---

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549    FORM 10-QSB QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE
SECURITIES EXCHANGE ACT OF 1934 For Quarter Ended
     
     June 30, 2006Commission File Number
     
     1-31070  Derma Sciences, Inc.(Exact name of small business issuer as specified in its charter) Pennsylvania
     23-2328753(State or other jurisdiction of
     incorporation or organization)
     (I.R.S. Employer Identification
     No.)  214 Carnegie Center, Suite 100Princeton, New Jersey
08540(609) 514-4744(Address including zip code and
telephonenumber, of principal executive offices)


Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the issuer was required to file
such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X]    
No [  ]

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

Yes [  ]    
No [X]

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

|                    |        |                                       
|------------------- | ------ | --------------------------------------
|Date: July 31, 2006 | Class: | Common Stock, par value $.01 per share
|                    |        | Shares Outstanding: 22,906,160        

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

---



Part IDERMA SCIENCES,
INC.FORM 10-QSBINDEX

|                                         |         |                                                                                                                  |   
|---------------------------------------- | ------- | ---------------------------------------------------------------------------------------------------------------- | --
|Description                              | Page   
|Part I - Condensed Financial Information
|                                         | Item 1. | Condensed Consolidated Financial Statements                                                                      |   
|                                         |         | Condensed Consolidated Balance
     Sheets - June 30, 2006 (Unaudited) and December 31, 2005                     | 3 
|                                         |         | Condensed Consolidated Statements of
     Operations - Three months ended June 30, 2006 and 2005 (Unaudited)     | 4 
|                                         |         | Condensed Consolidated Statements of
     Operations - Six months ended June 30, 2006 and 2005 (Unaudited)       | 5 
|                                         |         | Condensed Consolidated Statements of
     Cash Flows - Six months ended June 30, 2006, 2006 and 2005 (Unaudited) | 6 
|                                         |         | Notes to Condensed Consolidated Financial
     Statements (Unaudited)                                            | 7 
|                                         | Item 2. | Management's Discussion and
     Analysis or Plan of Operation                                                   | 20
|                                         | Item 3. | Controls and
     Procedures                                                                                     | 37
|Part II - Other Information             
|                                         | Item 1. | Legal
     Proceedings                                                                                           | 38
|                                         | Item 6. | Exhibits                                                                                                         | 38

Forward Looking Statements

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

1

---



Index

Part I - Financial Information

Item 1.  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                           |  |                |              |               |  
|-------------------------------------------------------------------------- |  | -------------- | ------------ | ------------- | -
|Condensed Consolidated Balance Sheets                                      | 
|                                                                          
|                                                                           |  | June 30,       | December 31,
|                                                                           |  | 2006           | 2005        
|                                                                           |  | (Unaudited)    | (Note 1)    
|ASSETS                                                                     |  |                |              |               |  
|                                                                          
|Current Assets                                                             | 
|Cash and cash equivalents                                                  |  | $   1,051,599  |              | $   1,105,330 |  
|Accounts receivable, net                                                   |  | 1,379,814      |              | 1,225,639     |  
|Inventories                                                                |  | 5,516,766      |              | 3,868,663     |  
|Prepaid expenses and other current assets                                  |  | 268,522        |              | 210,288       |  
|                                                                          
|Total current assets                                                       |  | 8,216,701      |              | 6,409,920     |  
|Equipment and improvements, net                                            |  | 4,046,255      |              | 3,385,862     |  
|Goodwill                                                                   |  | 3,773,102      |              | 200,000       |  
|Other intangible assets, net                                               |  | 2,179,180      |              | 349,152       |  
|Other assets, net                                                          |  | 238,591        |              | 250,312       |  
|                                                                          
|Total Assets                                                               |  | $ 18,453,829   |              | $ 10,595,246  |  
|                                                                          
|LIABILITIES AND SHAREHOLDERS' EQUITY                                       | 
|                                                                          
|Current Liabilities                                                        | 
|Line of credit borrowings                                                  |  | $      898,935 |              | $   1,080,561 |  
|Current maturities of long-term debt                                       |  | 548,072        |              | 285,945       |  
|Accounts payable                                                           |  | 1,301,992      |              | 1,197,062     |  
|Accrued expenses and other current liabilities                             |  | 517,358        |              | 491,559       |  
|                                                                          
|Total current liabilities                                                  |  | 3,266,357      |              | 3,055,127     |  
|Long-term debt, net of current portion                                     |  | 1,499,507      |              | 388,473       |  
|Other long-term liabilities                                                |  | 107,435        |              | 99,982        |  
|                                                                          
|Total Liabilities                                                          |  | 4,873,299      |              | 3,543,582     |  
|                                                                          
|Commitments                                                                | 
|Shareholders' Equity                                                       | 
|Convertible preferred stock, $.01 par value; 11,750,000 shares             | 
|authorized; issued and outstanding:  2,280,407 shares at June 30, 2006 and | 
|December 31, 2005 (liquidation preference of $4,210,231 at                 | 
|June 30, 2006 and December 31, 2005)                                       |  | 22,804         |              | 22,804        |  
|Common stock, $.01 par value, 50,000,000 and 30,000,000 shares             | 
|authorized at June 30, 2006 and December 31, 2005, respectively;           | 
|issued and outstanding:  22,906,160 shares at June 30, 2006 and            |  | 229,062        |              | 122,858       |  
|12,285,768 at December 31, 2005                                            | 
|Additional paid-in capital                                                 |  | 25,719,827     |              | 19,905,059    |  
|Accumulated other comprehensive income                                     |  | 1,115,461      |              | 896,077       |  
|Accumulated deficit                                                        |  | (13,506,624    | )            | (13,895,134   | )
|                                                                          
|Total Shareholders' Equity                                                 |  | 13,580,530     |              | 7,051,664     |  
|                                                                          
|Total Liabilities and Shareholders' Equity                                 |  | $ 18,453,829   |              | $ 10,595,246  |  
|                                                                          

See accompanying notes to
condensed consolidated financial statements.

3

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                            |  |                    |      |                  | 
|----------------------------------------------------------- |  | ------------------ | ---- | ---------------- | 
|Condensed Consolidated Statements of Operations (Unaudited) | 
|                                                           
|                                                            |  | Three months ended
|                                                            |  | June 30,          
|                                                            |  | 2006               | 2005
|                                                           
|Net Sales                                                   |  | $  7,386,681       |      | $  6,934,218     | 
|Cost of sales                                               |  | 4,669,119          |      | 4,693,456        | 
|                                                           
|Gross Profit                                                |  | 2,717,562          |      | 2,240,762        | 
|                                                           
|Operating expenses                                          |  | 2,254,712          |      | 1,968,312        | 
|Interest expense, net                                       |  | 110,145            |      | 95,269           | 
|Other expense, net                                          |  | 21,915             |      | 18,997           | 
|                                                           
|Total Expenses                                              |  | 2,386,772          |      | 2,082,578        | 
|                                                           
|Income before provision for income taxes                    |  | 330,790            |      | 158,184          | 
|Provision for income taxes                                  |  |                   |      |                 | 
|                                                           
|Net Income                                                  |  | $     330,790      |      | $     158,184    | 
|                                                           
|Income per common share - basic                             |  | $           0.02   |      | $           0.01 | 
|                                                           
|Income per common share - diluted                           |  | $           0.01   |      | $           0.01 | 
|                                                           
|Shares used in computing income per common share - basic    |  | 20,805,423         |      | 12,284,007       | 
|                                                           
|Shares used in computing income per common share - diluted  |  | 25,207,546         |      | 14,745,538       | 
|                                                           

See accompanying notes to
condensed consolidated financial statements.

4

---



Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                  |  |                   |      |                   |  
|----------------------------------------------------------------- |  | ----------------- | ---- | ----------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)       | 
|                                                                 
|                                                                  |  | Six months ended 
|                                                                  |  | June 30,         
|                                                                  |  | 2006              | 2005
|                                                                 
|Net sales                                                         |  | $ 13,143,595      |      | $ 11,827,665      |  
|Cost of sales                                                     |  | 8,234,032         |      | 8,116,059         |  
|                                                                 
|Gross Profit                                                      |  | 4,909,563         |      | 3,711,606         |  
|                                                                 
|Operating expenses                                                |  | 4,376,464         |      | 3,732,825         |  
|Interest expense, net                                             |  | 192,195           |      | 179,853           |  
|Other income, net                                                 |  | (47,606           | )    | (146,204          | )
|                                                                 
|Total Expenses                                                    |  | 4,521,053         |      | 3,766,474         |  
|                                                                 
|Income (loss) before provision for income taxes                   |  | 388,510           |      | (54,868           | )
|Provision for income taxes                                        |  |                  |      |                  |  
|                                                                 
|Net Income (Loss)                                                 |  | $      388,510    |      | $     (54,868     | )
|                                                                 
|Income (loss) per common share - basic                            |  | $            0.02 |      | $            0.00 |  
|                                                                 
|Income (loss) per common share - diluted                          |  | $            0.02 |      | $            0.00 |  
|                                                                 
|Shares used in computing income (loss) per common share - basic   |  | 16,569,131        |      | 12,147,841        |  
|                                                                 
|Shares used in computing income (loss) per common share - diluted |  | 20,455,906        |      | 12,147,841        |  
|                                                                 

See accompanying notes to
condensed consolidated financial statements.

5

---



Index

DERMA SCIENCES, INC. AND SUBSIDIARIES

|                                                                           |  |                  |      |              |  
|-------------------------------------------------------------------------- |  | ---------------- | ---- | ------------ | -
|Condensed Consolidated Statements of Cash Flows (Unaudited)                | 
|                                                                          
|                                                                           |  | Six months ended
|                                                                           |  | June 30,        
|                                                                           |  | 2006             | 2005
|                                                                          
|Operating Activities                                                       |  |                  |      |              |  
|Net income (loss)                                                          |  | $    388,510     |      | $   (54,868  | )
|Adjustments to reconcile net income (loss) to                              | 
|net cash provided by operating activities:                                 | 
|Depreciation of equipment and improvements                                 |  | 285,385          |      | 245,878      |  
|Amortization of intangible assets                                          |  | 132,663          |      | 42,071       |  
|Amortization of deferred financing costs                                   |  | 43,264           |      | 35,820       |  
|Provision for rebates                                                      |  | 806,885          |      | 1,141,869    |  
|Provision for bad debts                                                    |  | 3,919            |      | 1,861        |  
|Provision for inventory obsolescence                                       |  | (63,003          | )    | 45,519       |  
|Deferred rent expense                                                      |  | 6,296            |      | 22,113       |  
|Compensation charge for employee stock options                             |  | 92,284           |      | 1,000        |  
|Compensation charge for restricted stock                                   |  | 6,053            |      |             |  
|Gain on settlement of accounts payable                                     |  | (64,971          | )    |             |  
|Loss on disposal of equipment                                              |  |                 |      | 4,146        |  
|Changes in operating assets and liabilities, net of amounts acquired       | 
|from Western Medical asset purchase:                                       | 
|Accounts receivable                                                        |  | (505,482         | )    | (28,562      | )
|Inventories                                                                |  | (292,991         | )    | 982,316      |  
|Prepaid expenses and other current assets                                  |  | (45,021          | )    | (92,067      | )
|Other assets                                                               |  | 21,268           |      | (145,614     | )
|Accounts payable                                                           |  | (393,348         | )    | 135,449      |  
|Accrued expenses and other current liabilities                             |  | 9,249            |      | (3,339       | )
|Long-term liabilities                                                      |  |                 |      | 7,273        |  
|                                                                          
|Net cash provided by operating activities                                  |  | 430,960          |      | 2,340,865    |  
|                                                                          
|Investing Activities                                                       | 
|Acquisition of Western Medical,
     Inc.                                  |  | (6,000,000       | )    |             |  
|Costs of acquiring Western Medical,
     Inc.                              |  | (662,691         | )    |             |  
|Purchases of equipment and
     improvements                               |  | (329,338         | )    | (61,879      | )
|Proceeds from sale of equipment                                            |  |                 |      | 24,998       |  
|                                                                          
|Net cash used in investing activities                                      |  | (6,992,029       | )    | (36,881      | )
|                                                                          
|Financing Activities                                                       | 
|Loan proceeds                                                              |  | 1,000,000        |      |             |  
|Net change in bank lines of
     credit                                    |  | (181,626         | )    | (2,084,029   | )
|Deferred financing costs                                                   |  | (48,722          | )    | (116,590     | )
|Long-term debt repayments                                                  |  | (147,787         | )    | (312,142     | )
|Proceeds from issuance of stock, net
     of issuance costs                |  | 5,822,637        |      | 539,415      |  
|                                                                          
|Net cash provided by (used in) financing activities                        |  | 6,444,502        |      | (1,973,346   | )
|                                                                          
|Effect of exchange rate changes on cash                                    |  | 62,836           |      | (14,205      | )
|                                                                          
|Net (decrease) increase in cash and cash
     equivalents                  |  | (53,731          | )    | 316,433      |  
|Cash and cash equivalents                                                  | 
|Beginning of period                                                        |  | 1,105,330        |      | 46,508       |  
|                                                                          
|End of period                                                              |  | $ 1,051,599      |      | $    362,941 |  
|                                                                          
|Supplemental cash flow information:                                        | 
|Issuance of promissory note in connection with
     acquisition of Western |  | $    500,000     |      |             |  
|Medical, Inc. (see Note 2)                                                 | 
|                                                                          

See accompanying notes to
condensed consolidated financial statements.

6

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

1.    Organization and
Summary of Significant Accounting Policies

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

Basis
of Presentation

The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-QSB and Item 310(b)
of Regulation S-B. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States of America for
complete financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three and six month periods ended June 30, 2006, are
not necessarily indicative of the results that may be expected for the year ending
December 31, 2006. Information included in the condensed balance sheet as of December 31,
2005 has been derived from the consolidated financial statements and footnotes thereto for
the year ended December 31, 2005, included in Form 10-KSB previously filed with the
Securities and Exchange Commission. For further information, refer to that Form 10-KSB.

Summary
of Significant Accounting Policies:

The
accounting policies of the Company are unchanged from those disclosed in the Form 10-KSB
with the exception of the adoption of Statement of Financial Accounting Standards No.
123R, Share-Based Payment (SFAS 123R) described below:

Stock-Based
Compensation  Effective January 1, 2006 the Company adopted SFAS 123R which revises SFAS 123 Accounting for
Stock-Based Compensation (SFAS 123) and supersedes Accounting Principles Board Opinion 25 Accounting for
Stock Issued to Employees. Under APB 25, the Company used the intrinsic value method for employee stock options
and did not record any expense because option exercise prices equaled the market value at the date of grant. SFAS 123R requires
that new, modified and unvested share-based payment transactions with employees, such as grants of stock options and restricted
stock, be recognized in the financial statements based on their fair value at the grant date and recognized as compensation
expense over their vesting periods. The Company estimates the fair value of stock options as of the date of grant using the
Black-Scholes pricing model and restricted stock based on the quoted market price. The Company adopted SFAS 123R using the
modified prospective method and, accordingly, prior period financial statements were not revised. SFAS 123R requires that
the Company elect an approved method to calculate the historical pool of windfall tax benefits upon adoption of SFAS 123R within
one year of its adoption. As of June 30, 2006, the Company has not made that election.

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

7

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     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 the effects of the assumed exercise, conversion or issuance of
potentially issuable shares of common stock (potentially dilutive securities), including those attributable to stock
options, warrants, convertible preferred stock and restricted common stock in the weighted average number of common shares
outstanding for a period, if dilutive. Potentially dilutive securities have not been included in the computation of diluted loss
per share for the six months ended June 30, 2005 as the effect would be anti-dilutive.

Total
dilutive shares that have or would have been used to compute diluted income per common
share for the three and six months ended June 30, 2006 and 2005 (assuming profitability in
all periods) are outlined below:

|                                      |                             |            |                           |            |  |            |  |            | 
|------------------------------------- | --------------------------- | ---------- | ------------------------- | ---------- |  | ---------- |  | ---------- | 
|                                      | Three Months Ended June 30, |            | Six Months Ended June 30, |           
|                                      |                             | 2006       |                           | 2005       |  | 2006       |  | 2005       | 
|Weighted average common shares        |                            
|outstanding - basic                   |                             | 20,805,423 |                           | 12,284,007 |  | 16,569,131 |  | 12,147,841 | 
|                                     
|Potentially dilutive shares:          |                            
|Preferred stock                       |                             | 2,280,407  |                           | 2,280,407  |  | 2,280,407  |  | 2,280,407  | 
|Restricted common stock               |                             | 96,154     |                           | -          |  | 48,343     |  | -          | 
|Warrants                              |                             | 451,821    |                           | -          |  | 287,828    |  | 2,289      | 
|Stock options                         |                             | 1,573,741  |                           | 181,124    |  | 1,270,197  |  | 335,341    | 
|                                     
|Sub-total potentially dilutive shares |                             | 4,402,123  |                           | 2,461,531  |  | 3,886,775  |  | 2,618,037  | 
|                                     
|Weighted average common               |                            
|shares outstanding - diluted          |                             | 25,207,546 |                           | 14,745,538 |  | 20,455,906 |  | 14,765,878 | 

For
the three and six-month periods ended June 30, 2006 and 2005, 7,381,253, 7,576,253, 10,692,103 and 10,692,103 potentially
dilutive shares, respectively, were excluded from the computation of dilutive earnings per
share because their effect would have been anti-dilutive.

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

2.    
          Acquisition of Western Medical, Inc.

On
April 18, 2006, the Company acquired certain assets and assumed the trade payables and the business of Western Medical, Inc.
(Western Medical) for $6,500,000 of which $6,000,000 was paid in cash and $500,000 was paid via a three-year
promissory note issued to Western Medical by the Company. In addition, the Company anticipates incurring a total of approximately
$860,000 of transaction costs related to the purchase of which $662,691 had been paid or accrued as of June 30, 2006. The
purchased assets consist of trade receivables, inventories, equipment and certain identifiable intangibles. To fund the purchase,
the Company raised $5,822,637 (net of $549,599 in commissions and other offering expenses) from the private sale of 2,655,098
units (the Units) at $2.40 per Unit, each Unit consisting of four shares of common stock and one five-year warrant to
purchase one share of common stock at $1.00 per share. In addition, the placement agent for the Units received 754,806 five-year
warrants each to purchase one share of common stock at $0.72 per share. The Company also received $1,000,000 in cash from a new
term loan that bears interest at prime plus 5% from its U.S. lender through an amendment to its existing three-year revolving
credit facility. The $72,000 of estimated deferred financing costs, of which $48,722 had been paid or accrued as of June 30, 2006,
related to this financing are being amortized to interest
expense over the three year term of the amended credit facility.

8

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

Western
Medical was a privately held manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. For 2005, Western Medical
reported audited sales of $6,684,160, gross profit of $2,664,997 and net income of
$838,865. Western Medicals product line is complementary to and will serve to expand
the Companys existing basic wound care line. The Company anticipates being able to
leverage cross selling opportunities presented by the purchase to grow sales. In addition,
the Company anticipates being able to absorb Western Medicals business within its
existing operating infrastructure incurring only modest incremental cost increases. Both
of these initiatives are anticipated to increase the contribution of the business going
forward.

The
acquisition has been accounted for under the purchase method. Accordingly, the results of
operation of Western Medical have been included in the consolidated financial statements
commencing April 18, 2006. A preliminary allocation of the purchase price is outlined
below:

`Purchase Price:

                             Cash paid                                 $6,000,000
                             Promissory note                              500,000
                             Estimated transaction costs                  860,000
                                                                       -----------

                               Total                                   $7,360,000
                                                                       ===========

                         Allocation of Purchase Price:

                             Trade receivables                         $  473,000
                             Inventory                                  1,218,000
                             Equipment                                    484,000
                             Goodwill                                   3,573,000
                             Identifiable intangibles                   2,161,000
                             Accounts payable                            (549,000)
                                                                       -----------

                               Total                                   $7,360,000
                                                                       ===========`

The
allocation of the preliminary purchase price to the estimated fair values of the assets
acquired and liabilities assumed as reflected in the unaudited condensed consolidated
financial statements is preliminary and subject to change based on finalization of the
Companys valuation. The Company is currently assessing the fair value of the
identifiable tangible and intangible assets acquired and liabilities assumed. It is
expected that the current assets and liabilities assumed will approximate their historical
carrying values as of the date of the acquisition. A valuation study is presently being
conducted to establish the fair market value of the equipment and the identifiable
intangibles acquired. The intangible assets acquired consist primarily of customer lists, trademarks, non-compete
agreements and product rights. Since the date of acquisition, the estimated identifiable
intangibles have been amortized to general administrative expense assuming a useful life
of five years. The final purchase price allocation to reflect the fair values of the
assets acquired and liabilities assumed will be based on managements ongoing
evaluation and is expected to be completed prior to the Companys year-end.
Accordingly, the final allocation of the purchase price may differ significantly from the
preliminary allocation and as such may have a significant impact on the amount of goodwill recorded and the Companys
future operating results.

The
Company retained certain Western Medical personnel through May 31, 2006 to perform sales
and marketing transition services with respect to the products acquired from Western
Medical. In addition, the Company entered into a one year sales and marketing agreement
with an affiliate of Western Medical to provide sales and marketing consulting services
relative to the products acquired by the Company. The sales and marketing agreement
requires payments of $15,000 monthly for the first four months and $7,500 for the last
eight months of the agreements term.

9

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

The
Unaudited pro forma information below presents combined results of operations as if the
acquisition had occurred at the beginning of the periods presented instead of April 18, 2006. The pro forma
information is based on historical results and is not necessarily indicative of the results of
operations of the combined entity had the acquisition occurred at the beginning of the
periods presented, nor is it necessarily indicative of future results.

`Three Months Ended June 30,
                                                                   ---------------------------
                                                                     2006               2005
                                                                     ----               ----

                 Revenues                                        $7,688,681         $8,558,121
                                                                  ---------          ---------

                 Net income                                        $366,790           $368,648
                                                                    -------            -------
                 Net income per common  share:

                    Basic                                             $0.02              $0.02
                                                                       ----               ----
                    Fully diluted                                     $0.01              $0.01
                                                                       ----               ----

                                                                     Six Months Ended June 30,
                                                                     -------------------------
                                                                     2006               2005
                                                                     ----               ----

                Revenues                                        $14,944,128        $14,992,059
                                                                 ----------         ----------

                Net income                                         $597,463           $303,798
                                                                    -------            -------
                Net income per common share:

                    Basic                                             $0.03              $0.01
                                                                       ----               ----
                    Fully diluted                                     $0.02              $0.01
                                                                       ----               ----`

3.    Inventories

Inventories
include the following:

`June 30,             December 31,
                                                                  2006                   2005
                                                                  ----                   ----

        Finished goods                                        $3,786,225             $2,516,114
        Work in process                                           74,172                144,390
        Packaging materials                                      976,365                398,463
        Raw materials                                            680,004                809,696
                                                               ---------              ---------

             Total inventories                                $5,516,766             $3,868,663
                                                               =========              =========`

4. Line of Credit
Borrowings

Short-term borrowings include
the following:

`June 30,             December 31,
                                                                  2006                   2005
                                                                  ----                   ----

        U.S. line of credit                                     $898,935             $1,080,561
                                                                 =======              =========`

10

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

U.S. Line of Credit

On
April 18, 2006, in connection with the acquisition of Western Medical (see Note 2), the
Company entered into a three year revolving credit facility agreement (the
Agreement) with its U.S. lender for a maximum principal amount of $3,500,000.
This Agreement amends the $2,000,000 revolving credit facility with the U.S. lender
entered into on January 31, 2005. Advances will be utilized to fund strategic initiatives
and general working capital requirements. The Company incurred loan origination and legal
fees of $48,722 in connection with the implementation of the Agreement. These fees have
been deferred and are being amortized to interest expense over the three year term of the
Agreement. Unamortized deferred finance fees of $77,500 associated with the January 31,
2005 agreement will continue to be amortized over the three year term of that agreement.

The
Company may request advances under the Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.0%, but not less than 7.75% per annum. At June 30, 2006, the effective interest rate was
10.25%. In addition, the Company pays a monthly collateral management fee at the rate of
1.5% per annum upon the daily average amount of advances outstanding and a monthly unused
line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $3,500,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the U.S. lender its guarantee of payment together with
a second lien security interest in the assets of the Companys wholly owned Canadian
subsidiary. The U.S. lender has agreed not to exercise its rights under its second lien
security interest and guarantee against the Canadian assets without the Canadian
lenders approval.

Over
the term of the Agreement, the Company has agreed to comply with financial covenants
governing minimum EBITDA (earnings before interest, taxes, depreciation and amortization),
fixed charge ratio (EBITDA divided by the sum of debt service, capital expenditures,
income taxes and dividends) and its net leverage ratio (total debt divided by EBITDA)
measured at the end of each month for the average of the three most recent calendar months
based upon the Companys consolidated operating results. As it pertains to the
Companys U.S. operations, cash collections may not be less than a defined amount
each calendar month. In addition, at all times the Companys cash on hand (including
unused borrowing capacity under the Agreement) must not be less than $200,000. Additional
covenants governing permitted indebtedness, liens, payments of dividends and protection of
collateral are included in the Agreement. At June 30, 2006, the Company was in compliance
with its U.S. line of credit debt covenants.

The
Company may terminate the Agreement at any time by paying all outstanding indebtedness and
any other payments due the U.S. lender and paying the U.S. lender a yield maintenance
based early termination fee equal to the product of: (a) the effective yield on the
facility for the six months prior to termination (expressed as an annual percentage rate),
(b) $3,500,000, and (c) the quotient of the months remaining in the term of the Agreement
divided by 12.

Canadian
Line of Credit

In
November 2005, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $717,000 ($800,000
Canadian) with its Canadian lender. In light of the favorable impact of the new
distribution agreement on the borrowing requirements of the Companys wholly owned
Canadian subsidiary, Derma Sciences Canada Inc., the maximum principal amount of the
credit facility was reduced in line with the subsidiarys prospective maximum
borrowing capacity. The next annual review is expected to be completed in the second half
of 2006. Derma Sciences Canada Inc. may request advances under the Canadian Agreement up
to the value of 75% of eligible receivables (as defined) plus the lesser of $358,000
($400,000 Canadian) or 40% of eligible inventory (as defined), less priority claims.
Interest on outstanding advances is payable monthly in arrears at prime rate (as defined)
plus 1.0%, or 7.0% for Canadian dollar advances and 9.75% for U.S. dollar denominated
advances at June 30, 2006. Outstanding advances are secured by all tangible and intangible
assets of Derma Sciences Canada Inc. In addition, the Company has accorded the

11

---



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

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 $448,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default. At June 30, 2006, the
Company was in compliance with its Canadian line of credit debt covenants.

In
addition, the Canadian lender has granted Derma Sciences Canada Inc. a $448,000 ($500,000
Canadian) non-revolving term line of credit to finance equipment purchases and equipment
upgrades to Derma Sciences Canada Inc.s manufacturing facility. Advances against the
line are limited to 75% of the actual cost of the capital expenditure. Interest on
outstanding advances is payable monthly in arrears at prime (as defined), plus 1.25%. Each
advance shall be amortized and repaid over sixty months. As of June 30, 2006, there were no outstanding
advances against the line.

5.    Long-Term Debt

Long-term
debt includes the following:

`June 30,             December 31,
                                                                  2006                   2005
                                                                  ----                   ----

        U.S. term loan                                        $1,000,000                    -
        Promissory note                                          500,000                    -
        Canadian term loan                                       432,578               $533,809
        Capital lease obligations                                115,001                140,609
                                                               ---------                -------

             Total debt                                        2,047,579                674,418

        Less:  current maturities                                548,072                285,945
                                                               ---------                -------

             Long-term debt                                   $1,499,507               $388,473
                                                               =========                =======`

In connection with the
acquisition of Western Medical (see Note 2) in April 2006, the Company entered into a three-year term loan agreement with its U.S.
lender. Interest on the outstanding principal balance is payable monthly in arrears at the prime rate (as defined) plus 5.0%, but
not less than 7.75 % per annum. At June 30, 2006, the effective interest rate was 13.02 %. The loan is repayable commencing
October 1, 2006 in 29 monthly installments of $27,777 with a final payment on April 1, 2009 of $154,467. The term loan is secured
by all of the Companys existing and after-acquired tangible and intangible U.S. assets and is subject to the same conditions
applicable to the U.S. operating line of credit (see Note 4). Until such time as the term loan is fully repaid, the Company is
obligated to apply annually its excess cash flow (as defined) and the proceeds from the sale of any assets or stock to prepay the
term loan. Further, the Company may accelerate the payment of the term loan at its discretion, without penalty. Upon full
repayment of the loan, the Company is obligated to pay the U.S. lender a termination fee of $10,000. The termination fee is being
amortized to interest expense over the three year term of the loan.

12

---



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

In connection with the
acquisition of Western Medical in April 2006, a portion of the purchase price was paid via a three-year unsecured promissory note
issued to the seller. The principal amount of the promissory note, together with simple interest of 12%, is payable in 11
quarterly installments of interest only in the amount of $15,000 each and a final payment of accrued interest and the principal
balance of $515,000 on April 18, 2009. The promissory note may be prepaid in part or in full at any time without penalty.

In connection with the
acquisition of Dumex Medical Inc. in August 2002, the Company entered into a five-year term loan agreement with its Canadian
lender. The loan is repayable in monthly payments consisting of principal and interest. Interest on the outstanding principal
balance is payable monthly at the banks prime rate (as defined) plus 1.25%, or 7.25% at June 30, 2006. The term loan is secured
by all tangible and intangible assets of Derma Sciences Canada Inc. and is subject to the same conditions applicable to the
Canadian operating line of credit (see Note 4).

The
Company has three capital lease obligations for certain distribution and computer
equipment totaling $115,001 as of June 30, 2006. The capital lease obligations bear interest at
annual rates ranging from 3.9% to 10.2% with the longest lease term expiring in April
2009.

6.    Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at June 30, 2006.
The series A preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference of $4.00 per share, votes as a class
on matters affecting the series A preferred stock and maintains voting rights identical to
the common stock on all other matters.

There
are 440,003 shares of series B convertible preferred stock outstanding at June 30, 2006.
The series B preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference of $6.00 per share, votes as a class
on matters affecting the series B preferred stock and maintains voting rights identical to
the common stock on all other matters.

There
are 619,055 shares of series C convertible preferred stock outstanding at June 30, 2006.
The series C preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference averaging $0.70 per share, votes as
a class on matters affecting the series C preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 1,071,346 shares of series D convertible preferred stock outstanding at June 30, 2006.
The series D preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference averaging $0.50 per share, votes as
a class on matters affecting the series D preferred stock and maintains voting rights
identical to the common stock on all other matters.

Common
Stock

On
May 11, 2006, the Company increased the number of authorized shares of common stock from
30,000,000 to 50,000,000.

During the second quarter of
2006, the Company raised $5,822,637 (net of $549,599 in commission and other offering expenses) from a private offering of
2,655,098 units (10,620,392 shares in total) at $2.40 per unit, each unit consisting of four shares of the Companys common stock
and one five-year Series H warrant (2,655,098 warrants in total) to purchase one share of common stock at the price of $1.00. In
addition, the placement agent received 754,806 five-year Series I warrants to purchase one share of common stock at $0.72. Total
common shares outstanding increased from 12,285,768 before the transaction to 22,906,160 afterwards. The funds were used for the
acquisition of Western Medical.

13

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

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,246,656, net of $133,344 in offering expenses, were
received. The offering commenced prior to December 31, 2004. In 2005, the Company sold
1,205,000 units at $0.50 per unit and received total offering proceeds of $539,415, net of
$80,585 in offering expenses. Proceeds from the offering were used for working capital.

Stock
Options

The
Company adopted the Stock Option Plan (the Plan) July 18, 1991 and has amended
the Plan several times, the latest being May 11, 2006. The number of shares of Common
Stock reserved for issuance pursuant to the Plan is 5,000,000 shares. The Plan authorizes
the Company to grant two types of equity incentives: (i) options intended to qualify as
incentive stock options (ISOs) as defined in Section 422 of the
Internal Revenue Code of 1986, as amended, and (ii) nonqualified stock options
(NQSOs). The Plan authorizes options to be granted to directors, officers, key
employees and consultants of the Company, except that ISOs may be granted only to
employees. The Plan is administered by a committee of disinterested directors designated
by the Board of Directors (the Compensation Committee). Subject to the
provisions of the Plan, the Compensation Committee determines who is eligible to receive
stock options, together with the nature, amount, timing, exercise price, vesting schedule
and all other terms and conditions of the options to be granted.

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

At
June 30, 2006, options to purchase 3,621,625 shares of the Companys Common Stock at
prices in the range of $0.37 to $5.00 per share were issued and outstanding under the
Plan. In addition to options granted under the Plan, at June 30, 2006 there are 2,736,655
options granted outside the Plan that were not approved by shareholders.

During
the three and six months ended June 30, 2006 and 2005, the Company issued stock options as
outlined below:

`2006              2005
                                                             --------        ----------
         Number of stock options issued
             First quarter                                    390,000         1,021,000
             Second quarter                                   195,000           465,000
                                                              -------         ---------

               Total six months ended June 30, 2006           585,000         1,486,000
                                                              =======         =========

         Weighted-average exercise price
             First quarter                                      $0.70             $0.50
             Second quarter                                     $0.83             $0.42`

For
the three and six months ended June 30, 2006 and 2005 the fair value of each option award
was estimated at the date of grant using the Black-Scholes option pricing model. The
weighted-average assumptions for the three and six months ended June 30, 2006 and 2005
were as follows:

14

---



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

`2006                2005
                                                             ----                ----

         Risk-free interest rate
             First quarter                                   4.60%              4.25%
             Second quarter                                  5.10%              3.90%
         Volatility factor
             First quarter                                    .675              1.376
             Second quarter                                   .662              1.353
         Dividend yield                                        0%                0%
         Expected option life (years)                          5                  5
         Contractual life (years)                              10                10`

The
risk-free rate utilized represents the five year U.S. Treasury yield curve rate at the
time of grant and coincides with the expected option life. The three and six months ended
June 30, 2006 volatility factor is calculated based on the twenty-four month-end closing
prices of the Companys common stock preceding the month of stock option grant. The
twenty-four month time period was selected since it is representative of the
Companys common stock price volatility. The dividend yield is 0% since the Company
does not anticipate paying dividends in the near future. The expected option life of five
years is one-half of the option contractual life.

A
summary of option activity as of June 30, 2006, and changes during the three and six
months then ended, is presented below:

`Weighted Average
                                                                                     Remaining
                                                           Weighted Average         Contractual           Aggregate
              Options                      Shares           Exercise Price          Term (Years)       Intrinsic Value
              -------                      ------           --------------          ------------       ---------------

Outstanding at January 1, 2006             5,773,280            $0.92
Granted                                      390,000            $0.70
Exercised, forfeited or expired                  -                -
                                           ---------

Outstanding at March 31, 2006              6,163,280            $0.90
                                           =========

Granted                                      195,000            $0.83
Exercised, forfeited or expired                  -                -
                                           ---------

Outstanding at June 30, 2006               6,358,280            $0.90                   6.9              $1,342,130
                                           =========                                                      ==========

Exercisable at June 30, 2006               5,964,530            $0.91                   6.8              $1,310,280
                                           =========                                                      ==========`

For
the three and six months ended June 30, 2006, no income tax benefit was recognized related
to stock option activity.

The
weighted-average grant-date fair value of options granted during the three months ended
June 30, 2006 and 2005 were $0.50 and $0.37 per share, respectively. The weighted-average grant-date
fair value of options granted during the six months ended June 30, 2006 and 2005 were
$0.45 and $0.42 per share, respectively.

During
the three and six months ended June 30, 2006, stock option compensation expense was
recorded using the fair value method under SFAS 123R as follows:

15

---



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

`Three Months Ended         Six Months Ended
                                                             June 30, 2006            June 30, 2006
                                                             -------------            -------------

         Cost of sales                                         $  1,594                   $7,845
         Distribution                                               146                      719
         Sales                                                    5,588                   10,697
         General and administrative                              46,331                   73,023
                                                                 ------                   ------

         Total stock option compensation expense                $53,659                  $92,284
                                                                 ======                   ======`

As
of June 30, 2006, there was $158,516 of total unrecognized compensation cost related to
nonvested share-based awards granted under the Plan. That cost is expected to be
recognized over the options remaining weighted average vesting period of 2.75 years.

The
Companys net income (loss) and income (loss) per common share and pro forma net loss and loss per
common share assuming compensation expense had been determined for the three and six
months ended June 30, 2005 based on the fair value at the grant date for all awards, using
the Black-Scholes option pricing model consistent with the provisions of SFAS 123 and SFAS
123R, and amortized ratably over the vesting period, instead of the intrinsic value method
under APB 25, are set forth below:

`Three Months Ended         Six Months Ended
                                                             June 30, 2006            June 30, 2006
                                                             -------------            -------------

         Net income (loss) as reported                         $ 158,184               $ (54,868)
         Pro forma compensation expense                         (302,162)               (472,388)
                                                                 -------                 -------

         Pro forma net loss                                    $(143,978)              $(527,256)
                                                                 =======                 =======

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

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

Stock
Purchase Warrants

At
June 30, 2006, the Company had warrants outstanding to purchase 7,479,345 shares of the
Companys common stock as outlined below:

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

                     F               1,309,441               $0.57       January 6, 2007
                     G               2,760,000               $1.05       December 31, 2008
                     H               2,655,098               $1.00       April 30, 2011
                     I                 754,806               $0.72       April 30, 2011
                                     ---------

                  Total              7,479,345
                                     =========`

During
the three months ended June 30, 2006, the Company issued 2,655,098 series H warrants and
754,806 series I warrants in conjunction with the acquisition of Western Medical (see Note 6  Common Stock).

16

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

Shares
Reserved for Future Issuance

At
June 30, 2006, the Company had reserved the following shares of common stock for future
issuance:

`Convertible preferred shares (series A - D)                          2,280,407
         Common stock options outstanding                                     6,358,280
         Common stock warrants outstanding (series F - I)                     7,479,345
         Restricted common stock grants                                         175,000
                                                                              ---------

             Total common stock shares reserved                              16,293,032
                                                                             ==========`

Restricted
Common Stock

On
May 11, 2006, the Company adopted a restricted common stock plan and reserved 2,500,000 shares of common stock for issuance.

On
May 12, 2006, 175,000 shares of restricted common stock were granted to non-employee
members of the Companys board of directors and will vest in three years. The fair
market value at the date of grant, determined by the quoted market price, was $145,250.
The fair market value of the grant is being recognized to compensation expense over the
three year vesting period. For the three months ended June 30, 2006, $6,053 was expensed.

A summary of restricted
common stock activity as of June 30, 2006, and the changes during the three and six months then ended, is presented below:

`Weighted-Average
         Restricted Common Stock                        Shares             Grant-Date Fair Value
         -----------------------                        ------             ---------------------

         Nonvested at January 1, 2006                         0                        0

         Granted                                        175,000                    $0.83
                                                        -------

         Nonvested at June 30, 2006                     175,000                    $0.83
                                                        =======`

The
weighted-average remaining contractual term for the restricted common stock grant is 2.86
years.

7.    Comprehensive Income
(Loss)

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

`Three Months Ended June 30,       Six Months Ended June 30,
                                                           ---------------------------       -------------------------
                                                               2006             2005            2006             2005
                                                             --------         --------        --------        ----------

         Net income (loss) as reported                       $330,790         $158,184        $388,510        $ (54,868)
         Other comprehensive income:
              Foreign currency translation adjustment         243,659          (39,550)        219,384          (66,738)
                                                              -------          -------         -------           ------

         Comprehensive income (loss)                         $574,449         $118,634        $607,894        $(121,606)
                                                              =======          =======         =======         ========`

8. Operating Segments

The Company
consists of three operating segments: wound care, wound closure-fasteners and skin care.
Products in the wound care segment consist of basic and advanced dressings, ointments and
sprays designed to treat wounds. Wound closure-fastener products include wound closure
strips, nasal tube fasteners, a variety of catheter

17

---



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

fasteners and net dressings. The skin
care segment consists of bath sponges, antibacterial skin cleansers, hair and body soaps,
lotions and moisturizers designed to enable customers to implement and maintain successful
skin care/ hygiene programs.

Products
in all three operating segments are marketed to long-term care facilities, hospitals,
physicians, clinics, home health care agencies and other healthcare institutions. The
manufacture of basic and advanced wound care products, along with wound closure-fastener
products, are performed both internally and outsourced, while the manufacture of skin care
products is totally outsourced. Internally, the segments are managed at the gross profit
level. The aggregation or allocation of other costs by segment is not practical.

Segment
net sales and gross profit (loss) for the three and six months ended June 30, 2006 and
2005 were as follows:

`Three Months Ended June 30, 2006
                                    --------------------------------

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

Net sales             $6,459,312           $635,333         $292,036              -           $7,386,681
                       ---------            -------          -------         ---------         ---------

Gross profit           2,402,442            313,738            1,382              -            2,717,562

Total expenses             -                   -                 -         $(2,386,772)       (2,386,772)
                                                                                               ---------

Net income                                                                                    $  330,790
                                                                                               =========




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

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

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

Gross profit (loss)    2,004,129            335,979          (99,346)             -            2,240,762
Total expenses             -                   -                -          $(2,082,578)       (2,082,578)
                                                                                               ---------

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





                                     Six Months Ended June 30, 2006
                                     ------------------------------

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

Net sales            $11,343,868         $1,228,570         $571,157              -          $13,143,595
                      ----------          ---------          -------         ---------        ----------

Gross profit (loss)    4,303,893            606,054             (384)                -         4,909,563
Total expenses             -                   -                 -         $(4,521,053)       (4,521,053)
                                                                                               ---------

Net income                                                                                   $   388,510
                                                                                              ==========`

18

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

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

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

Net sales             $9,751,483         $1,298,272         $777,910              -          $11,827,665
                      ----------          ---------          -------         ---------        ----------

Gross profit (loss)    3,143,538            662,153          (94,085)                -         3,711,606
Total expenses             -                   -                -          $(3,766,474)       (3,766,474)
                                                                                               ---------

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

The
following table presents net sales by geographic region.

`Three Months Ended June 30,       Six Months Ended June 30,
                                 ---------------------------       -------------------------
                                    2006             2005            2006             2005
                                  --------         --------        --------        ---------

         United States               56%              34%             51%              40%
         Canada                      40%              62%             45%              56%
         Other                        4%               4%               4%              4%`

Canada
net sales for the three and six months ended June 30, 2005 represent a higher percentage
of total net sales compared with 2006 as a result of the one-time estimated benefit of
$1,840,000 related to the sale of inventory on hand to fill the distribution pipeline in
conjunction with the appointment of an exclusive third party distributor for the
Companys Canadian subsidiary in the second quarter 2005.

For
the six months ended June 30, 2006, the Company has a major U.S. customer comprising 18%
of sales. The Companys wholly owned Canadian subsidiary sells to one customer who
serves as its exclusive third party distributor.

9.    Income Taxes

The
Company did not record any provision for income taxes in the three months ended June 30, 2006 and 2005
and the six months ended June 30, 2006 and 2005 due to available net operating loss
carryforwards. No benefit has been recognized as the realization of the resultant deferred
tax assets is not assured.

10.    Subsequent Event

Sale
of Stock

On August 3, 2006 the Company
entered into an agreement to sell 2,000,000 shares of its common stock at $0.75 per share for a total sales price of $1,500,000 to
an existing shareholder (the Purchaser). The Purchaser paid $500,000 upon execution and shall pay $1,000,000 together
with interest thereon at the annual rate of 2.5%, not later than February 13, 2007. The balance is secured by a promissory note
issued to the Company by the Purchaser. During the period that there remains any principal or interest due the Company under the
promissory note, the Purchaser shall be precluded from selling, transferring, pledging or otherwise alienating any shares of the
common stock. Further, in the event all principal and interest due under the promissory note is not paid when due, the Company
may, at its option, either enforce payment in accordance with the promissory note or cancel any and all shares of common stock for
which payment has not been made.

The
initial payment of $500,000 was received on August 3, 2006 in accordance with the
agreement. The $500,000 was used to pay down the U.S. term loan entered into in connection
with the acquisition of Western Medical (see Note 5).

19

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Index

|Item 2. |  | MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF OPERATION
|------- |  | --------------------------------------------------------------------------------

THREE MONTHS ENDED
JUNE 30, 2006 COMPARED TO THREE MONTHS
ENDED JUNE 30, 2005.

Results of Operations

Overview

The 2006 and 2005 operating
results include Derma Sciences, Inc. and its subsidiaries. The results of Western Medical have only been included in the
Companys operating results from April 18, 2006, the acquisition date. Unless otherwise indicated by the context, the term
Canadian operations is used throughout this discussion in reference to the operations of Derma Sciences Canada Inc. and the term
U.S. operations is used throughout this discussion in reference to the Companys U.S. operations.

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

The
following table highlights the three months ended June 30, 2006 versus 2005 operating results:

`Three Months Ended June 30,
                                              ---------------------------
                                                 2006             2005                  Variance
                                                 ----             ----             --------------------

Gross Sales                                  $8,742,743       $8,210,230           $532,513        6.5%
Sales adjustments                            (1,356,062)      (1,276,012)           (80,050)       6.3%
                                             -----------      -----------          ---------

Net sales                                     7,386,681        6,934,218            452,463        6.5%
Cost of sales                                 4,669,119        4,693,456            (24,337)      (0.0%)
                                             -----------      -----------          ---------

Gross profit                                  2,717,562        2,240,762            476,800       21.3%
Gross profit percentage                            36.8%            32.3%
Operating expenses                            2,254,712        1,968,312            286,400       14.6%
Interest expense, net                           110,145           95,269             14,876       15.6%
Other expense, net                               21,915           18,997              2,918       15.4%
                                             -----------      -----------          ---------

Total expenses                                2,386,772        2,082,578            304,194       14.6%
Income before income taxes                      330,790          158,184            172,606      109.1%

Provision for income taxes                         -                -                  -           -
                                             -----------      -----------          ---------

Net income                                   $  330,790       $  158,184           $172,606      109.1%
                                             ===========      ===========          =========`

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, Medicaid rebates, returns and allowances and cash
discounts to derive net sales. Trade rebates are trued-up monthly based upon an analysis
of historical sales subject to rebate and actual rebates received from distributors. The
normal rebate cycle is one month. Non-exclusive distributors generally carry one
months inventory. As distributor inventory is depleted via sales, it is replenished
via purchases from the Company. Rebates are processed and submitted for credit on a timely
basis consistent with distributor sales. If the normal rebate cycle were one-half month
less than estimated at June 30, 2006, the trade rebate reserve would be overstated by
approximately $167,000. If the normal rebate cycle were one month greater than estimated

20

---



Index

at June 30, 2006, the trade rebate reserve would be understated by
approximately $334,000. To minimize its cash outflow invested in rebates, distributors generally strive to optimize the rebate
credit submission process.

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

Medicaid
rebates are accrued monthly based upon recent historical activity and reconciled quarterly
based upon receipt of rebate reports from participating state agencies. Returns and
allowances and cash discounts have historically been accounted for as incurred.

Gross
to net sales adjustments comprise the following:

`Three Months Ended June 30,
                                              ---------------------------
                                                 2006             2005
                                                 ----             ----

Gross Sales                                  $8,742,743       $8,210,230
                                             -----------      -----------

Trade rebates                                (1,294,886)      (1,222,550)
Medicaid rebates                                   (678)          (6,000)
Returns and allowances                          (18,309)          (6,911)
Cash discounts                                  (42,189)         (40,551)
                                             -----------      -----------

Total adjustments                            (1,356,062)      (1,276,012)
                                             -----------      -----------

Net sales                                    $7,386,681       $6,934,218
                                             ===========      ===========`

Trade rebates
increased in the second quarter 2006 versus 2005 due to the continuing growth of rebate
intensive U.S. private label sales and the addition of incremental rebates associated with
the Western Medical business acquired in April 2006 partially offset by a decrease 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. Sales returns and allowances
were up period to period as 2006 activity was higher due to an increase in the level of
shipping errors associated with integrating the Western Medical business into the U.S.
supply chain. The increase in cash discounts reflects the growth of sales to larger
customers that routinely take advantage of available discount terms.

Rebate Reserve Roll
Forward

A
quarterly roll forward of the trade rebate accruals at June 30, 2006 and 2005 is outlined
below:

`Three Months Ended June 30,
                                              ---------------------------
                                                 2006             2005
                                                 ----             ----

Beginning balance - April 1st                $1,835,230      $   330,340
Rebates paid                                   (674,304)        (154,877)
Rebates accrued                               1,294,886        1,222,550
                                             -----------      -----------

Ending balance - June 30th                   $2,455,812       $1,398,013
                                             ===========      ===========`

The
$620,582 increase in the second quarter 2006 trade rebate reserve reflects a $432,814
increase in the Canadian reserve due to higher sales and an adjustment to the reserve to
reflect a change in the estimate used to calculate the rebate amount for certain products,
lower rebates paid due to continuation of extended payment terms with one large customer
and incremental reserve requirements associated with the Western Medical business acquired
in April 2006, less a reduction of $30,000 due to a change in estimate to a prior period
amount due. There

21

---



Index

has been no other discernable change in the nature of the Companys
business as it relates to the accrual and subsequent payment of rebates. The $1,067,673
increase in the second quarter 2005 trade rebate reserve reflects a $972,068 incremental
reserve associated with implementing the third party distribution agreement in Canada in
June 2005 coupled with the continued growth of the rebate intensive U.S. private label
business and lower rebates paid due to extended payment terms with two large customers.

The
ending balance consists of accrued rebates included as a component of accounts receivable
and third party deductions accrued by and paid by the Company that are recorded in accrued
liabilities. The ending balance at June 30, 2006 and 2005 consist of the following:

`June 30,
                                                -----------------------
                                                 2006             2005
                                                 ----             ----

Accrued rebates                              $2,273,164       $1,238,662
Third party deductions recorded
   in accrued liabilities                       182,648          159,351
                                             -----------      -----------

       Total                                 $2,455,812       $1,398,013
                                             ===========      ===========`

Net Sales and Gross Margin

The
following table highlights the June 30, 2006 versus 2005 product line net sales and gross
profit:

`Three Months Ended June 30,
                                              ---------------------------
                                                 2006             2005                  Variance
                                                 ----             ----             --------------------
Product Line Net Sales
----------------------

Wound care                                   $6,459,312       $5,880,353           $578,959        9.9%
Wound closure-fasteners                         635,333          669,973            (34,640)      (5.2%)
Skin care                                       292,036          383,892            (91,856)     (23.9%)
                                             -----------      -----------          ---------

    Total                                    $7,386,681       $6,934,218           $452,463        6.5%
                                             ===========      ===========          =========

Product Line Gross Profit (Loss)
--------------------------------

Wound care                                   $2,402,442       $2,004,129           $398,313       19.9%
Wound closure-fasteners                         313,738          335,979            (22,241)      (6.6%)
Skin care                                         1,382          (99,346)           100,728        -
                                             -----------      -----------          ---------

    Total                                    $2,717,562       $2,240,762           $476,800       21.3%
                                             ===========      ===========          =========`

Company
net sales increased $452,463, or 6.5%, to $7,386,681 in 2006 from $6,934,218 in 2005.
Canadian net sales decreased $1,300,901, or 30.4%, to $2,983,844 in 2006 from $4,284,745
in 2005. This decrease was driven by the non-recurrence of an estimated $1,840,000 sales
benefit related to the sale of inventory on hand to fill the distribution pipeline in
conjunction with the appointment of an exclusive third party distributor for Canada in the
second quarter 2005, partially offset by favorable exchange of $476,627 associated with a
10.0% strengthening of the Canadian dollar and organic growth of $62,472, or 2.6%. U.S.
net sales increased $1,753,364, or 66.2%, to $4,402,837 in 2006 from $2,649,473 in 2005.
The increase was driven by the addition of incremental Western Medical sales of $1,256,575
coupled with continued growth of the private label business partially offset by the
continued decline in skin care sales due to competitive pressure. Excluding Western
Medical sales, U.S. sales were up $496,789, or 18.8%.

Company
gross profit increased $476,800, or 21.3%, to $2,717,562 in 2006 from $2,240,762 in 2005.
Company gross profit margin percentage increased to 36.8% in 2006 from 32.3% in 2005.
Canadian gross profit decreased $285,482, or 20.2%, to $1,128,770 in 2006 from $1,414,252
in 2005. Canadian gross profit margin increased to 37.8% in 2006 from 33.0% in 2005. The
decrease in Canadian 2006 gross profit dollars was driven by the non-recurrence of an
estimated $600,000 margin benefit related to the one-time sale of inventory to fill the
new

22

---



Index

Canadian distributors pipeline in the second quarter 2005. This adverse
impact was partially offset by improving margin dollars and percentage on the continuing business reflecting the combined impact
of higher sales, continuing improvement in manufacturing performance, higher unit volume flow through the Toronto plant and the
benefit of lower negotiated basic wound care costs. U.S. gross profit increased $762,282, or 92.2%, to $1,588,792 in 2006 from
$826,510 in 2005. Gross profit margin increased to 36.1% in 2006 from 31.2% in 2005. The improvement in U.S. gross margin dollars
and margin percentage reflects the combined impact of higher sales, favorable product mix and the benefit of lower product costs
from Canada and third party skin care product costs associated with outsourcing the line in the third quarter 2005. The
non-recurrence of a $98,000 charge taken in the second quarter 2005 to close the skin care manufacturing facility also
contributed. Excluding Western Medical gross profit, U.S. gross profit was up $237,694, or 28.8%, and the gross profit margin
percentage would have been 33.8%.

Wound
care sales increased $578,959, or 9.9%, to $6,459,312 in 2006 from $5,880,353 in 2005. The
increase is attributable to an advanced wound care sales increase of $603,848, or 51.2%.
This increase was principally driven by continued growth of the Companys private
label sales. Basic wound care sales decreased $24,889, or 0.5%. This essentially flat
performance reflects the non-recurrence of the one-time benefit of $1,840,000 related to
implementation of the exclusive distribution agreement in Canada in the second quarter
2005, offset by incremental Western Medical sales of $1,256,575 coupled with incremental
Canadian basic wound care sales of $539,099, or 22.1%, on its continuing business
comprised of favorable exchange of $476,627, or 19.5%, and growth of $62,472, or 2.6%, and
modest U.S. sales growth of $19,437, or 4.7%.

Wound
care gross profit increased $398,313, or 19.9%, to $2,402,442 in 2006 from $2,004,129 in
2005. The gross profit margin percentage increased to 37.2% in 2006 from 34.1% in 2005.
The margin dollar increase and improved gross margin percentage reflects the increase in
sales and the flow through of lower products costs as a result of continued improvement in
the Toronto manufacturing operations and the benefit of lower basic wound care and silver
product purchase prices, partially offset by the non-recurrence of an estimated $600,000
margin benefit related to the one-time sale of inventory to fill the new Canadian
distributors pipeline in the second quarter 2005.

Wound
closure-fastener sales decreased $34,640, or 5.2%, to $635,333 in 2006 from $669,973
in 2005. The non-recurrence of approximately $11,000 in residual sales of certain catheter
fasteners in 2005 associated with the loss of the Companys exclusive distribution
agreement for the sale of these products in August 2004 and a slight softening of demand
for the continuing products is responsible for the decrease.

Wound
closure-fastener gross profit decreased $22,241, or 6.6%, to $313,738 in 2006 from
$335,979 in 2005. The gross profit margin percentage decreased to 49.4% in 2006 from 50.1%
in 2005. The decrease in margin dollars reflects the lower sales and margin deterioration.
The margin deterioration is due principally to the combined impact of pricing pressure and
higher product costs.

Skin
care sales decreased $91,856, or 23.9%, to $292,036 in 2006 from $383,892 in 2005 due to
continuing competitive pressure. Skin care gross profit improved $100,728 to $1,382 in
2006 from a negative $99,346 in 2005. The main driver for the margin improvement is the
non-recurrence of the one-time closure costs of $98,000 recorded in the second quarter
2005. The elimination of most of the fixed overhead associated with the former skin
care manufacturing facility that was closed in August 2005 and outsourcing production to
lower cost third parties have allowed the business to operate at essentially break even
while the sales continue to decline.

Operating Expense

The
following table highlights June 30, 2006 versus 2005 operating expenses by type:

`Three Months Ended June 30,
                                              ---------------------------
                                                 2006             2005                  Variance
                                                 ----             ----             --------------------

Distribution                                 $  452,165       $   428,530          $  23,635       5.5%
Marketing                                       127,553           128,507               (954)     (0.0%)
Sales                                           550,150           476,958             73,192      15.4%
General administrative                        1,124,844           934,317            190,527      20.4%
                                             -----------      -----------          ---------

    Total                                    $2,254,712        $1,968,312           $286,400      14.6%
                                             ===========      ===========          =========`

23

---



Index

Operating
expense increased $286,400, or 14.6%, to $2,254,712 in 2006 from $1,968,312 in 2005
including an increase of $83,886, or 4.3%, attributable to exchange associated with a
10.0% strengthening of the Canadian dollar.

Distribution
expense increased $23,635, or 5.5%, in 2006 versus 2005. Expenses in Canada increased
$7,315 (including $33,334 expense related to exchange) while expenses in the U.S decreased
$16,320. Excluding foreign exchange, distribution expense in Canada decreased $26,019, or
8.5%, due principally to the non-recurrence of transition related costs associated with
implementation of the new exclusive third party distribution agreement in the second
quarter 2005. The U.S. increase was attributable to incremental one-time Western Medical
related transition and integration costs, partially offset by the elimination of
compensation related occupancy costs in the third quarter 2005 in connection with the
closure of the skin care manufacturing facility in August 2005.

Marketing
expense decreased $954 to $127,553 in 2006 versus $128,507 in 2005. The decrease reflects
lower literature related promotion expense in 2006 (which was a 2005 focus), for the most
part offset by higher compensation, travel and product development expenses.

Sales
expense increased $73,192, or 15.4%, in 2006 versus 2005. Expenses in Canada decreased
$11,091 (including $16,898 expense related to exchange) while expenses in the U.S.
increased $84,283. Excluding foreign exchange, sales expense in Canada decreased $27,989,
or 18.2%, due principally to the cost saving initiatives implemented in 2005 in connection
with implementation of the new exclusive third party distribution agreement, partially
offset by a higher level of sales support activities to expand market visibility and
improve contract compliance. The U.S. increase was attributable to incremental fees and
expenses of approximately $41,000 to hire a consulting firm to assist in the integration
of the Western Medical business into the Company and higher compensation and commissions
associated with hiring two new sales representatives (one replacement and one new
position) in the third quarter 2005, partially offset by lower recruiting and sample
expenses.

General
administrative expense increased $190,527, or 20.4%, in 2006 versus 2005. Expenses in
Canada decreased $31,087 (including $33,654 expense related to exchange) while expenses in
the U.S. increased $221,614. Excluding foreign exchange, general administrative expense in
Canada decreased $64,741, or 21.0%, due principally to cost savings initiatives
implemented in 2005 and the non-recurrence of transition related expenses associated with
the new exclusive third party distribution agreement and lower accounting, recruiting and
travel costs, partially offset by higher compensation and bonus expenses. The U.S.
increase of $221,614 principally reflects incremental intangible asset amortization
expense of $90,000 related to the Western Medical acquisition, board of director related
equity based compensation expense of approximately $46,000, one-time Western Medical
transition costs of approximately $37,000 together with higher compensation, consulting,
bad debt and compensation charge for employee stock options, partially offset by lower information
technology and insurance costs.

Interest Expense

Interest
expense increased $14,876, or 15.6%, to $110,145 in 2006 from $95,269 in 2005. Interest
expense in Canada decreased $13,366 (net of $3,014 expense related to exchange) while
interest expense in the U.S. increased $28,242. The decrease in Canada reflects lower
outstanding line of credit and term loan balances in 2006 versus 2005 partially offset by
higher interest rates. Canadas outstanding line of credit balance was reduced to
zero by the end of June 2005 through use of the one-time positive cash flow generated by
implementation of the new distribution agreement. The U.S. increase is due to incremental
term loan and promissory note interest related to the Western Medical acquisition in April
2006 coupled with higher overall line of credit interest rates. These increases were
partially offset by lower outstanding line of credit balances due to improved U.S. cash
flow and lower line of credit fees.

Other Expense

Other
expense increased $2,918 to $21,915 in 2006 from $18,977 in 2005.

24

---



Index

Income Taxes

The
Company did not record any income taxes in the three months ended June 30, 2006 or 2005
due to available net operating loss carry forwards.

Net Income

The Company generated net income of
$330,790, or $0.02 per share basic and $0.01 per share diluted, in the three months
ended June 30, 2006 compared to net income $158,184, $0.01 per share basic and diluted, in
the three months ended June 30, 2005.

25

---



Index

SIX MONTHS ENDED
JUNE 30, 2006 COMPARED TO SIX MONTHS ENDED
JUNE 30, 2005.

Results of Operations

Overview

The
following table highlights the six months ended June 30, 2006 versus 2005 operating
results:

`Six Months Ended June 30,
                                               -------------------------
                                                 2006             2005                  Variance
                                                 ----             ----           ----------------------

Gross Sales                                 $15,507,509      $13,447,268         $2,060,241       15.3%
Sales adjustments                            (2,363,914)      (1,619,603)          (744,311)      46.0%
                                            ------------     ------------        -----------

Net sales                                    13,143,595       11,827,665          1,315,930       11.1%
Cost of sales                                 8,234,032        8,116,059            117,973        1.5%
                                            ------------     ------------        -----------

Gross profit                                  4,909,563        3,711,606          1,197,957       32.3%
Gross profit percentage                            37.4%            31.4%
Operating expenses                            4,376,464        3,732,825            643,639       17.2%
Interest expense, net                           192,195          179,853             12,342        6.9%
Other income, net                               (47,606)        (146,204)            98,598       67.4%
                                             -----------     ------------        -----------

Total expenses                                4,521,053        3,766,474            754,579       20.0%
Income (loss) before income taxes               388,510          (54,868)           443,378        -

Provision for income taxes                         -                -                  -           -
                                            ------------     ------------        -----------

Net income (loss)                           $    388,510     $   (54,868)        $  443,378        -
                                            ============     ============        ===========`

Gross to Net Sales
Adjustments

Gross
to net sales adjustments comprise the following:

`Six Months Ended June 30,
                                               -------------------------
                                                 2006             2005
                                                 ----             ----

Gross Sales                                 $15,507,509      $13,447,268
                                            ------------     ------------

Trade rebates                                (2,247,933)      (1,495,734)
Medicaid rebates                                 (7,128)         (13,420)
Returns and allowances                          (30,564)         (38,494)
Cash discounts                                  (78,289)         (71,955)
                                            ------------     ------------

Total adjustments                            (2,363,914)      (1,619,603)
                                            ------------     ------------

Net sales                                   $13,143,595      $11,827,665
                                            ============     ============`

Trade rebates
increased $752,199 in the first half 2006 versus 2005 due to the Companys
implementing an exclusive third party distribution agreement in the second quarter 2005
for its Canadian business, the continuing growth of rebate intensive U.S. private label
sales and the addition of incremental rebates associated with the Western Medical business
acquired in April 2006, partially offset by a decrease in the level of sales subject to
rebate (contract business) in other areas of the Companys business.
Implementing the third party distribution agreement was responsible for $741,344 of the
increase as the majority of the Canadian sales represent contract business subject to
rebate. A continuing trend towards lower levels of Medicaid reimbursed sales is
responsible for the lower level of Medicaid rebates. Sales returns and allowances were
down period to period as 2005 first quarter activity

26

---



Index

was unusually high due to an increase
in the level of shipping errors associated with upgrading the Companys supply chain
information technology systems. The increase in cash discounts reflects the growth of
sales to larger customers that routinely take advantage of available discount terms.

Rebate Reserve Roll
Forward

A
six month roll forward of the trade rebate accruals at June 30, 2006 and 2005 is outlined
below:

`Six Months Ended June 30,
                                               -------------------------
                                                 2006             2005
                                                 ----             ----
Beginning balance - January 1st              $1,600,172      $   253,815
Rebates paid                                 (1,392,293)        (351,536)
Rebates accrued                               2,247,933        1,495,734
                                             -----------      -----------

Ending balance - June 30th                   $2,455,812       $1,398,013
                                             ===========      ===========`

The
$855,640 increase in the first six months of 2006 trade rebate reserve reflects a $790,455
increase to the Canadian reserve due to a higher level of sales since its implementation
in the second quarter 2005 and an adjustment to the reserve to reflect a change in the
estimate used to calculate the rebate amount for certain products, lower rebates paid due
to continuation of extended payment terms with one large customer and incremental reserve
requirements associated with the Western Medical business acquired in April 2006, less a
reduction of $72,300 due to a change in estimate to a prior period amount due. There has
been no other discernable change in the nature of the Companys business as it
relates to the accrual and subsequent payment of rebates. The $1,144,198 increase in the
first six months of 2005 trade rebate reserve reflects a $972,068 incremental reserve
associated with implementing the third party distribution agreement in Canada in the
second quarter 2005 coupled with the continued growth of the rebate intensive U.S. private
label business and lower rebates paid due to extended payment terms with two large
customers.

Net Sales and Gross Margin

The
following table highlights the June 30, 2006 versus 2005 product line net sales and gross
profit:

`Six Months Ended June 30,
                                               -------------------------
                                                 2006             2005                  Variance
                                                 ----             ----           ----------------------
Product Line Net Sales
----------------------

Wound care                                  $11,343,868      $ 9,751,483         $1,592,385       16.3%
Wound closure-fasteners                       1,228,570        1,298,272            (69,702)      (5.4%)
Skin care                                       571,157          777,910           (206,753)     (26.6%)
                                            ------------     ------------        -----------

    Total                                   $13,143,595      $11,827,665         $1,315,930       11.1%
                                            ============     ============        ===========

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

Wound care                                  $ 4,303,893      $ 3,143,538         $1,160,355       36.9%
Wound closure-fasteners                         606,054          662,153            (56,099)      (8.5%)
Skin care                                          (384)         (94,085)            93,701       99.6%
                                            ------------     ------------        -----------

    Total                                   $ 4,909,563      $ 3,711,606         $1,197,957       32.3%
                                            ============     ============        ===========`

Company
net sales increased $1,315,930, or 11.1%, to $13,143,595 in 2006 from $11,827,665 in 2005.
Canadian net sales decreased $575,529, or 8.8%, to $5,995,344 in 2006 from $6,570,873 in
2005. This decrease was driven by the non-recurrence of an estimated $1,840,000 sales
benefit related to the sale of inventory on hand to fill the distribution pipeline in
conjunction with the appointment of an exclusive third party distributor for Canada in the
second quarter 2005, partially offset by growth of $678,841 and favorable exchange of
$585,630 associated with a 8.2% strengthening of the Canadian dollar. U.S. net sales
increased $1,891,459, or 36.0%, to $7,148,251 in 2006

27

---



Index

from $5,256,792 in 2005. The increase
was driven by the addition of incremental Western Medical sales of $1,256,575 and with
continued growth of the private label business, partially offset by the continued decline
in skin care sales due to competitive pressure and softening demand for basic wound care
products. Excluding Western Medical sales, U.S. sales were up $634,884, or 12.1%.

Company
gross profit increased $1,197,957, or 32.3%, to $4,909,563 in 2006 from $3,711,606 in
2005. Company gross profit margin percentage increased to 37.4% in 2006 from 31.4% in
2005. Canadian gross profit increased $301,078, or 15.0%, to $2,304,505 in 2006 from
$2,003,427 in 2005. The Canadian gross profit margin increased to 38.4% in 2006 from 30.5%
in 2005. The improvement in Canadian 2006 gross profit dollars and margin percentage
reflects the combined impact of higher sales, continuing improvement in manufacturing
performance, higher unit volume flow through the Companys Canadian manufacturing
operation and the benefit of lower negotiated basic wound care costs, partially offset by
the non-recurrence of an estimated $600,000 margin benefit related to the one-time sale of
inventory to fill the new Canadian distributors pipeline in the second quarter 2005.
U.S. gross profit increased $896,879, or 52.5%, to $2,605,058 in 2006 from $1,708,179 in
2005. The gross profit margin percentage increased to 36.4% in 2006 from 32.5% in 2005.
The improvement in U.S. gross margin dollars and margin percentage reflects the combined
impact of higher sales, favorable product mix and the benefit of lower wound care product
costs from Canada and third party skin care product costs associated with outsourcing the
line in the third quarter 2005. Excluding Western Medical, gross profit was up $372,291,
or 21.8%, and the gross profit margin percentage would have been 35.3%.

Wound
care sales increased $1,592,385, or 16.3%, to $11,343,868 in 2006 from $9,751,483 in 2005.
The increase is attributable to an advanced wound care increase of $967,765, or 42.6%.
This increase was principally driven by continued growth of the Companys private
label sales. Basic wound care sales increased $624,620, or 8.4%. This performance reflects
incremental Western Medical sales of $1,256,575, incremental Canadian sales of $1,264,471,
or 27.7%, on its continuing business comprised of favorable growth of $678,841, or 14.4%,
and favorable exchange of $585,630, or 13.3%, partially offset by the non-recurrence of
the one-time estimated benefit of $1,840,000 related to implementation of the exclusive
distribution agreement in Canada in the second quarter 2005 and lower U.S. sales of
$56,426. The U.S. sales performance reflects a softening of demand for these products.

Wound
care gross profit increased $1,160,355, or 36.9%, to $4,303,893 in 2006 from $3,143,538 in
2005. The gross profit margin percentage increased to 37.9% in 2006 from 32.2% in 2005.
The margin dollar increase and improved gross margin percentage reflects the increase in
sales and the flow through of lower product costs as a result of continued improvement in
the Companys Canadian manufacturing operation and the benefit of lower basic wound
care and silver product purchase prices, partially offset by the non-recurrence of an
estimated $600,000 margin benefit related to the one-time sale of inventory to fill the
new Canadian distributors pipeline in the second quarter 2005.

Wound
closure-fastener sales decreased $69,702, or 5.4%, to $1,228,570 in 2006 from $1,298,272
in 2005. The non-recurrence of approximately $49,000 in residual sales of certain catheter
fasteners in 2005 associated with the loss of the Companys exclusive distribution
agreement for the sale of these products in August 2004 and a slight softening of demand
for the continuing products is responsible for the decrease.

Wound
closure-fastener gross profit decreased $56,099, or 8.5%, to $606,054 in 2006 from
$662,153 in 2005. The gross profit margin percentage decreased to 49.3% in 2006 from 51.0%
in 2005. The decrease in margin dollars reflects the lower sales and margin deterioration.
The gross margin percentage deterioration is due principally to the combined impact of
pricing pressure and higher product costs.

Skin
care sales decreased $206,753, or 26.6%, to $571,157 in 2006 from $777,910 in 2005 due to
continuing competitive pressure. Skin care gross profit improved $93,701 to a negative
$384 in 2006 from a negative $94,085 in 2005. The main driver for the margin improvement
is the non-recurrence of the one-time closure costs of $98,000 recorded in the second
quarter 2005. The elimination of most of the fixed overhead associated with the former
skin care manufacturing facility that closed in August 2005 and outsourcing production to
lower cost third parties have allowed the business to operate at essentially break even
while the sales continue to decline.

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Operating Expense

The
following table highlights June 30, 2006 versus 2005 operating expenses by type:

`Six Months Ended June 30,
                                               -------------------------
                                                 2006             2005                  Variance
                                                 ----             ----             --------------------

Distribution                                 $  868,583       $  777,032           $ 91,551       11.8%
Marketing                                       269,174          225,302             43,872       19.5%
Sales                                         1,055,572          932,172            123,400       13.2%
General administrative                        2,183,135        1,798,319            384,816       21.4%
                                             ----------       ----------           --------

    Total                                    $4,376,464       $3,732,825           $643,639       17.2%
                                             ==========       ==========           =========`

Operating
expense increased $643,639, or 17.2%, to $4,376,464 in 2006 from $3,732,825 in 2005
including an increase of $115,728, or 3.1%, attributable to exchange associated with a
8.2% strengthening of the Canadian dollar on the Canadian operations.

Distribution
expense increased $91,551, or 11.8%, in 2006 versus 2005. Expenses in Canada increased
$95,250 (including $44,769 expense related to exchange) while expenses in the U.S
decreased $3,699. Excluding foreign exchange, distribution expense in Canada increased
$50,481, or 9.8%, due principally to higher distribution costs associated with higher
sales based third party distribution fees and the corresponding increase in costs
associated with a higher level of distributor sales in 2006 versus 2005. Partially
offsetting this increase was the non-recurrence of transition related costs associated
with implementation of the new exclusive third party distribution agreement in the second
quarter 2005. The U.S. decrease was attributable to elimination of compensation related
occupancy costs in the third quarter 2005 in connection with the closure of the skin care
manufacturing facility in August 2005, partially offset by incremental one-time Western
Medical related transition and integration costs in the second quarter 2006.

Marketing
expense increased $43,872, or 19.5%, in 2006 versus 2005. The increase was principally
attributable to higher promotion and product development expense in support of the
Companys growth initiatives. Higher compensation (associated with an employee
promotion) and travel, also contributed.

Sales
expense increased $123,400, or 13.2%, in 2006 versus 2005. Expenses in Canada increased
$14,791 (including $23,210 expense related to exchange) while expenses in the U.S.
increased $108,609. Excluding foreign exchange, sales expense in Canada decreased $8,419,
or 3.1%, due principally to the cost savings initiatives implemented in 2005 and the
non-recurrence of transition related costs associated with implementation of the new
exclusive third party distribution agreement in the second quarter 2005. Partially
offsetting these decreases were higher commission and operating expenses to expand sales
support activities to improve market visibility and contract compliance. The U.S. increase
was attributable to incremental fees and expenses of approximately $41,000 to hire a
consulting firm to assist in the integration of the Western Medical business into the
Company and higher compensation and commissions associated with hiring two new sales
representatives (one replacement and one new position) in the third quarter 2005,
partially offset by lower recruiting and sample expenses.

General
administrative expense increased $384,816, or 21.4%, in 2006 versus 2005. Expenses in
Canada increased $99,427 (including $47,749 expense related to exchange) while expenses in
the U.S. increased $285,389. Excluding foreign exchange, general administrative expense in
Canada increased $51,678, or 9.4%. The increase in Canada reflects higher compensation,
bonus and benefit costs, higher travel costs principally to China and in support of new
private label business opportunities, employee stock option expense and higher audit and
legal costs. Partially offsetting these increases were cost savings initiatives
implemented in 2005 and the non-recurrence of transition related expenses associated with
implementation of the new exclusive third party distribution agreement in the second
quarter 2005. The U.S. increase of $285,389 principally reflects incremental intangible
asset amortization expense of $90,000 related to the Western Medical acquisition, board of
director related equity based compensation expense of $46,000 and one-time Western Medical
transition costs of $37,000 together with higher audit, legal, bad debt, compensation charge for employee stock
options, consulting and investor relations expenses. Partially offsetting these increases
were lower recruiting, information technology and insurance expenses.

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Interest Expense

Interest
expense increased $12,342, or 6.9%, to $192,195 in 2006 from $179,853 in 2005. Interest
expense in Canada decreased $33,103 (net of $5,183 expense related to exchange) while
interest expense in the U.S. increased $45,445. The decrease in Canada reflects lower
outstanding line of credit and term loan balances in 2006 versus 2005 partially offset by
higher interest rates. Canadas outstanding line of credit balance was reduced to
zero by the end of June 2005 through use of the one-time positive cash flow generated by
implementation of the new distribution agreement. The U.S. increase is due to incremental
term loan and promissory note interest related to the Western Medical acquisition in April
2006 and higher line of credit fees and overall line of credit interest rates. These
increases were partially offset by lower outstanding line of credit balances due to
improved U.S. cash flow.

Other Income

Other
income decreased $98,598 to $47,606 in 2006 from $146,204 in 2005. The main driver for the
decrease was the non-recurrence of a $164,300 gain recorded in the first quarter 2005
associated with a one-time distribution agreement upset fee, partially offset by the
favorable settlement of a supplier liability of $64,971 in the first quarter 2006. Higher
exchange and container demurrage expense, partially offset by higher profit sharing income
and miscellaneous income in 2006, also contributed.

Income Taxes

The
Company did not record any provision for income taxes in the six months ended June 30,
2006 or 2005 due to available net operating loss carry forwards.

Net Income (Loss)

The
Company generated net income of $388,510, or $0.02 per share basic and diluted, in
the six months ended June 30, 2006 compared to net loss of $54,868, or $0.00 per share basic
and diluted, in the six months ended June 30, 2005.

Liquidity and Capital
Resources

Operational Overview

Net
sales increased 11.1% (5.0% adjusted for foreign exchange) in the first six months 2006
over 2005. This growth was driven by a sales increase in the U.S. of 36.0%, partially
offset by a decrease in Canadian sales of 8.8% (17.7% adjusted for foreign exchange).
Sales growth in the U.S. was driven by the addition of incremental sales of $1,256,575
associated with the Western Medical acquisition in April 2006 and the continued growth of
the private label business. In addition, with the exception of skin care sales, overall
U.S. core product sales have remained relatively stable period to period with strength in
some areas offsetting softness in others. Skin care sales continue to deteriorate in the
face of significant competitive pressure. Excluding the incremental Western Medical sales,
U.S. sales growth was 12.1%. Adjusted for the non-recurrence of an estimated $1,840,000
sales benefit related to the sale of inventory on hand to fill the distribution pipeline
in conjunction with the appointment of an exclusive third party distributor for Canada in
the second quarter 2005, sales in Canada have met expectations, increasing 26.7% (14.3%
adjusted for foreign exchange) as the Company has continued to focus on contract
compliance, exploring opportunities in other market segments (other than its traditional
strength in the acute care segment) and working closely with its new exclusive distributor
to capitalize on sales growth opportunities presented by this new relationship.

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

Operating
expenses increased 17.2% (14.1% adjusted for foreign exchange) in the first six months
2006 over 2005. The increase is attributable to incremental Western Medical costs
(intangible asset amortization, planned

30

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sales and marketing and one-time integration
expenses), non-cash equity based compensation expense commencing in 2006 and planned
increases in marketing and sales expenses in support of the Companys growth
initiatives. Excluding these expenses, growth in the balance of operating expenses is in
line with inflation and continues to be closely monitored.

Excluding
a goodwill impairment charge in the fourth quarter 2005, the Company has reported
profitability in its last five quarters. With the addition of the Western Medical sales,
continued Canadian sales improvement and the expected growth of the private label business
in the U.S. coupled with ongoing manufacturing cost reduction initiatives and operating
expense management, the Company anticipates to continue this trend going forward.

Acquisition of Western Medical

On April 18, 2006, the
Company acquired certain assets and assumed the trade payables and the business of Western Medical for $6,500,000 of which
$6,000,000 was paid in cash and $500,000 was paid via a three-year promissory note issued to Western Medical by the Company. In
addition, the Company anticipates incurring transaction expenses totaling $860,000 related to the purchase of which $662,691 had
been paid or accrued as of June 30, 2006. The purchased assets consist of trade receivables, inventory, equipment and certain
identifiable intangibles. To fund the purchase, the company raised $5,822,637 (net of $549,599 in commissions and other offering
expenses) from the private sale of 2,655,098 units at $2.40 per unit each unit consisting of four shares of common stock and one
five-year warrant to purchase one share of common stock at $1.00 per share. In addition, the placement agent for the units
received 754,806 five-year warrants each to purchase one share of common stock at $0.72 per share. The Company also received
$1,000,000 in cash from a new three-year term loan that bears interest at prime plus 5% from its U.S. lender through an amendment
to its existing three-year revolving credit facility. The amendment amends and restates various loan covenants of the revolving
credit facility and increases the revolving credit facility cap from $2,000,000 to $3,500,000. Estimated deferred financing costs
of $72,000, of which $48,722 had been paid or accrued as of June 30, 2006, related to this financing are being amortized to
interest expense over the three-year term of the amended credit facility.

Western
Medical was a privately held manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. In 2005, Western Medical
reported audited sales of $6,684,160, gross profit of $2,664,997 and net income of
$838,865. Western Medicals product line is complementary to and will serve to expand
the Companys existing basic wound care line. The Company anticipates being able to
leverage cross selling opportunities presented by the purchase to grow sales. In addition,
the Company expects to absorb Western Medicals business within its existing
operating infrastructure incurring only modest incremental cost increases. Both of these
initiatives are expected to increase the contribution of the business going forward.

Cash Flow and Working
Capital

At
June 30, 2006 and December 31, 2005, the Company had cash and cash equivalents on hand of
$1,051,599 and $1,105,330, respectively. The $53,731 decrease principally represents a
timing difference that results from net cash provided by operating activities of $430,960,
net cash used in investing activities of $6,992,029, net cash provided by financing
activities of $6,444,502 and cash provided as a result of exchange rate changes of
$62,836. The timing difference relative to cash used by operating activities reflects
receipt of a large Canadian receivable payment at month-end June 2006 and December 2005.
Subject to lender and tax authority constraints surrounding the movement of cash between
affiliated entities, the Companys objective is to maintain minimum cash balances on
hand while using available funds to pay down its outstanding line of credit balances.

Net
cash provided in operating activities of $430,960 stems from $1,637,285 cash provided from
operations (net income plus non cash items) partially offset by $1,206,325 cash used from
the net change in operating assets and liabilities (excluding estimated Western Medical
operating assets and liabilities acquired as of the date of acquisition). Higher
receivables and inventory, partially offset by an increase in accounts payable were the
main drivers behind the net change in ongoing operating assets and liabilities. The
increase in receivables principally reflects the increased level and timing (late in the
second quarter) of new and existing private label sales. An increase in the level of core
product sales also contributed. The increase in inventory reflects incremental investment
in raw and packaging materials in support of two new private label customers and bringing
the manufacture of the wound closure-fastener line of products in-house. The Company also
made an investment in

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inventory during the first six months of 2006 to replenish low
levels of third party sourced product and to better balance its inventory to improve
customer service. The increase in payables principally reflects incremental transaction
related expenses associated with the Western Medical acquisition and an increase in the
level of inventory spending.

Net
cash used in investing activities of $6,992,029 reflects funds used for the acquisition of Western
Medical consisting of the purchase price of $6,000,000 together with
deferred business acquisition related expenses of $662,691. In addition, $329,338 was
expended principally on purchases of equipment at the Companys manufacturing
operation in Canada to expand manufacturing capability in response to an increase in
private label business and to bring the manufacture of the Companys wound
closure-fastener line of products in-house. Both of these initiatives are anticipated to
generate an above average long term return on investment.

Net
cash provided in financing activities of $6,444,502 reflects cash received of $5,822,637,
net of offering expenses from the private sale of common stock, together with loan
proceeds of $1,000,000 from the Companys U.S. lender in April 2006, partially offset
by the Western Medical acquisition related deferred financing costs of $48,722 together
with the use of available funds generated by ongoing operations to pay down the
Companys outstanding line of credit balance by $181,626 and make normally scheduled
long-term debt repayments of $147,787.

Working
capital increased $1,595,551, or 47.6%, at June 30, 2006 to $4,950,344 from $3,354,793 at
December 31, 2005. The increase is principally attributable to the net working capital
acquired as part of the acquisition of Western Medical. Improving operating performance
also contributed. Working capital of this magnitude is considered sufficient to support
ongoing operations.

Financing Arrangements

On
April 18, 2006, the Company entered into an amended three-year revolving credit facility
agreement with its U.S. lender for a maximum principal amount of $3,500,000. Maximum
potential advances under the agreement at June 30, 2006 were $2,862,000. Advances
outstanding against the line were $898,935 at June 30, 2006, leaving an additional
$1,963,065 available for borrowing.

In
November 2005, the Company renewed its annual revolving credit facility agreement with its
Canadian lender for a maximum principal amount of $717,000 ($800,000 Canadian). Maximum
potential advances under the agreement at June 30, 2006 were $225,000. Advances
outstanding against the agreement were zero at June 30, 2006, leaving an additional
$225,000 available for borrowing.

In
addition, the Canadian lender has granted Derma Sciences Canada Inc. a $448,000 ($500,000
Canadian) non-revolving term line of credit to finance equipment purchases and equipment
upgrades to Derma Sciences Canada Inc.s manufacturing facility. Advances against the
line are limited to 75% of the actual cost of the capital expenditure. Interest on
outstanding advances is payable monthly in arrears at prime (as defined), plus 1.25%. Each
advance shall be amortized and repaid over sixty months. As of June 30, 2006, outstanding
advances against the line was zero.

Prospective Assessment

The
Companys objective is to continue to grow sales and gross profit in 2006. Beginning
in 2005, the Company expanded its product development efforts. As a result of these
efforts, the Company expects to launch two new products in late 2006 and additional new
product launches are anticipated in 2007. The April 2006 acquisition of the Western
Medical business is anticipated to have a positive impact on the Companys U.S.
business going forward. Growth of the Companys private label business is anticipated
to accelerate in 2006 as the existing business continues to grow and new customers are
brought on board. Plans are in place to better leverage existing opportunities in the
Companys basic and advanced wound care lines in the U.S. by working more closely
with several key existing and potential new customers to increase business. In Canada, the
exclusive distribution agreement represents an opportunity for sales growth in the near
future.

The
Company plans to build upon its recent success in the area of product cost savings. Higher
throughput and improved operational efficiencies are expected to lower the Companys
overall internal cost of manufacturing

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going forward. Plans are in place to bring the
manufacture of the Companys wound closure-fastener line in-house during 2006 at a
savings versus existing third party sourced product costs. The Company also anticipates
realizing savings when it begins sterilizing its China sourced products in China in the
second half of 2006. Subject to commodity driven cotton prices and foreign exchange
changes, which are outside of the Companys control, the Company anticipates
continuing to building on its successful relationships in China to keep its basic wound
care costs competitive.

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

Going forward, capital
expenditures will continue to be limited to those projects capable of generating an acceptable level of return and those necessary
to support ongoing operations. The Company plans to continue to closely monitor inventory levels with the objective of properly
balancing customer service requirements while minimizing its investment in inventory wherever possible. In the second half of
2006, the Companys Canadian manufacturing operation is anticipating spending $500,000 to $700,000 for production equipment
and related leasehold improvements. This spending will provide the Company with the capacity and capability to manufacture higher
volumes of existing products, along with accommodating the introduction of new products. The Company anticipates funding this
spending through internally generated cash flow or use of available lines of credit.

The
Company believes that available funds from expected improving operations and available
lines of credit will be sufficient to satisfy the Companys liquidity requirements
through at least December 31, 2006. In addition, the Company will continue to evaluate
external opportunities to leverage its core capabilities for growth.

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

Update of Factors
Affecting Future Prospects

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

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

As
of June 30, 2006, 16,293,032 shares of the Companys common stock were issuable upon
the conversion or exercise of outstanding convertible preferred stock, warrants and
options and the vesting of restricted shares (derivative securities). The
shares of common stock issuable upon conversion or exercise of derivative securities and
the vesting of restricted shares are substantial compared to the 22,906,160 shares of
common stock currently outstanding.

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

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

The
Company earned net income of $388,510 (unaudited) in the first six months of 2006, $22,241
in 2003, $61,368 in 2002 and $192,398 in 2001 and incurred losses of $909,104 in 2005,
$2,338,693 in 2004, $2,581,337 in 2000 and $2,998,919 in 1999. At June 30, 2006, the
Company had an accumulated deficit of $13,506,624 (unaudited). Although the Company
achieved profitability in the first six months of 2006, in 2003, 2002 and 2001, the
Company cannot offer any assurance that it will be able to generate sustained or
significant earnings.

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

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

`Derma Sciences
                                        Trading Range - Common Stock

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

                           2001                     $0.22         $0.80
                           2002                     $0.35         $0.85
                           2003                     $0.35         $2.30
                           2004                     $0.43         $1.90
                           2005                     $0.42         $0.78
                           2006(*)                  $0.45         $0.97
                           ___________________
                           (*) January 1 through July 31.`

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

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

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

Additional Financial
Information

Forward Looking Statements

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

34

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Index

product development, commercialization or technological delays or
difficulties, and trade, legal, social, financial and economic risks.

Critical Accounting
Policies

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

Revenue Recognition and
Adjustments to Revenue

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

Goodwill

At
June 30, 2006, the Company had $3,773,102 of goodwill. The goodwill is comprised of
$3,573,102 included in the wound care segment representing a preliminary estimate relating
to the acquisition of Western Medical in April 2006. The remaining $200,000 balance
relates to the 1998 Sunshine acquisition and is included within the skin care segment. 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 each reporting unit. These
assumptions include future growth rates, discount factors, future tax rates and other
factors. The Companys cash flow forecasts are based on assumptions that are
consistent with the plans and estimates used to manage the underlying business. In
addition, the Company makes certain judgments about allocating shared assets to the
balance sheet for this segment. If the expected cash flows are not realized, impairment
losses may be recorded in the future.

Inventory

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

Stock-Based Compensation

Effective
January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123R,
Share-Based Payment (SFAS 123R), which revises SFAS 123
Accounting for Stock-Based Compensation (SFAS 123) and supersedes
Accounting Principles Board Opinion 25 Accounting for Stock Issued to
Employees. Under APB 25, the Company used the intrinsic value method for
employee stock options and did not record any expense because option exercise prices
equaled the market value at the date of grant. SFAS 123R requires that new, modified and
unvested share-based payment transactions with employees, such as grants of stock

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options and restricted stock, be recognized in the financial statements based
on their fair value at the grant date and recognized as compensation expense over their vesting periods. The Company estimates the
fair value of stock options as of the date of grant using the Black-Scholes pricing model and restricted stock based on the quoted
market price. The Company adopted SFAS 123R using the modified prospective method and, accordingly, prior period financial
statements were not revised. The Company recognized stock-based employee compensation of $53,659 and $92,284 in the three and six
months ended June 30, 2006, respectively, under SFAS 123R and $1,000 compensation under APB 25 in the three and six months ended
June 30, 2005. Assuming compensation expense had been determined based on the fair value at the grant date for all awards to
employees, using the Black-Scholes option pricing model consistent with the provisions of SFAS 123 and SFAS 123R, and amortized
ratably over the vesting period, instead of the intrinsic value method under APB 25, the Company would have recorded compensation
expense of $302,162 and $472,388 for the three and six months ended June 30, 2005, respectively.

Recent Accounting
Pronouncements

In
July 2006, the FASB issued FASB Interpretation 48, Accounting for Uncertainty in
Income Taxes: an Interpretation of FASB Statement No. 109 (FIN 48). FIN
48 clarifies the accounting for uncertainty involved in the recognition and measurement of
a tax position taken or expected to be taken in a tax return. FIN 48 requires that we
recognize in our financial statements the impact of a tax position, if that position is
more likely than not of being sustained on audit, based on the technical merits of the
position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal
year, with the cumulative effect of the change in accounting principle recorded as an
adjustment to opening retained earnings. The Company does not expect the adoption of FIN
48 to have an effect on our financial condition or results of operations.

In
May 2005, the FASB issued FASB Statement 154, Accounting Changes and Error
Corrections  a Replacement of APB Opinion No. 20 and FASB Statement
No. 3 (FAS 154). FAS 154 changes the requirements of the accounting
for and reporting of a change in accounting principle. The provisions of FAS 154 require,
unless impracticable, retrospective application to prior periods financial
statements of (1) all voluntary changes in accounting principles and (2) changes
required by a new accounting pronouncement, if a specific transition is not provided. FAS
154 also requires that a change in depreciation, amortization, or depletion method for
long-lived, non-financial assets be accounted for as a change in accounting estimate,
which requires prospective application of the new method. FAS 154 is effective for all
accounting changes made in fiscal years beginning after December 15, 2005. The
Company adopted FAS 154 during the first quarter of 2006 and the adoption did not have a
material effect on our financial condition or results of operations.

Management
is not aware of any recently issued accounting pronouncement that became effective during
the six months ended June 30, 2006, or that will become effective in a subsequent period, that
has had or is anticipated to have a material impact on the Companys consolidated
financial statements.

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|Item 3. |  | CONTROLS AND PROCEDURES
|------- |  | -----------------------

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of June 30, 2006. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures were effective as of that date for gathering, analyzing
and disclosing the information the Company is required to disclose in the reports it files
under the Securities Exchange Act of 1934, within the time periods specified in the
SECs rules and forms.

During
the three months ended June 30, 2006, there was no change in the Companys internal
controls over financial reporting that materially affected, or is reasonably likely to
materially affect, the Companys internal controls over financial reporting.

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Part II  Other
Information

Item 1. Legal Proceedings

None.

Item 6. Exhibits

All exhibits
required by Item 601 of Regulation S-B and required hereunder, as filed with the
Securities and Exchange Commission in Form 10-KSB on March 31, 2006, are incorporated
herein by reference.

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

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

|                       |                                                                                              
|---------------------- | ---------------------------------------------------------------------------------------------
|                       | DERMA SCIENCES, INC.                                                                         
|                       |                                                                                              
|                       |                                                                                              
|Dated: August 14, 2006 | By:/s/ John E.
     Yetter
         John E. Yetter, CPA
         Chief Financial
     Officer

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EXHIBIT INDEX

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