $1,341,458    $   260,319     $ 5,019,107
                          =========      =======      =========     ==========      ===========



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

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


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

Gross profit                866,140      467,383         99,383           -          1,432,906
Total expenses                -            -              -        $(2,409,372)     (2,409,372)
                                                                                    -----------
Net loss                                                                           $  (976,466)
                                                                                    ===========
Net long-lived assets    $2,818,342        -         $1,338,848    $   226,650     $ 4,383,840
                          =========      =======      =========     ==========      ===========`

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.

16

---

Index

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

---

The
following table presents net sales by geographic region.

`Three Months Ended March 31,
                                                 ----------------------------
                                                     2005           2004
                                                   --------       --------

                  United States                      49%            56%
                  Canada                             47%            40%
                  Other                               4%             4%`

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

`March 31, 2005      March 31, 2004
                                                --------------      --------------

                  United States                   $1,979,013          $3,620,210
                  Canada                           3,020,109             722,915
                  Other                               19,985              40,715
                                                   ---------           ---------

                                                  $5,019,107          $4,383,840
                                                   =========           =========`

14. Income Taxes

No
provision for income taxes has been made in the first quarter 2005 and 2004 given the
Companys net operating losses. No benefit has been recorded as the realization of
the net operating losses is not assured.

At
December 31, 2004, the Company has net operating loss carryforwards of approximately
$8,130,000 for federal income tax purposes that begin to expire in years 2012 through
2024. For state income tax purposes, the Company has net operating loss carryforwards in a
number of jurisdictions in varying amounts and with varying expiration dates. The most
significant net operating loss is in New Jersey, site of the Companys domicile. This
state presently has a moratorium on the use of net operating losses. As of December 31,
2004, the Company has foreign net operating loss carryforwards of approximately $1,065,000
which begin to expire in 2009. The timing in which the Company can utilize its net
operating loss carryforwards in any year or in total may be limited under the Internal
Revenue Code section 382 regarding changes in ownership of corporations. Due to
uncertainties surrounding the Companys ability to use its net operating loss
carryforwards, a valuation allowance has been provided as of March 31, 2005.

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 months ended March 31, 2005 and 2004 were as
follows:

`Three Months Ended March 31,
                                                       ----------------------------
                                                          2005            2004
                                                        --------        --------

                      Sales                             $38,000         $311,000
                      Gross profit                      $17,000         $141,000`

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

17

---

Index

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

---

16. Employee Termination
Costs

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

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

17. Subsequent Events

Distribution Agreement
for Silver Plated Wound Dressings

On
April 15, 2005 the Company entered into a one and one-half year agreement with a new
manufacturer to serve as the exclusive distributor for certain silver plated wound
dressings to the U.S. military through the Defense Supply Center Philadelphia
(DSCP). The agreement further grants the Company the right to market and sell
the dressings on a non-exclusive basis within the United States and Canada. This agreement
positions the Company to expand its sales base for silver plated wound dressings. During
the initial term of the agreement the Company is required to meet minimum U.S. military
sales failing which the manufacturer, at its option, may terminate the exclusive nature of
the agreement. The agreement will automatically renew for successive one-year periods
unless, not less than ninety days prior to expiration of the then current term, either
party notifies the other of its intent not to renew. In connection with entering into this
agreement, the Company terminated its existing relationship with another manufacturer of
silver plated wound dressings.

Appointment of Canadian
Distributor

On
May 9, 2005 the Company entered into a five-year agreement 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 contracts held directly
by the Company and to perform normal logistics functions associated with the maintenance
and warehousing of inventory, order processing and product delivery. The agreement
requires the distributor to meet minimum purchase and growth targets failing which the
Company may cancel the agreement upon 180 days notice. The Company believes that this
agreement will allow it to better service its customers throughout Canada and provide
greater opportunity for growth in sales of basic and advanced wound care products.

18

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Index

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

QUARTER ENDED MARCH 31, 2005 COMPARED
TO QUARTER ENDED MARCH 31, 2004.

Results of Operations

Overview

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

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

The
following table highlights the quarters ended March 31, 2005 versus March 31, 2004
operating results:

`Quarter Ended March 31,
                                -----------------------
                                  2005           2004               Variance
                                  ----           ----               --------

Gross Sales                    $5,260,630     $5,303,477     $ (42,847)    (0.1%)
Adjustments                      (367,183)      (274,055)       93,128     34.0%
                                ----------     ----------     ---------

Net sales                       4,893,447      5,029,422      (135,975)    (2.7%)
Cost of sales                   3,506,061      3,596,516       (90,455)    (2.5%)
                                ----------     ----------     ---------

Gross profit                    1,387,386      1,432,906       (45,520)    (3.2%)
Gross profit percentage              28.4%          28.5%
Operating expenses              1,681,055      2,245,055      (564,000)   (25.1%)
Interest expense, net              84,584         46,667        37,917     81.3%
Other (income) expense, net      (165,201)       117,650      (282,851)     -
                                ----------     ----------     ---------

Total expenses                  1,600,438      2,409,372      (808,934)   (33.6%)
Loss before income taxes         (213,052)      (976,466)      763,414     78.2%
Provision for income taxes           -              -             -         -
                                ----------     ----------     ---------

Net loss                       $ (213,052)    $ (976,466)    $ 763,414     78.2%
                                ==========     ==========     =========`

Sales and Gross Profit

Gross
sales are adjusted for trade rebates, Medicaid rebates, returns and allowances and cash
discounts to derive net sales. The rebates are accrued monthly based upon an analysis of
sales subject to rebate and actual rebates received. Trends are monitored and accruals are
adjusted as appropriate. 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.

19

---

Index

Gross
to net sales adjustments comprise the following:

`Quarter Ended March 31,
                                                         -----------------------
                                                           2005           2004
                                                           ----           ----

          Gross Sales                                  $5,260,630     $5,303,477
                                                        ----------     ----------

          Trade rebates                                  (273,184)      (187,917)
          Medicaid rebates                                 (7,420)       (14,400)
          Returns and allowances                          (55,175)       (24,229)
          Cash discounts                                  (31,404)       (47,509)
                                                        ----------     ----------

          Total adjustments                              (367,183)      (274,055)
                                                        ----------     ----------

          Net sales                                    $4,893,447     $5,029,422
                                                        ==========     ==========`

Trade rebates
increased in the first quarter 2005 versus 2004 due to new rebate intensive private label
sales and an increase in the level of sales subject to rebate (contract
business) in other areas of the Companys business. A continuing trend towards
lower levels of Medicaid reimbursed sales is responsible for the lower level of Medicaid
rebates. The increase in returns and allowances generally reflects an increase in the
level of shipping errors and damaged products associated with opening of the new U.S.
distribution center in March 2004, a significant increase in the number of new product
stock keeping units introduced after the first quarter 2004 in connection with the
acquisition of the Kimberly-Clark wound care products and the launch of a large number of
new private label products. The decrease in cash discounts reflects the Companys
efforts to tighten its overall discount terms started in 2004 and the loss of a
significant customer in late 2004 that historically took its cash discount.

A
roll forward of the trade rebate accruals at March 31, 2005 and 2004 is outlined below:

`Quarter Ended March 31,
                                                          -----------------------
                                                            2005          2004
                                                            ----          ----
          Beginning balance - January 1                  $ 235,200     $ 212,000
          Rebates paid                                    (202,684)     (204,917)
          Rebates accrued                                  273,184       187,917
                                                          ---------     ---------

          Ending balance - March 31                      $ 305,700     $ 195,000
                                                          =========     =========`

The
$70,500 increase in the first quarter 2005 trade rebate reserve reflects the
quarter-to-quarter changes discussed above coupled with lower rebates paid due to extended
payment terms with two large customers. With the exception of these two customers, there
has been no discernable change in the nature of the Companys business as it relates
to the accrual and subsequent payment of rebates. The $17,000 decrease in the first
quarter 2004 trade rebate reserve reflects the work down (via payment of rebates without a
corresponding amount of accruals) of a higher than normal beginning balance due to
significant sales of product subject to rebate in December 2003.

The
following table highlights the March 31, 2005 versus March 31, 2004 product line net sales
and gross profit:

`Quarter Ended March 31,
                                -----------------------
                                  2005           2004                Variance
                                  ----           ----                --------
Product Line Net Sales

Wound care                     $3,871,130     $3,609,348     $ 261,782       7.3%
Wound closure and fasteners       628,298        958,269      (329,971)    (34.4%)
Skin care                         394,019        461,805       (67,786)    (14.7%)
                                ---------      ---------      ---------

    Totals                     $4,893,447     $5,029,422     $(135,975)     (2.7%)
                                =========      =========      =========

Product Line Gross Profit

Wound care                     $1,069,385     $  866,141      $203,244      23.5%
Wound closure and fasteners       312,739        467,382      (154,643)    (33.1%)
Skin care                           5,262         99,383       (94,121)    (94.7%)
                                ---------      ---------      ---------

    Totals                     $1,387,386     $1,432,906     $ (45,520)     (3.2%)
                                =========      =========      =========`

20

---

Index

Wound
care sales increased $261,782, or 7.3%, to $3,871,130 in 2005 from $3,609,348 in 2004. The
increase is attributable to a basic wound care increase of $364,746, or 15.1%. This
increase was driven by continued growth in the U.S. of $73,871, or 17.7%, and Canada of
$290,875, or 14.6% (comprised of 7.1% real growth and 7.5% related to a 7.0% strengthening
of the Canadian dollar). Advanced wound care sales decreased $102,964, or 8.6%, to
$1,092,831 in 2005 from $1,195,795 in 2004. This decrease was driven by a reduction in
former Kimberly-Clark Corporation branded and private label business that was higher in
2004 due to customer buy-ins in the first quarter prior to discontinuation of production
at the Kimberly-Clark facility and transfer of the equipment to the Companys
facility in Canada and a significant reduction in 2005 of silver product sales versus a
very strong 2004 first quarter as customer demand for these products remains soft. These
decreases were partially offset by continued growth of the Companys private label
sales to U.S. distributors. Dermagran sales were essentially flat quarter to quarter
curtailing a trend of decreasing quarterly sales of this product line in 2004.

Wound
care gross profit increased $203,244, or 23.5%, to $1,069,385 in 2005 from $866,141 in
2004. Gross profit margins increased to 27.6% in 2005 from 24.0% in 2004. The improved
gross profit dollars and margins are due to the flow through of lower basic wound care
costs negotiated in 2004, lower advanced wound care costs associated with manufacturing
the former Kimberly-Clark products in-house versus the acquisition related negotiated
costing used in 2004 and the non-recurrence of a one-time $59,400 inventory write-off
incurred in 2004.

Wound
closure and fastener sales decreased $329,971, or 34.4%, to $628,298 in 2005 from $958,269
in 2004. A reduction of approximately $250,000 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. A $60,000 suture strip backorder in the first quarter 2005 due to a delay in
product receipt from a supplier and slightly softer demand for the Companys other
catheter securement devices also contributed.

Wound
closure-fastener gross profit decreased $154,643, or 33.1%, to $312,739 in 2005 from
$467,382 in 2004. Gross profit margins improved slightly to 49.8% in 2005 from 48.8% in
2004. The decrease in margin dollars is consistent with the sales shortfall. The margin
improvement reflects the benefit of the loss of the exclusive catheter fastener business
which was slightly lower margined than the average for the line, partially offset by
slightly higher overall product costs for the balance of the products in the line in 2005
versus 2004 due to supplier price increases.

Skin
care sales decreased $67,786, or 14.7%, to $394,019 in 2005 from $461,805 in 2004 due to
continuing competitive pressure and the loss of several customers (distributors) who
initiated their own private label skin care lines using other suppliers. Skin care gross
profit decreased $94,121, or 94.7%, to $5,262 in 2005 from $99,383 in 2004. The decrease
is driven by lower pricing to retain or secure business in a highly competitive
marketplace, the adverse impact of lower production volumes on overhead absorption and
higher material and freight costs associated with increasing energy prices.

21

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Index

Operating Expense

The
following table highlights March 31, 2005 versus March 31, 2004 operating expenses by
type:

`Quarter Ended March 31,
                             -----------------------
                               2005           2004               Variance
                               ----           ----               --------

Distribution              $  244,667     $  306,925     $ (62,258)      (20.3%)
Marketing                     96,795         87,896         8,899        10.1%
Sales                        455,214        456,673        (1,459)       (0.3%)
General administrative       884,379      1,393,561      (509,182)      (36.5%)
                           ---------      ---------      ---------

    Total                 $1,681,055     $2,245,055     $(564,000)      (25.1%)
                           =========      =========      =========`

Operating
expense decreased $564,000, or 25.1%, to $1,681,055 in 2005 from $2,245,055 in 2004, net
of a $71,727, or 6.0% increase related to the impact of a 7.0% strengthening of the
Canadian dollar on the Canadian operations.

Distribution
expense decreased $62,258, or 20.3%, in 2005 versus 2004. The decrease was due principally
to the non recurrence of one-time costs of $50,000 accrued in the first quarter 2004 to
close one of the Companys existing distribution centers as part of its U.S.
distribution consolidation program and other one-time costs associated with opening the
new U.S. distribution center in March 2004.

Marketing
expense increased $8,899, or 10.1%, to $96,795 in 2005 from $87,896 in 2004 as a result of
hiring a marketing director in February 2004, together with higher literature and
promotion expense in support of the Companys growth initiatives partially offset by
a reduction in recruiting expense associated with the directors hiring in 2004.

Sales
expense decreased $1,459, or 0.3%, to $455,214 in 2005 from $456,673 in 2004. This
essentially flat change was driven by a decrease in the U.S. sales operation due to lower
operating expenses offset by an increase in the level of sales support in Canada in the
form of additional sales resources and operating expense in an effort to strengthen sales
representation in eastern and western provinces.

General
administrative expense decreased $509,182, or 36.5%, to $884,379 in 2005 from $1,393,561
in 2004. The primary drivers for the decrease were the non-recurrence in 2005 of a
$450,000 charge for employee termination costs and a $42,600 bad debt write-off taken in
the first quarter of 2004. The balance of the decrease reflects the impact of various cost
reduction initiatives partially offset by higher compensation, benefits, accounting and
board of directors expenses.

Interest Expense

Interest
expense increased $37,917, or 81.3%, to $84,584 in 2005 from $46,667 in 2004. The increase
is due to higher interest and related fees associated with the U.S. operations moving into
a net borrowing position in the second half of 2004 versus no borrowing in the first
quarter 2004. Canadian interest expense in the first quarter 2005 was comparable to the
first quarter 2004.

Other Income/Expense

Other
income/expense increased $282,851 to $165,201 income in 2005 from $117,650 expense in
2004. The increase is primarily driven by $164,300 in income relative to a distribution
agreement upset fee recorded in 2005 and the non-recurrence in 2005 of $94,428 in obsolete
equipment write-off incurred in the first quarter of 2004. A lower level of miscellaneous
expenses in 2005 versus 2004 also contributed.

Income Taxes

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

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Index

Net Loss

The
Company incurred a $213,052 loss, or $0.02 loss per share (basic and diluted), in 2005
compared to a $976,466 loss, or $0.11 loss per share (basic and diluted) in 2004.

Liquidity and Capital
Resources

Operational Overview

In
the first quarter 2005, the Company continued to operate at a loss as the ramp up of its
key sales growth initiatives continue to move slower than planned. As expected, in the
first quarter 2005 the Company began to realize the benefit of its major manufacturing
initiatives that were completed in late 2004. Excluding one-time costs of $542,600
incurred in 2004, operating expenses were essentially flat quarter-to-quarter 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 net loss in
the first quarter was $377,352. This performance continued to put pressure on the
Companys overall liquidity. In response, the Company is taking steps to accelerate
sales growth and properly align operating expenses with expected revenues in 2005 while
closely monitoring its liquidity.

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 will 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 at March 31, 2005 was $16,534.

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

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,246,656, net of $133,344 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
$565,297, net of $54,703 in offering expenses.

23

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Index

In
2004, the Companys exclusive distribution agreement for certain catheter fasteners
expired and was not renewed by the manufacturer. In accordance with the Companys
distribution agreement with a major customer for the fasteners, if the customer
subsequently enters into an agreement with the manufacturer to distribute these products,
then the customer shall pay the Company an upset fee of $200,000 in forty-eight monthly
installments of $4,167.

As
of January 2005, the customer advised the Company that it had entered into an agreement
with the manufacturer to distribute the catheter fasteners and that it was liable for
payment of the upset fee. In January 2005, the Company discounted the future cash flow
stream associated with the payment of the upset fee and recognized a gain of $164,300.

Cash Flow

At
March 31, 2005 and December 31, 2004, the Company had cash and cash equivalents on hand of
$76,578 and $46,508, respectively. The $30,070 increase represents a timing difference
that results from net cash provided by investing activities of $478,425 partially offset
by net cash used in operating activities of $423,055 and net cash used in investing
activities of $25,480.

Net
cash used in operating activities stems from cash used in ongoing operations of $127,710
(net loss less non cash items) offset by cash used from the net change of $295,345 in
operating assets and liabilities. Increases in receivables and other assets related to the
$164,300 distribution upset fee receivable recorded in the first quarter 2005 and payable
monthly over four years and the payment of scheduled employee termination and annual
Canadian sales tax liabilities were primarily responsible for the decrease in accrued
expenses and other current liabilities. Trade receivables were up slightly due to higher
March 2005 sales representing a use of cash. The increase in accounts payable exceeded
that of inventory representing a net source of cash due to close monitoring in an effort
to improve the Companys cash flow in these areas.

Net
cash used in investing activities of $25,480 reflects the Companys plan to limit
capital expenditures to that necessary to continue running the business until operational
performance improves.

Net
cash provided by financing activities of $478,425 consisted of net proceeds of $565,297
from the sale of common stock in the first quarter 2005 coupled with additional line of
credit borrowings of $277,161, partially offset by deferred financing costs of $108,804
related to refinancing the U.S. line of credit in January 2005 and debt repayment of
$255,229. Aside from regularly scheduled debt payments, $200,000 of the debt repayment
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 in January 2005. The payment 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.

Working Capital

Working
capital decreased $16,085 at March 31,2005 to $2,833,511 from $2,849,596 at December 31,
2004. The modest change principally reflects the infusion of cash associated with the
securities private placement in the first quarter 2005 and additional line of credit
borrowing offset by the net change in operating assets and liabilities, debt repayment and
deferred financing costs. Cash used in operations of $127,710 (net loss less non cash
items) during the quarter also contributed.

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 $139,600 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.

24

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Index

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 March 31, 2005 the effective interest rate was
8.25%. In addition, the Company pays a monthly collateral management fee at the rate of
1.5% per annum upon the daily average amount of advances outstanding and a monthly unused
line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $2,000,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the 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 March 31, 2005 were $1,795,466. Advances
outstanding against the line were $1,378,677 at March 31, 2005, leaving an additional
$416,789 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 2005, the Company was out of compliance with
its EBITDA and fixed charge ratio covenant under the new agreement at March 31, 2005. The
U.S. lender agreed to waive these covenant violations. The Company expects to, but cannot
assure that it will, maintain compliance with all applicable loan covenants in the future.

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

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

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

25

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Index

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 has incurred waiver fees of $7,500 and agreed to an
increase in the rate of interest payable under the line. All other terms of the prior
agreement were maintained in full force and effect.

Financing Arrangements
 Canada

In
September 2004, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $1,820,000
($2,200,000 Canadian) with its Canadian lender. The Companys wholly owned Canadian
subsidiary, Derma Sciences Canada Inc., may request advances under the Canadian Agreement
up to the value of 75% of eligible receivables (as defined) plus the lesser of $910,000
($1,100,000 Canadian) or 40% of eligible inventory (as defined), less priority claims.
Interest on outstanding advances is payable monthly in arrears at prime rate (as defined)
plus 1.0%, or 5.25% for Canadian dollar advances and 7.25% for U.S. dollar denominated
advances at March 31, 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 March 31, 2005 were $1,820,000. Advances outstanding against the
Canadian agreement were $1,712,527 at March 31, 2005, leaving an additional $107,473
available for borrowing.

Over
the term of the Canadian Agreement, the Company has agreed to comply with a number of
financial covenants governing minimum working capital, current ratios, tangible net worth,
interest coverage, total indebtedness to tangible net worth and total indebtedness to
adjusted pre-tax earnings. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $413,000 ($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.

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.

26

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Index

Prospective Assessment

The
Company seeks to increase sales and gross margins and return to profitability by
increasing sales of contracted private label products and focusing on organic growth of
its core product lines in the U.S. and Canada. In the first quarter 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 three quarters
of 2004 associated with bringing the manufacture of private label advanced wound care and
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 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 can secure additional
equity funding to improve liquidity. In addition, the Company will continue to evaluate
external opportunities to leverage its core capabilities for growth.

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

Additional Financial
Information

Forward Looking Statements

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

Critical Accounting
Policies

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

Revenue Recognition and
Adjustments to Revenue

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

27

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Index

Goodwill

At
March 31, 2005, the Companys skin care segment had $1,110,967 of goodwill. The
Company tests goodwill for impairment in the fourth quarter of each year or when
impairment indicators are present. The process of evaluating the potential impairment of
goodwill is highly subjective and requires significant judgments and assumptions in
estimating future cash flows to determine the fair value of the reporting unit. These
assumptions include future growth rates, discount factors, future tax rates and other
factors. The Companys cash flow forecasts are based on assumptions that are
consistent with the plans and estimates used to manage the underlying business. In
addition, the Company makes certain judgments about allocating shared assets to the
balance sheet for this segment. If the expected cash flows are not realized, impairment
losses may be recorded in the future.

Inventory

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

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Index

Item 3.  CONTROLS AND PROCEDURES

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of March 31, 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 March 31, 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.

29

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Index

Part II  Other
Information

Item 1. Legal Proceedings

None

Item 6. Exhibits

All exhibits
required by Item 601 of Regulation S-B and required hereunder, as filed with the
Securities and Exchange Commission in Form 10-KSB on March 31, 2005, are incorporated
herein by reference.

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

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

|                    |  | DERMA SCIENCES, INC.                                                                         
|------------------- |  | ---------------------------------------------------------------------------------------------
|                    |  |                                                                                              
|                    |  |                                                                                              
|                    |  |                                                                                              
|Dated: May 13, 2005 |  | By:/s/ John E.
     Yetter
         John E. Yetter, CPA
         Chief Financial
     Officer

30

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