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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

(Mark One)

|    |                                                                                              |                                                  
|--- | -------------------------------------------------------------------------------------------- | -------------------------------------------------
|[X] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
|   
|    |                                                                                              | For the quarterly period ended September 30, 2007

|     |                                                                                               |                                                         
|---- | --------------------------------------------------------------------------------------------- | --------------------------------------------------------
|[  ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
|    
|     |                                                                                               | For the transition period from ___________ to __________
|    
|     |                                                                                               | Commission 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) | (IRS Employer Identification
     No.)

214 Carnegie Center, Suite 300Princeton, New Jersey
08540(Address  of principal executive offices)

(609) 514-4744(Issuer's telephone number)

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.
   Yesx
No
o

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

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

|                        |        |                                       
|----------------------- | ------ | --------------------------------------
|Date: November 12, 2007 | Class: | Common Stock, par value $.01 per share
|                        |        | Shares Outstanding: 33,829,755        

Transitional Small Business Disclosure Format (check one):
   Yeso
No
x

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Part IDERMA SCIENCES,
INC.FORM 10-QSBINDEX

|                                         |                                                                         |                                                                                                                        |  
|---------------------------------------- | ----------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------- | -
|Description                              | Page                                                                   
|Part I - Condensed Financial Information
|                                         | Item 1.  Condensed Consolidated Financial Statements                    |                                                                                                                       
|                                         |                                                                         | Condensed Consolidated Balance
     Sheets  September 30, 2007 (Unaudited) and December 31, 2006                      | 3
|                                         |                                                                         | Condensed Consolidated Statements of
     Operations  Three months ended September 30, 2007 and 2006 (1) (Unaudited)  | 4
|                                         |                                                                         | Condensed Consolidated Statements of
     Operations  Nine months ended September 30, 2007 and 2006 (1)  (Unaudited)  | 5
|                                         |                                                                         | Condensed Consolidated Statements of
     Cash Flows  Nine months ended September 30, 2007, and 2006 (1)  (Unaudited) | 6
|                                         |                                                                         | Notes to Condensed Consolidated Financial
     Statements (1)  (Unaudited)                                             | 7
|                                         | Item 2.  Management's Discussion and
     Analysis or Plan of Operation | 25                                                                                                                    
|                                         | Item 3.  Controls and
     Procedures                                   | 42                                                                                                                    
|Part II - Other Information             
|                                         | Item 1.  Legal
     Proceedings                                         | 43                                                                                                                    
|                                         | Item 6.  Exhibits                                                       | 43                                                                                                                    

(1)  The Company's previously issued
financial statements for the three and nine months ended September 30, 2006 have been
restated for the correction of errors related to the accounting for an exclusive
distribution agreement in Canada.  The restatement is more fully described in the Notes
to the Condensed Consolidated Financial Statements.

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

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Index

Part I - Financial Information

Item 1.  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                   |  |                 |              |               |  
|------------------------------------------------------------------ |  | --------------- | ------------ | ------------- | -
|Condensed Consolidated Balance Sheets                             
|                                                                   |  | September 30,   | December 31,
|                                                                   |  | 2007            | 2006        
|                                                                   |  | (Unaudited)     |             
|ASSETS                                                             | 
|                                                                  
|Current Assets                                                     |  |                 |              |               |  
|Cash and cash equivalents                                          |  | $      674,871  |              | $   1,285,943 |  
|Accounts receivable, net                                           |  | 2,111,042       |              | 2,270,552     |  
|Inventories                                                        |  | 6,386,112       |              | 4,678,107     |  
|Prepaid expenses and other current assets                          |  | 311,495         |              | 279,864       |  
|                                                                  
|Total current assets                                               |  | 9,483,520       |              | 8,514,466     |  
|Equipment and improvements, net                                    |  | 4,742,648       |              | 4,133,595     |  
|Goodwill                                                           |  | 2,441,542       |              | 2,441,542     |  
|Other intangible assets, net                                       |  | 2,787,577       |              | 3,197,365     |  
|Other assets, net                                                  |  | 322,056         |              | 218,953       |  
|                                                                  
|Total Assets                                                       |  | $ 19,777,343    |              | $ 18,505,921  |  
|                                                                  
|LIABILITIES AND SHAREHOLDERS' EQUITY                               | 
|                                                                  
|Current Liabilities                                                | 
|Line of Credit                                                     |  | $        11,607 |              | $         -   |  
|Current maturities of long-term debt                               |  | 86,616          |              | 338,155       |  
|Accounts payable                                                   |  | 1,305,545       |              | 1,645,575     |  
|Accrued expenses and other current liabilities                     |  | 1,179,786       |              | 762,687       |  
|                                                                  
|Total current liabilities                                          |  | 2,583,554       |              | 2,746,417     |  
|                                                                  
|Long-term debt, net of current portion                             |  | 615,001         |              | 546,268       |  
|Other long-term liabilities                                        |  | 448,995         |              | 235,224       |  
|                                                                  
|Total Liabilities                                                  |  | 3,647,550       |              | 3,527,909     |  
|                                                                  
|Shareholders' Equity                                               | 
|Convertible preferred stock, $.01 par value; 11,750,000 shares     | 
|authorized; issued and outstanding:  2,280,407 shares (liquidation | 
|preference of $4,210,231 at September 30, 2007)                    |  | 22,804          |              | 22,804        |  
|Common stock, $.01 par value, 50,000,000 shares authorized; issued | 
|and outstanding:  25,258,335 shares at September 30, 2007 and      | 
|24,906,160 shares at December 31, 2006                             |  | 252,583         |              | 249,062       |  
|Additional paid-in capital                                         |  | 27,671,491      |              | 27,272,440    |  
|Accumulated other comprehensive income - cumulative translation    | 
|adjustments                                                        |  | 1,838,858       |              | 850,987       |  
|Accumulated deficit                                                |  | (13,655,943     | )            | (13,417,281   | )
|                                                                  
|Total Shareholders' Equity                                         |  | 16,129,793      |              | 14,978,012    |  
|                                                                  
|Total Liabilities and Shareholders' Equity                         |  | $ 19,777,343    |              | $ 18,505,921  |  
|                                                                  

See accompanying notes to
condensed consolidated financial statements.

3

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                            |  |                    |                        |                | 
|----------------------------------------------------------- |  | ------------------ | ---------------------- | -------------- | 
|Condensed Consolidated Statements of Operations (Unaudited) | 
|                                                            |  | Three months ended
|                                                            |  | September 30,     
|                                                            |  | 2007               | 2006        (Restated)
|Net sales                                                   |  | $   8,056,402      |                        | $  7,606,851   | 
|Cost of sales                                               |  | 5,341,799          |                        | 4,959,232      | 
|                                                           
|Gross Profit                                                |  | 2,714,603          |                        | 2,647,619      | 
|                                                           
|Operating expenses                                          |  | 2,658,998          |                        | 2,098,057      | 
|Interest expense                                            |  | 45,577             |                        | 106,505        | 
|Other (income) expense, net                                 |  | (7,468             | )                      | 21,558         | 
|                                                           
|Total Expenses                                              |  | 2,697,107          |                        | 2,226,120      | 
|                                                           
|Income before provision for income taxes                    |  | 17,496             |                        | 421,499        | 
|Provision for income taxes                                  |  | 7,642              |                        | 19,000         | 
|                                                           
|Net Income                                                  |  | $        9,854     |                        | $   402,499    | 
|                                                           
|Income per common share - basic                             |  | $          0.00    |                        | $         0.02 | 
|                                                           
|Income per common share - diluted                           |  | $          0.00    |                        | $         0.01 | 
|                                                           
|Shares used in computing income per common share - basic    |  | 25,258,335         |                        | 24,188,769     | 
|                                                           
|Shares used in computing income per common share - diluted  |  | 29,060,904         |                        | 27,959,757     | 
|                                                           

See accompanying notes to
condensed consolidated financial statements.

4

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                  |  |                   |                        |                   |  
|----------------------------------------------------------------- |  | ----------------- | ---------------------- | ----------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)      
|                                                                  |  | Nine months ended
|                                                                  |  | September 30,    
|                                                                  |  | 2007              | 2006        (Restated)
|Net sales                                                         |  | $ 23,483,457      |                        | $ 20,200,382      |  
|Cost of sales                                                     |  | 15,299,228        |                        | 13,193,264        |  
|                                                                 
|Gross Profit                                                      |  | 8,184,229         |                        | 7,007,118         |  
|                                                                 
|Operating expenses                                                |  | 8,042,109         |                        | 5,939,328         |  
|Interest expense                                                  |  | 143,387           |                        | 298,700           |  
|Other expense (income), net                                       |  | 42,230            |                        | (26,048           | )
|                                                                 
|Total Expenses                                                    |  | 8,227,726         |                        | 6,211,980         |  
|                                                                 
|(Loss) income before provision for income taxes                   |  | (43,497           | )                      | 795,138           |  
|Provision for income taxes                                        |  | 195,165           |                        | 19,000            |  
|                                                                 
|Net (Loss) Income                                                 |  | $    (238,662     | )                      | $      776,138    |  
|                                                                 
|(Loss) income per common share - basic                            |  | ($      0.01      | )                      | $            0.04 |  
|                                                                 
|(Loss) income per common share - diluted                          |  | ($      0.01      | )                      | $            0.03 |  
|                                                                 
|Shares used in computing (loss) income per common share - basic   |  | 25,254,465        |                        | 19,136,921        |  
|                                                                 
|Shares used in computing (loss) income per common share - diluted |  | 25,254,465        |                        | 22,880,812        |  
|                                                                 

See accompanying notes to
condensed consolidated financial statements.

5

---



Index

DERMA SCIENCES, INC. AND SUBSIDIARIES

|                                                                      |  |                   |                        |              |  
|--------------------------------------------------------------------- |  | ----------------- | ---------------------- | ------------ | -
|Condensed Consolidated Statements of Cash Flows (Unaudited)          
|                                                                      |  | Nine months ended
|                                                                      |  | September 30,    
|                                                                      |  | 2007              | 2006        (Restated)
|Operating Activities                                                  |  |                   |                        |              |  
|Net (loss) income                                                     |  | $  (238,662       | )                      | $    776,138 |  
|Adjustments to reconcile net (loss) income                            | 
|to net cash provided by operating activities:                         | 
|Depreciation of equipment and improvements                            |  | 556,880           |                        | 445,770      |  
|Amortization of intangible assets                                     |  | 409,787           |                        | 262,498      |  
|Amortization of deferred financing costs                              |  | 44,236            |                        | 64,568       |  
|Recovery of bad debts                                                 |  | (11,439           | )                      | (25,122      | )
|Allowance for sales adjustments                                       |  | 448,912           |                        | 502,052      |  
|Provision for inventory obsolescence                                  |  | 49,479            |                        | 8,404        |  
|Deferred rent                                                         |  | (19,670           | )                      | 6,615        |  
|Share based compensation expense                                      |  | 402,572           |                        | 146,191      |  
|Deferred tax provision                                                |  | 187,820           |                        |             |  
|Loss on disposal of equipment                                         |  | 5,208             |                        | 23,849       |  
|Gain on settlement of accounts payable                                |  |                  |                        | (64,971      | )
|Changes in operating assets and liabilities:                          | 
|Accounts receivable                                                   |  | (5,102            | )                      | (1,198,644   | )
|Inventories                                                           |  | (1,200,070        | )                      | 679,475      |  
|Prepaid expenses and other current assets                             |  | (25,402           | )                      | (100,817     | )
|Other assets                                                          |  | 35,011            |                        | 32,034       |  
|Accounts payable                                                      |  | (410,903          | )                      | (260,836     | )
|Accrued expenses and other current liabilities                        |  | (11,109           | )                      | 216,145      |  
|                                                                     
|Net cash provided by operating activities                             |  | 217,548           |                        | 1,513,349    |  
|                                                                     
|Investing Activities                                                  | 
|Acquisition of Western Medical assets                                 |  |                  |                        | (6,000,000   | )
|Business acquisition costs                                            |  | (175,090          | )                      | (758,866     | )
|Proceeds from sale of equipment                                       |  |                  |                        | 9,952        |  
|Purchases of equipment and improvements                               |  | (424,200          | )                      | (755,488     | )
|                                                                     
|Net cash used in investing activities                                 |  | (599,290          | )                      | (7,504,402   | )
|                                                                     
|Financing Activities                                                  | 
|Loan proceeds                                                         |  |                  |                        | 1,000,000    |  
|Net change in bank lines of credit                                    |  | 73,923            |                        | (608,809     | )
|Deferred financing costs                                              |  |                  |                        | (48,722      | )
|Long-term debt repayments                                             |  | (378,601          | )                      | (722,620     | )
|Proceeds from issuance of stock, net of issuance costs                |  |                  |                        | 6,297,801    |  
|                                                                     
|Net cash (used in) provided by financing activities                   |  | (304,678          | )                      | 5,917,650    |  
|                                                                     
|Effect of exchange rate changes on cash and cash equivalents          |  | 75,348            |                        | 56,851       |  
|                                                                     
|Net decrease in cash and cash equivalents                             |  | (611,072          | )                      | (16,552      | )
|Cash and cash equivalents                                             | 
|Beginning of period                                                   |  | 1,285,943         |                        | 1,105,330    |  
|                                                                     
|End of period                                                         |  | $    674,871      |                        | $ 1,088,778  |  
|                                                                     
|Supplemental cash flow information:                                   | 
|Office furniture obtained with capital lease                          |  | $    163,745      |                        |             |  
|Issuance of promissory note in connection with acquisition of Western | 
|Medical assets (see Note 2)                                           |  |                  |                        | $    500,000 |  
|                                                                     

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-specialty securement devices and skin care products. The Company
markets its products principally through independent distributors servicing the long-term
care, home health and acute care markets in the United States, Canada and other select
international markets. The Companys U.S. distribution facility is located in St.
Louis, Missouri, while the Companys Canadian distribution facility is located in
Toronto. The Company has manufacturing facilities in Toronto, Canada and Nantong, China.

Restatement
of Financial Statements

In
May 2005, the Company entered into a five-year distribution agreement with a Canadian
company to serve as the Companys exclusive distributor in Canada. The Company
records revenue at the time product is shipped to the distributor. The distribution
agreement requires the Company to pay a distribution fee to the distributor. Prior to
October 1, 2006, the Company classified this distribution fee in operating expenses. The
Company has since concluded that this fee should be classified as an adjustment to gross
sales in arriving at net sales, similar to trade rebates and other adjustments to gross
sales. Further, the Company has concluded that the distribution fee should be accrued and
expensed at the time of sale. Previously the Company expensed the fee when billed by the
distributor to the Company. Accrued distribution fees are recorded as a credit to accounts
receivable on the consolidated balance sheet. Previously, accrued distribution fees were
recorded in accounts payable on the consolidated balance sheet. As a result of the
foregoing errors, the Company has restated its financial statements and accompanying notes
for the correction of these errors in the application of U.S. generally accepted
accounting principles. A summary of the restatement impact on the consolidated balance
sheet at September 30, 2006 and on the consolidated statement of operations for the three
and nine months ended September 30, 2006 is outlined below:

|                                          |  |                       |  |             | 
|----------------------------------------- |  | --------------------- |  | ----------- | 
|                                          |  | September 30, 2006    | 
|                                          |  | As PreviouslyReported |  | As Restated | 
|                                         
|                                          |  | (Unaudited)          
|Selected consolidated balance sheet data: |  |                       |  |             | 
|                                         
|Total current assets                      |  | $8,239,993            |  | $7,933,385  | 
|Total assets                              |  | $18,713,261           |  | $18,406,653 | 
|Total current liabilities                 |  | $3,406,693            |  | $3,304,584  | 
|Total liabilities                         |  | $4,236,951            |  | $4,134,842  | 
|Total shareholders' equity                |  | $14,476,310           |  | $14,271,811 | 

7

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

|                                                        |  |  |                                 |            |                                     |   |                       |  |             |            |   |   |            |  
|------------------------------------------------------- |  |  | ------------------------------- | ---------- | ----------------------------------- | - | --------------------- |  | ----------- | ---------- | - | - | ---------- | -
|                                                        |  |  | Quarter EndedSeptember 30, 2006 |            | Nine Months EndedSeptember 30, 2006 |  
|                                                        |  |  | As PreviouslyReported           |            | As Restated                         |   | As PreviouslyReported |  | As Restated |           
|                                                       
|                                                        |  |  | (Unaudited)                     |            | (Unaudited)                         |  
|Consolidated statements of
            operations data:
|                                                       
|Net Sales                                               |  |  | $                               | 7,876,307  |                                     | $ | 7,606,851             |  | $           | 21,019,902 |   | $ | 20,200,382 |  
|Cost of sales                                           |  |  |                                 | 4,959,232  |                                     |   | 4,959,232             |  |             | 13,193,264 |   |   | 13,193,264 |  
|Gross profit                                            |  |  |                                 | 2,917,075  |                                     |   | 2,647,619             |  |             | 7,826,638  |   |   | 7,007,118  |  
|                                                       
|Operating expenses                                      |  |  |                                 | 2,389,818  |                                     |   | 2,098,057             |  |             | 6,766,282  |   |   | 5,939,328  |  
|Interest                                                |  |  |                                 | 106,505    |                                     |   | 106,505               |  |             | 298,700    |   |   | 298,700    |  
|Other expense (income), net                             |  |  |                                 | 21,558     |                                     |   | 21,558                |  |             | (26,048    | ) |   | (26,048    | )
|                                                       
|Total expense                                           |  |  |                                 | 2,517,881  |                                     |   | 2,226,120             |  |             | 7,038,934  |   |   | 6,211,980  |  
|                                                       
|Income before provision for                             |  | 
|income taxes                                            |  |  |                                 | 399,194    |                                     |   | 421,499               |  |             | 787,704    |   |   | 795,138    |  
|Provision for income taxes                              |  |  |                                 | 19,000     |                                     |   | 19,000                |  |             | 19,000     |   |   | 19,000     |  
|                                                       
|Net income                                              |  |  | $                               | 380,194    |                                     | $ | 402,499               |  | $           | 768,704    |   | $ | 776,138    |  
|                                                       
|Income per common share  basic                         |  |  | $                               | 0.02       |                                     | $ | 0.02                  |  | $           | 0.04       |   | $ | 0.04       |  
|                                                       
|Income per common share  diluted                       |  |  | $                               | 0.01       |                                     | $ | 0.01                  |  | $           | 0.03       |   | $ | 0.03       |  
|Shares used in computing income                         |  | 
|per common share  basic                                |  |  |                                 | 24,188,769 |                                     |   | 24,188,769            |  |             | 19,136,921 |   |   | 19,136,921 |  
|Shares used in computing income                         |  | 
|per common share  diluted                              |  |  |                                 | 27,959,757 |                                     |   | 27,959,757            |  |             | 22,880,812 |   |   | 22,880,812 |  

Basis
of Presentation

The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-QSB and Item 310(b)
of Regulation S-B. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States of America for
complete financial statements. In the opinion of management, all adjustments (consisting
of normal recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three and nine month periods ended September 30, 2007,
are not necessarily indicative of the results that may be expected for the year ending
December 31, 2007. Information included in the condensed balance sheet as of December 31,
2006 has been derived from the consolidated financial statements and footnotes thereto for
the year ended December 31, 2006, included in Form 10-KSB previously filed with the
Securities and Exchange Commission. For further information, refer to that Form 10-KSB.

8

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

Summary
of Significant Accounting Policies:

Accounting
for Uncertainty in Income Taxes  In June 2006, the Financial Accounting Standards
Board (FASB) issued FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes  an Interpretation of SFAS No. 109 (FIN
48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in
financial statements in accordance with Statement of Financial Accounting Standards
(SFAS) No. 109, Accounting for Income Taxes. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement recognition
and measurement of a tax position taken or expected to be taken in a tax return. FIN 48
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. The Company adopted the
provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 did not have a material
effect on the Companys financial condition or results of operations for the three
and nine months ended September 30, 2007.

As
of January 1, 2007 and September 30, 2007, the Company had no unrecognized tax benefits,
and no adjustment to its financial position, results of operations or cash flows was
required. The Company does not expect that unrecognized tax benefits will increase within
the next twelve months. The Company records interest and penalties related to tax matters
within other expense on the accompanying Condensed Consolidated Statements of Operations.
These amounts are not material to the consolidated financial statements for the periods
presented. The Companys U.S. tax returns are subject to examination by federal and
state taxing authorities. Tax years prior to 2002 are no longer subject to federal or
state examination. The Companys State of New Jersey tax returns for the tax years
2002 through 2005 have been examined and there were no assessments. The Companys
2003 and 2002 Canadian tax returns were subject to examination and adjustment by the
Canada Customs and Revenue Agency. These adjustments will not have a material impact on
the Companys financial position, results of operations or cash flows. Tax years
prior to 2004 are no longer subject to examination in Canada.

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. The effects of the assumed exercise of
warrants and stock options are determined using the treasury stock method. Potentially
dilutive securities have not been included in the computation of diluted loss per share
for the nine months ended September 30, 2007 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 nine months ended September 30, 2007 and 2006 are outlined below:

9

---



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

|                                 |  |                                  |  |                                 |  |            |  |            | 
|-------------------------------- |  | -------------------------------- |  | ------------------------------- |  | ---------- |  | ---------- | 
|                                 |  | Three Months Ended September 30, |  | Nine Months Ended September 30, | 
|                                 |  | 2007                             |  | 2006                            |  | 2007       |  | 2006       | 
|Weighted average common shares   |  |                                  |  |                                 |  |            |  |            | 
|outstanding  basic              |  | 25,258,335                       |  | 24,188,769                      |  | 25,254,465 |  | 19,136,921 | 
|Dilutive shares attributable to: | 
|Convertible preferred stock      |  | 2,280,407                        |  | 2,280,407                       |  |           |  | 2,280,407  | 
|Restricted common stock          |  | 175,000                          |  | 175,000                         |  |           |  | 91,026     | 
|Warrants                         |  | 62,290                           |  | 261,012                         |  |           |  | 278,403    | 
|Stock options                    |  | 1,284,872                        |  | 1,054,569                       |  |           |  | 1,094,055  | 
|                                
|Sub-total dilutive shares        |  | 3,802,569                        |  | 3,770,988                       |  |           |  | 3,743,891  | 
|                                
|Weighted average common          | 
|shares outstanding  diluted     |  | 29,060,904                       |  | 27,959,767                      |  | 25,254,465 |  | 22,880,812 | 

Potentially
dilutive shares excluded as a result of the effects being anti-dilutive are as follows:

|                            |  |                                  |  |                                 |  |            |  |           | 
|--------------------------- |  | -------------------------------- |  | ------------------------------- |  | ---------- |  | --------- | 
|                            |  | Three Months Ended September 30, |  | Nine Months Ended September 30, | 
|                            |  | 2007                             |  | 2006                            |  | 2007       |  | 2006      | 
|Dilutive shares:            |  |                                  |  |                                 |  |            |  |           | 
|Convertible preferred stock |  |                                 |  |                                |  | 2,280,407  |  |          | 
|Restricted common stock     |  |                                 |  |                                |  | 175,000    |  |          | 
|Warrants                    |  | 5,415,098                        |  | 6,169,904                       |  | 6,169,904  |  | 5,415,098 | 
|Stock options               |  | 2,931,355                        |  | 2,161,155                       |  | 6,718,480  |  | 2,161,155 | 
|                           
|Total dilutive shares       |  | 8,346,453                        |  | 8,331,059                       |  | 15,343,791 |  | 7,576,253 | 

2.     Acquisition of Western
Medical Assets

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 incurred a total of $819,052
of transaction costs related to the acquisition. The purchased assets consist of trade
receivables, inventories, equipment and certain identifiable intangibles. To fund the
purchase, the Company raised $5,803,304 (net of $568,932 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.

Western
Medical was a privately held manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. 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 acquisition to grow sales. In addition, the Company
anticipates being able to absorb Western Medicals business within its existing
operating infrastructure with only modest incremental overhead increases. Both of these
initiatives are anticipated to increase the contribution of the business going forward.

10

---



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

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

|                                                 |  |              |  
|------------------------------------------------ |  | ------------ | -
|Purchase Price:                                  |  |              |  
|                                                
|Cash paid                                        |  | $ 6,000,000  |  
|Promissory note bearing interest at 12%          |  | 500,000      |  
|Transaction costs                                |  | 819,052      |  
|                                                
|Total                                            |  | $ 7,319,052  |  
|                                                
|Allocation of Purchase Price:                    | 
|                                                
|Trade receivables                                |  | $    483,465 |  
|Inventory                                        |  | 1,179,233    |  
|Equipment                                        |  | 483,932      |  
|Goodwill                                         |  | 2,441,542    |  
|Identifiable intangibles subject to amortization |  | 3,300,000    |  
|Accounts payable                                 |  | (569,120     | )
|                                                
|Total                                            |  | $ 7,319,052  |  

The
allocation of the purchase price to the assets acquired and liabilities assumed as
reflected in the consolidated financial statements is based on finalization of the
Companys valuation study to establish the fair market value of the assets,
liabilities and the identifiable intangible assets and goodwill acquired. The identifiable
intangible assets acquired consist of customer lists, trademarks and a non-compete
agreement.

3.     Inventories

Inventories
include the following:

|                    |  |  |   |                   |  |   |                  | 
|------------------- |  |  | - | ----------------- |  | - | ---------------- | 
|                    |  |  |   | September 30,2007 |  |   | December 31,2006 | 
|                   
|Finished goods      |  |  | $ | 3,863,914         |  | $ | 2,784,612        | 
|Work in process     |  |  |   | 37,158            |  |   | 92,780           | 
|Packaging materials |  |  |   | 1,143,132         |  |   | 777,046          | 
|Raw materials       |  |  |   | 1,341,908         |  |   | 1,023,669        | 
|                   
|Total inventories   |  |  | $ | 6,386,112         |  | $ | 4,678,107        | 

4.     Lines of Credit

U.S.
Line of Credit

In
connection with the acquisition of Western Medical (see Note 2), the Company entered into
an amended three-year revolving credit facility agreement (the Agreement)
dated April 18, 2006. The amended Agreement provides for maximum borrowings of $3,500,000
with its U.S. lender. The Agreement replaces the $2,000,000 revolving credit facility that
the Company entered into on January 31, 2005. At September 30, 2007 and December 31, 2006,
the outstanding balances under the Agreement were $11,607 and zero, respectively. Advances
will be utilized to fund general working capital requirements, new product development,
marketing efforts and strategic initiatives.

11

---



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

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 7.50% per annum. At September 30, 2007, the effective interest
rate was 9.75%. 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 certain financial
covenants. 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
September 30, 2007, the Company was in compliance with its financial covenants.

On
May 14, 2007, the Companys U.S. lender agreed to waive the Companys covenant
violations as of March 31, 2007 and to amend the Companys monthly minimum EBITDA and
fixed charge coverage ratios effective April 1, 2007. The covenant amendments were
requested and approved by the U.S. lender in light of the Companys projected
operating results. A waiver and amendment fee of $5,000 was charged by the U.S. lender.

On
March 12, 2007, the Company and its U.S. lender agreed to amend the Companys monthly
minimum EBITDA and certain of the monthly fixed charge coverage ratio financial covenants
for 2007, effective January 1, 2007. The changes were requested and approved by the U.S.
lender in light of the Companys 2007 business plan and its overall existing and
projected financial condition. No fee was charged by the U.S. lender for this amendment.

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.

The
Company terminated its revolving credit facility agreement and paid off all outstanding
indebtedness with its U.S. lender on November 9, 2007.  In connection with the
termination, the Company paid a $200,000 early termination fee.

Canadian
Line of Credit

In
December 2006, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $502,000 ($500,000
Canadian) with its Canadian lender. At September 30, 2007 and December 31, 2006, the
outstanding balances under the Canadian Agreement were zero. 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 $402,000 ($400,000 Canadian) or 40% of
eligible inventory (as defined), less priority claims. Interest on outstanding advances is
payable monthly in arrears at the prime rate (as defined) plus 1.0%, or 7.25% for Canadian
dollar advances and 9.25% for U.S. dollar denominated advances at September 30, 2007. The
line of credit also provides for direct advances in U.S. dollars limited to the U.S.
dollar equivalent of $402,000 ($400,000 Canadian). Outstanding advances are secured by all
tangible and intangible assets of Derma Sciences Canada Inc. In addition, the Company has
accorded the Canadian lender its guarantee of payment together with a second lien security
interest in the Companys assets located in the U.S.

12

---



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

Over
the term of the Canadian Agreement, the Company has agreed to comply with certain
financial covenants. 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 $502,000 ($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 September 30, 2007 the
Company was in compliance with its Canadian line of credit covenants, in as much as there was
no longer a borrowing line available for use due to the ongoing process of terminating the
revolving line of credit. The Company officially terminated its revolving credit facility
agreement with the Canadian lender on October 10, 2007.

5.     Long-Term Debt

Long-term
debt includes the following:

|                          |  |  |   |                   |  |   |                  | 
|------------------------- |  |  | - | ----------------- |  | - | ---------------- | 
|                          |  |  |   | September 30,2007 |  |   | December 31,2006 | 
|                         
|Canadian term loan        |  |  | $ |                  |  | $ | 295,881          | 
|Promissory note           |  |  |   | 500,000           |  |   | 500,000          | 
|Capital lease obligations |  |  |   | 201,617           |  |   | 88,542           | 
|                         
|Total debt                |  |  |   | 701,617           |  |   | 884,423          | 
|                         
|Less:  current maturities |  |  |   | 86,616            |  |   | 338,155          | 
|                         
|Long-term debt            |  |  | $ | 615,001           |  | $ | 546,268          | 

Canadian
Term Loan

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. This loan was paid in full
on September 10, 2007.

In
2006, the Companys Canadian lender granted a non-revolving term line of credit to
finance equipment purchases and equipment upgrades to the Companys Canadian
manufacturing facility.  The Company officially terminated its non-revolving term line of
credit on October 10, 2007.

Promissory
Note

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 and a final
payment of accrued interest of $15,000 and the principal balance of $500,000 on April 18,
2009. The promissory note may be prepaid in part or in full at any time without penalty.

Capital
Lease Obligations

The
Company has three capital lease obligations for certain office furniture, distribution and
computer equipment totaling $201,617 as of September 30, 2007. The capital lease
obligations bear interest at annual rates ranging from 3.9% to 10.2% with the longest
lease term expiring in June 2010.

13

---



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

U.S.
Term Loan

In
connection with the acquisition of Western Medical (see Note 2) in April 2006, the Company
entered into a three-year term loan agreement for $1,000,000 with its U.S. lender.
Utilizing funds received from the sale of common stock (see Note 6) on August 4 and
December 14, 2006, the Company accelerated, without penalty, repayment of the $1,000,000
loan. Upon full repayment of the loan, the Company paid the U.S. lender a $10,000
termination fee.

6.     Shareholders
Equity

Convertible
Preferred Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at September 30,
2007. The series A preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $4.00 per share, votes as
a class on matters affecting the series A preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 440,003 shares of series B convertible preferred stock outstanding at September 30,
2007. 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 September 30,
2007. The series C preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.70 per share,
votes as a class on matters affecting the series C preferred stock and maintains voting
rights identical to the common stock on all other matters.

There
are 1,071,346 shares of series D convertible preferred stock outstanding at September 30,
2007. 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

In
accordance with the series F warrant agreement, effective January 4, 2007, the owners
effected a cashless exercise of all issued and outstanding series F warrants comprising
1,309,441 warrants with an exercise price of $0.57 per warrant. Based on the thirty day
trailing average closing price of $0.78 per share, the warrants had a calculated value of
$0.21 each ($0.78  $0.57), or $274,983 in the aggregate, and were exchanged for
352,175 shares of common 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 on August 3, 2006 and
paid the balance due of $1,000,000, together with interest thereon at the annual rate of
2.5%, or $8,500, on December 5, 2006. The Company raised $1,478,525 (net of $21,475 in
offering expenses) related to this offering. A portion of the proceeds from this offering
was used to pay off the U.S. term loan entered into in connection with the acquisition of
Western Medical (see Notes 2 and 5).

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

In
April 2006, the Company raised $5,803,304 (net of $568,932 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

14

---



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

754,806 five-year Series I warrants
to purchase one share of common stock at $0.72. The funds were used for the acquisition
of certain assets of Western Medical.

Stock
Purchase Warrants

At
September 30, 2007, the Company had warrants outstanding to purchase 6,169,904 shares of
the Companys common stock as outlined below:

|       |  |                    |           |                |  |                 |  |                   | 
|------ |  | ------------------ | --------- | -------------- |  | --------------- |  | ----------------- | 
|Series |  | Number of Warrants |           | Exercise Price |  | Expiration Date | 
|      
|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  |  |                    | 6,169,904 |                | 

Stock
Options

The
Company has a stock option plan under which options to purchase a maximum of 5,000,000
shares of common stock may be issued. The plan permits the granting of both incentive
stock options and nonqualified stock options to employees and directors of the Company and
certain outside consultants and advisors to the Company. The option exercise price may not
be less than the fair market value of the stock on the date of the grant of the option.
The duration of each option may not exceed 10 years from the date of grant. Options under
the plan to purchase 1,075,000 shares of common stock were granted to officers, directors,
agents and employees in the nine months ended September 30, 2007 at a weighted average
exercise price of $0.79 per share. During the nine months ended September 30, 2007, 29,000
plan options expired. As of September 30, 2007, options to purchase 4,647,625 shares of
the Companys common stock were issued and outstanding under the plan. No options
granted under the plan have been exercised.

The
Company has previously granted nonqualified stock options to officers, directors, agents
and employees outside of the stock option plan (non-plan options). All
non-plan options were granted at the fair market value at the date of grant. During the
nine months ended September 30, 2007, 165,800 non-plan options expired. As of September
30, 2007, non-plan options to purchase 2,070,855 shares of the Companys common stock
were issued and outstanding.

For
the nine months ended September 30, 2007 and 2006 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 nine months ended September 30, 2007 and 2006 were as
follows:

|                             |       |       | 
|---------------------------- | ----- | ----- | 
|                             | 2007  | 2006  | 
|                            
|Risk-free interest rate      | 4.72% | 4.56% | 
|Volatility factor            | 118%  | 127%  | 
|Dividend yield               | 0%    | 0%    | 
|Expected option life (years) | 6.25  | 6.25  | 
|Contractual life (years)     | 10    | 10    | 

In
the nine months ended September 30, 2007 and 2006, the risk-free rate utilized represents
the U.S. Treasury yield curve rate which approximates the risk-free rate for the expected
option life at the time of grant. In the nine months ended September 30, 2007 and 2006,
the volatility factor was calculated based on the seventy-five month-end closing prices
of the Companys common stock preceding the month of stock option grant. Effective
January 1, 2006, the Company adopted, based on guidance from Staff Accounting Bulletin
107, a stock option life of 6.25 years. As a result, the Company also adopted on January
1, 2006, a seventy-five month volatility period to

15

---



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

coincide with the expected stock
option life. The dividend yield is 0% since the Company does not anticipate paying
dividends in the near future. Based on the Companys historical experience of
options that cancel before becoming fully vested, effective January 1, 2006, the Company
has assumed an annualized forfeiture rate of 1.0% for all employee options. Under the
true-up provision of SFAS 123R, the Company will record additional expense if the actual
forfeiture rate is lower than estimated, and will record a recovery of prior expense if
the actual forfeiture rate is higher than estimated.

A
summary of the Companys stock option activity and related information for the three
months ended September 30, 2007 and 2006 follows:

|                            |           |                               |      |           |                              
|--------------------------- | --------- | ----------------------------- | ---- | --------- | -----------------------------
|                            | 2007      |                               | 2006
|                           
|                            | Options   | WeightedAverageExercise Price |      | Options   | WeightedAverageExercise Price
|                           
|Outstanding  June 30       | 6,783,480 | $0.83                         |      | 6,358,280 | $0.90                        
|Granted                     | 35,000    | $0.81                         |      |          |                             
|Forfeited/Expired           | (100,000) | $1.25                         |      | (500,000) | $0.50                        
|                           
|Outstanding  September 30  | 6,718,480 | $0.82                         |      | 5,858,280 | $0.94                        
|                           
|Exercisable at September 30 | 5,684,730 | $0.83                         |      | 5,464,530 | $0.95                        

The
weighted average fair value per share of options granted during the three months ended
September 30, 2007 and 2006 was $0.69 and $0.59, respectively.

For
the three months ended September 30, 2007 and 2006, no income tax benefit was recognized
related to stock option activity.

During
the three months ended September 30, 2007 and 2006, stock option compensation expense was
recorded using the fair value method under SFAS 123R as follows:

|                                        |  |  |   |        |  |   |        | 
|--------------------------------------- |  |  | - | ------ |  | - | ------ | 
|                                        |  |  |   | 2007   |  |   | 2006   | 
|                                       
|Cost of sales                           |  |  | $ | 7,164  |  | $ | 3,398  | 
|Operating expenses                      |  |  |   | 64,142 |  |   | 32,351 | 
|                                       
|Total stock option compensation expense |  |  | $ | 71,306 |  | $ | 35,749 | 

A
summary of the Companys stock option activity and related information for the nine
months ended September 30, 2007 and 2006 follows:

16

---



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

|                            |           |                               |      |           |                              
|--------------------------- | --------- | ----------------------------- | ---- | --------- | -----------------------------
|                            | 2007      |                               | 2006
|                           
|                            | Options   | WeightedAverageExercise Price |      | Options   | WeightedAverageExercise Price
|                           
|Outstanding  January 1     | 5,838,280 | $0.94                         |      | 5,773,280 | $0.92                        
|Granted                     | 1,075,000 | $0.79                         |      | 585,000   | $0.74                        
|Forfeited/Expired           | (194,800) | $4.08                         |      | (500,000) | $0.50                        
|                           
|Outstanding  September 30  | 6,718,480 | $0.82                         |      | 5,858,280 | $0.94                        
|                           
|Exercisable at September 30 | 5,684,730 | $0.83                         |      | 5,464,530 | $0.95                        

The
weighted average fair value per share of options granted during the nine months ended
September 30, 2007 and 2006 was $0.69 and $0.53, respectively.

For
the nine months ended September 30, 2007 and 2006, no income tax benefit was recognized
related to stock option activity.

During
the nine months ended September 30, 2007 and 2006, stock option compensation expense was
recorded using the fair value method under SFAS 123R as follows:

|                                        |  |  |   |         |  |   |         | 
|--------------------------------------- |  |  | - | ------- |  | - | ------- | 
|                                        |  |  |   | 2007    |  |   | 2006    | 
|                                       
|Cost of sales                           |  |  | $ | 37,126  |  | $ | 11,242  | 
|Operating expenses                      |  |  |   | 329,131 |  |   | 116,791 | 
|                                       
|Total stock option compensation expense |  |  | $ | 366,257 |  | $ | 128,033 | 

As
of September 30, 2007, there was $566,319 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 2.15 years.

Shares
Reserved for Future Issuance

At
September 30, 2007, 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 available for grant         | 352,375    | 
|Common stock options outstanding                 | 6,718,480  | 
|Common stock warrants outstanding (series G - I) | 6,169,904  | 
|Restricted common stock available for grant      | 2,325,000  | 
|Restricted common stock outstanding              | 175,000    | 
|                                                
|Total common stock shares reserved               | 18,021,166 | 

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 thereunder.

17

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

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 three years from the date
of the grant. 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 service period. For the nine months ended
September 30, 2007, $36,315 was recorded in operating expenses for these grants.

At
September 30, 2007, the weighted-average remaining contractual term for the restricted
common stock grant is 1.61 years.

7.     Comprehensive Income

The
Companys comprehensive income was as follows:

|                              |  |  |                                 |         |                                |   |         |   |                |          |   |   |         | 
|----------------------------- |  |  | ------------------------------- | ------- | ------------------------------ | - | ------- | - | -------------- | -------- | - | - | ------- | 
|                              |  |  | Three Months EndedSeptember 30, |         | Nine Months EndedSeptember 30, |  
|                              |  |  | 2007                            |         | 2006(Restated)                 |   | 2007    |   | 2006(Restated) |         
|                             
|Net income (loss) as reported |  |  | $                               | 9,854   |                                | $ | 402,499 |   | $              | (238,662 | ) | $ | 776,138 | 
|Other comprehensive income:   |  | 
|Foreign currency translation  |  | 
|adjustment                    |  |  |                                 | 423,537 |                                |   | (7,049  | ) |                | 987,871  |   |   | 202,881 | 
|                             
|Comprehensive income          |  |  | $                               | 433,391 |                                | $ | 395,450 |   | $              | 749,209  |   | $ | 979,019 | 

8.     Operating Segments

The Company
consists of three operating segments: wound care, wound closure-specialty securement
devices and skin care. Products in the wound care segment consist of basic and advanced
dressings, ointments and sprays. Wound closure-specialty securement device products
include wound closure strips and a variety of catheter fasteners. The skin care segment
consists of bath sponges, antibacterial skin cleansers, hair and body soaps, lotions and
moisturizers.

Products
in all three operating segments are marketed to long-term care facilities, hospitals,
physicians, clinics, home health care agencies and other healthcare institutions. Basic
and advanced wound care products are manufactured both internally and outsourced, while
the manufacture of skin care products is totally outsourced. Wound closure-specialty
securement devices are for the most part manufactured in-house. Internally, the segments
are managed at the gross profit level. The aggregation or allocation of other costs by
segment is not practical.

18

---



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

Segment
net sales, gross profit and other related information for the three and nine months ended
September 30, 2007 and 2006 were as follows:

|                                                 |  |   |          |            |  |   |                                          |  |   |           |  |   |             |   |   |              |  
|------------------------------------------------ |  | - | -------- | ---------- |  | - | ---------------------------------------- |  | - | --------- |  | - | ----------- | - | - | ------------ | -
|Three Months Ended September 30, 2007           
|                                                
|                                                 |  |   |          | Wound Care |  |   | Wound Closure-SpecialtySecurementDevices |  |   | Skin Care |  |   | Other Costs |   |   | TotalCompany |  
|                                                
|Net sales                                        |  |   | $        | 7,339,625  |  | $ | 509,638                                  |  | $ | 207,139   |  |   |            |   | $ | 8,056,402    |  
|                                                
|Gross profit                                     |  |   |          | 2,371,000  |  |   | 303,112                                  |  |   | 40,491    |  |   |            |   |   | 2,714,603    |  
|Total expenses                                   |  |   |          |           |  |   |                                         |  |   |          |  | $ | (2,704,749  | ) |   | (2,704,749   | )
|                                                
|Net income                                       |  | $ | 9,854    |           
|                                                
|Three Months Ended September 30, 2006 (Restated)
|                                                
|                                                 |  |   |          | Wound Care |  |   | Wound Closure-SpecialtySecurementDevices |  |   | Skin Care |  |   | Other Costs |   |   | TotalCompany |  
|                                                
|Net sales                                        |  |   | $        | 6,719,834  |  | $ | 630,624                                  |  | $ | 256,393   |  |   |            |   | $ | 7,606,851    |  
|                                                
|Gross profit                                     |  |   |          | 2,333,284  |  |   | 301,123                                  |  |   | 13,212    |  |   |            |   |   | 2,647,619    |  
|Total expenses                                   |  |   |          |           |  |   |                                         |  |   |          |  | $ | (2,245,120  | ) |   | (2,245,120   | )
|                                                
|Net income                                       |  | $ | 402,499  |           
|                                                
|Nine Months Ended September 30, 2007            
|                                                
|                                                 |  |   |          | Wound Care |  |   | Wound Closure-SpecialtySecurementDevices |  |   | Skin Care |  |   | Other Costs |   |   | TotalCompany |  
|                                                
|Net sales                                        |  |   | $        | 21,055,665 |  | $ | 1,772,309                                |  | $ | 655,483   |  |   |            |   | $ | 23,483,457   |  
|                                                
|Gross profit                                     |  |   |          | 7,044,363  |  |   | 1,036,703                                |  |   | 103,163   |  |   |            |   |   | 8,184,229    |  
|Total expenses                                   |  |   |          |           |  |   |                                         |  |   |          |  | $ | (8,422,891  | ) |   | (8,422,891   | )
|                                                
|Net loss                                         |  | $ | (238,662 | )         

19

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

|                                                |  |   |         |            |  |   |                                          |  |   |           |  |   |             |   |   |              |  
|----------------------------------------------- |  | - | ------- | ---------- |  | - | ---------------------------------------- |  | - | --------- |  | - | ----------- | - | - | ------------ | -
|                                               
|Nine Months Ended September 30, 2006 (Restated)
|                                               
|                                                |  |   |         | Wound Care |  |   | Wound Closure-SpecialtySecurementDevices |  |   | Skin Care |  |   | Other Costs |   |   | TotalCompany |  
|                                               
|Net sales                                       |  |   | $       | 17,547,680 |  | $ | 1,805,296                                |  | $ | 847,406   |  |   |            |   | $ | 20,200,382   |  
|                                               
|Gross profit                                    |  |   |         | 6,086,167  |  |   | 892,827                                  |  |   | 28,124    |  |   |            |   |   | 7,007,118    |  
|Total expenses                                  |  |   |         |           |  |   |                                         |  |   |          |  | $ | (6,230,980  | ) |   | (6,230,980   | )
|                                               
|Net income                                      |  | $ | 776,138 |           

The
following table presents net sales by geographic region.

|              |                                 |                |                                |      |               
|------------- | ------------------------------- | -------------- | ------------------------------ | ---- | --------------
|              | Three Months EndedSeptember 30, |                | Nine Months EndedSeptember 30,
|              | 2007                            | 2006(Restated) |                                | 2007 | 2006(Restated)
|             
|United States | 57%                             | 60%            |                                | 58%  | 55%           
|Canada        | 37%                             | 35%            |                                | 37%  | 40%           
|Other         | 6%                              | 5%             |                                | 5%   | 5%            

For the
nine months ended September 30, 2007 and 2006, the Company has a major U.S. customer
comprising 16% and 18% of U.S. sales, respectively. The Companys wholly owned
Canadian subsidiary sells to one customer who serves as its exclusive third party
distributor.

9.    Income Taxes

The
Company recorded a $7,642 and $195,165 deferred foreign income tax provision for the three
and nine months ended September 30, 2007, respectively, based on the operating results of
the Companys wholly owned Canadian subsidiary. No provision was made for the
Companys U.S. operations in the three and nine months ended September 30, 2007 due
to a net operating loss for the nine months and available U.S. net operating loss carry
forwards. The Company recorded a $19,000 provision for income taxes in the third quarter
2006 principally related to estimated federal alternative minimum taxes payable associated
with operating results for the nine months ended September 30, 2006.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred assets, a full valuation allowance has been provided.
Effective December 31, 2006 the Companys wholly owned Canadian subsidiary, based on
recent operating profitability and the prospect of future profitable operations, realized
its net operating loss carry forward and deferred tax assets and liabilities.

10.   Comvita Licensing,
Manufacturing and Sales Agreement

On
February 13, 2006 the Company entered into an exclusive five year licensing,
manufacturing and sales agreement (the Agreement) with Comvita New Zealand
Limited whereby the Company will manufacture and sell a line of honey based wound care
products developed by Comvita. These products are supported by proprietary intellectual
property that will serve to provide a competitive advantage in the market place. Access
to this technology and these products represents a significant milestone in the Companys
strategy to build a larger presence in the advanced wound care market segment. Under the
Agreement, the Company receives exclusive

20

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

rights to manufacture and sell its
branded products throughout North and South America within the professional
medical-surgical marketplace (i.e. extended care, acute care, home care, etc). Comvita
retains the right to these products in the consumer marketplace and has the option to
purchase its branded consumer product requirements from the Company at agreed upon
pricing.

In
accordance with the Agreement, the Company will purchase its requirements for active honey
from Comvita at agreed upon pricing. As consideration for the grant of the license, the
Company will pay Comvita a royalty based on sales. The Agreement calls for the Company to
spend a minimum of either $200,000 or 8% of sales per year on advertising and promotion in
support of these products. Further, effective for twelve-month periods beginning July 23,
2008 and thereafter, the Agreement requires that the Company meet minimum sales targets in
order to maintain exclusivity. On July 23, 2007, the Food and Drug Administration
(FDA) granted clearance to the Company to market and sell in the United States
its active honey absorbent dressings. The Company commenced selling honey based wound care
products in the United States on October 9, 2007.

11.   Quick-Med
Technologies, Inc.  License Agreement

On
March 23, 2007, the Company entered into a patent and technology license agreement (the
Agreement) with Quick-Med Technologies, Inc. (QMT) relating to
QMTs proprietary anti-microbial technology (the Technology). The Company
anticipates utilizing the Technology in a series of wound care products, including
conforming gauze, gauze sponges, gauze bandage rolls, gauze packing strips, oil emulsion
acetate and Unna boot dressings. Initiation of the marketing and sale of products
incorporating the Technology is dependent upon the grant by the FDA of approval for use of
the Technology in primary and secondary wound dressings. The fact and timing of such
approval are uncertain.

The
initial term of the Agreement extends from March 23, 2007 (the Effective Date)
for a period equal to the shorter of five years from the first commercial sale of products
under the Agreement or seven years from the Effective Date. Under the Agreement, QMT
grants to the Company an exclusive, royalty-bearing right and license to make, use and
sell products incorporating the Technology in the United States and Canada (with the
exception of sales to the United States government and agencies thereof in which case the
license will be non-exclusive).

In
consideration for the license to the Technology, the Company paid QMT a license fee in the
amount of $50,000 and is committed to make additional advance royalty payments in the
amount of $25,000 each, three months, six months and nine months after the Effective Date.
The foregoing advance royalty payments are creditable against future royalties that become
due under the Agreement. The total non-refundable license and advance royalty payments of
$125,000 were charged to general administrative expense in March 2007, a component of
operating expense in the consolidated statement of operations. The Company made a $25,000
payment during the third quarter 2007 with respect to this Agreement.

Royalties
are payable upon the Companys net sales of products utilizing the Technology at the
rate of 20% for sales within exclusive territories and 10% for sales within non-exclusive
territories. The Agreement provides for escalating minimum royalty payments for each
contract year. In the event for a given contract year the Company fails to make the
required minimum royalty payments, but makes at least 50% of the required minimum royalty
payments, QMTs exclusive remedy would be the termination of the Companys
exclusive rights to the Technology. In the event for a given contract year the Company
fails to make at least 50% of the required minimum royalty payments, or if the Company
fails to make the required minimum royalty payments for three contract years, QMTs
exclusive remedies would be the termination of the Companys exclusive rights to the
Technology or termination of the Agreement.

21

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

12.   Subsequent Events

USC
License Agreement

On
November 2, 2007, the Company entered into a license agreement (the License
Agreement) with the University of Southern California (USC) pursuant to
which the Company acquired exclusive rights to 49 United States and foreign patents and
non-exclusive rights to one patent, together with trade secrets and know-how, related to
an angiotensin analog (the patents, trade secrets and know-how, collectively, the
Angiotensin Analog Technology). The Angiotensin Analog Technology relates to a
topical application for the treatment of chronic wounds such as diabetic ulcers, leg
ulcers associated with venous insufficiency, pressure ulcers (bed sores), burns and
surgical scars.

Not
later than November 12, 2007 and December 2, 2007, the Company will pay to or on behalf of
USC initial license fees of $539,348 and $300,000, respectively. The Company will pay USC
royalties relative to sales of products employing the Angiotensin Analog Technology at the
rates of 6.5% and 8.5% in respect of revenues less than $100 Million and revenues equal to
or greater than $100 Million, respectively. In addition, the Company will make milestone
payments to USC of up to $9,625,000 predicated upon obtaining approval of the FDA of
various indications for the Angiotensin Analog Products as well as the attainment of
various sales objectives. Further, the Company is obligated to spend at least $1,250,000
on direct marketing of the initial Angiotensin Analog Product within twelve months of the
FDAs approval thereof.

The
compound employing the Angiotensin Analog Technology is classified as a drug
the sale of which is conditioned upon FDA approval. The process of obtaining FDA approval
for the compound consists of subjecting the compound to a series of pre-clinical and
clinical studies, these latter known as phase I, phase II and phase III studies.

The
compound has successfully undergone pre-clinical and phase I clinical studies. The phase II
clinical studies will begin immediately and are expected to be concluded by the end of
2009. If the phase II clinical studies are successful, phase III clinical studies are
expected to begin in January, 2010 and, barring unforeseen events, are expected to be
completed by the end of 2012. In the event the phase III clinical studies are successful,
evaluation of the clinical studies by the FDA is expected to be completed by the end of
2013.

The
Companys costs incident to conducting phase II and phase III clinical studies relative
to the compound are expected to aggregate approximately $1.3 Million and $10.0 Million,
respectively. The Company is under no obligation to undertake or complete phase II or phase
III studies. Should it elect not to do so, the Company may either sublicense the Angiotensin
Analog Technology to one or more pharmaceutical concerns or release the Technology to USC.
In this latter event, USC would reimburse the Company for certain of its costs incident to
clinical studies that have theretofore been performed.

NutraMax
Products, Inc., First Aid Division Asset Purchase and Financing Transaction

On
November 8, 2007, the Company acquired certain assets and assumed the trade payables of
the NutraMax Products, Inc., (NutraMax) first aid division (FAD)
for $13,000,000 cash and a $500,000 potential earn out bonus. The cash purchase price
consisted of $10,250,000 paid to NutraMax, $2,000,000 deposited in a supply agreement
escrow account and $750,000 deposited in an indemnification escrow account. The supply
agreement escrow funds are payable to NutraMax quarterly, in the amount of $500,000 plus
interest at 6% from the

22

---



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

closing date, upon achievement of
certain agreed-upon third party supplier product cost and delivery performance
objectives. The indemnification escrow funds are being held for one year from the date of
closing against any intervening adjustments to the purchase price. If certain agreed-upon
third party supplier product cost and delivery performance objectives are met during the
twelve month post closing period, the Company will pay to NutraMax an additional $500,000
classified as an addition to the purchase price.

The
purchased assets consist of receivables, inventory, equipment, other amortizable
intangibles and goodwill. The Company anticipates capitalized transaction and deferred
financing costs totaling $1,500,000 and direct expenses of $500,000 related to the
purchase. The Company is presently conducting a valuation analysis to determine the
allocation of the final purchase price to the underlying assets acquired.

The
FAD is a leading manufacturer and marketer of branded and private label adhesive strips
and related first aid products to the medical, industrial and retail markets.
The latest NutraMax estimate of FAD sales, gross profit and pretax earnings for the twelve
months ended September 30, 2007 was $16,650,000, $3,800,000 and $1,850,000, respectively.
The FADs product line will serve to expand the Companys existing basic wound
care line to new customers and markets, especially the retail market where the Company
does not have a presence. The Company anticipates being able to leverage cross selling
opportunities presented by the purchase to grow sales. In addition, the Company expects to
be able to cost effectively integrate the FAD business within its operating
infrastructure.

In
connection with the purchase, the Company raised $5,499,994 (net of $500,000 in commission
and other offering expenses) from the private sale to two institutional investors of
8,571,420 shares of the Companys common stock at the price of $0.70 per share,
together with 2,142,855 five-year warrants to purchase one share of common stock at the
price of $0.77. By virtue of the sale, total common shares outstanding increased from
25,258,335 to 33,829,755.

Also
in connection with the acquisition, the Company entered into a new five-year credit and
security agreement (the Agreement) comprised of an $8,000,000 revolver and a
$6,000,000 term loan. The Agreement replaces the Companys existing $3,500,000
revolving credit agreement with its previous lender. Advances under the revolver may be
drawn, from time to time, up to the amount of 85% of eligible receivables (as defined) and
60% of eligible inventory (as defined). Interest on outstanding advances under the
revolver is payable at the LIBOR monthly rate, plus 2.75%, or 7.42% on the closing date.
In addition, the Company will pay a monthly unused line fee of 0.5% per annum on the
difference between the daily average amount of advances outstanding under the revolver and
$8,000,000 together with a monthly collateral management fee of $2,000. Interest on the
term loan is payable at the LIBOR monthly rate plus 4.25%, or 8.92% on the closing date.
Outstanding balances under the revolver and term loans are secured by all of the
Companys and its subsidiaries existing and after-acquired tangible and
intangible assets located in the United States and Canada.

The
Agreement includes the following covenants: (a) the Company must maintain EBITDA during
the six calendar months in the period January through June, 2008, of not less than
$36,000, $217,705, $165,000, $391,000, $288,000 and $238,000, respectively; (b) the
Company must maintain EBITDA of $430,000 and $917,000 for the calendar quarters ending
March 31 and June 30, 2008, respectively; (c) the Company must maintain its fixed charge
coverage ratio (adjusted EBITDA (EBITDA less capital expenditures) divided by the sum of
debt service, interest, taxes and certain other costs) for the six-month period ending
June 30, 2008, the nine-month period ending September 30, 2008 and each calendar quarter
ending December 31, 2008 and thereafter, at not less than 0.75 to 1.0, 1.15 to 1.0 and
1.2 to 1.0, respectively; (d) the Company must maintain its senior leverage ratio (senior
debt divided by EBITDA) for the three month period ending March 31, 2008 (annualized),
the six-month period ending June 30, 2008 (annualized), the nine-month period ending
September 30, 2008 (annualized) and each calendar quarter thereafter (measured on a
trailing twelve-month basis), at not less than 6.0 to 1.0, 3.5 to 1.0, 3.0 to 1.0 and 3.0
to 1.0, respectively; and (e) the Company must maintain its total leverage ratio (total
debt divided by EBITDA) for the

23

---



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

three month period ending March 31,
2008 (annualized), the six-month period ending June 30, 2008 (annualized), the nine-month
period ending September 30, 2008 (annualized) and each calendar quarter thereafter
(measured on a trailing twelve-month basis), at not less than 6.3 to 1.0, 4.0 to 1.0, 4.0
to 1.0 and 4.0 to 1.0, respectively. Additional covenants governing permitted
investments, indebtedness and liens, together with payments of dividends and protection
of collateral, are included in the Agreement.

On
November 9, 2007, the Company applied the entirety of the $6,000,000 term loan and
$3,000,000 of the revolver in satisfaction of the Companys obligations under the FAD
purchase agreement, payment of its obligations to its former lender (including a $200,000
early termination fee) and payment of FDA, credit facility and equity syndication closing
costs. Maximum potential advances under the Agreement following closing of the FAD
purchase were $7,000,000, leaving $4,000,000 available under the revolver for strategic
initiatives and general working capital.

The
Company will retain certain NutraMax personnel to perform sales and marketing,
manufacturing and distribution activities on a permanent and transitional basis. The
Company has entered into a six month lease for NutraMaxs former facility in
Houston, Texas. Under the terms of the lease, the Company will pay the landlord $18,750
per month and will be responsible for utilities and ongoing normal repair and maintenance
costs. Under a side agreement between the Company and NutraMax, NutraMax has agreed to
reimburse the Company for one-half of the utilities expense during the lease term and to pay
for the clean up and removal of any of its assets remaining in the facility at the end of
the Companys lease.

A
property inspection report will be completed as soon as possible after the closing date.
The results of the report will establish the base line for the condition of the facility
as of the date of occupancy. The Companys responsibilities as they relate to the
facility will be to return the facility in substantially as good condition as when it
received it, except for usual or ordinary wear and tear. The Companys responsibility
for the cost of any single replacement item not listed on the property inspection report
will be limited to $10,000.

24

---



Index

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

QUARTER ENDED SEPTEMBER 30, 2007
COMPARED TO QUARTER ENDED SEPTEMBER 30, 2006.

Results of Operations

Overview

The
2007 and 2006 operating results include Derma Sciences, Inc. and its subsidiaries. The
results of operations of Western Medical have been included in the consolidated results of
operations commencing April 18, 2006. Unless otherwise indicated by the context, the terms
U.S. operations and Canadian operations are used throughout this discussion in reference
to the Companys U.S. operations and the operations of Derma Sciences Canada Inc.,
respectively.

The
Company engages in the manufacture, marketing and sale of three dermatological product
lines consisting of wound care, wound closure-specialty securement devices 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-specialty securement device
line consists of wound closure strips and a variety of catheter fasteners. The skin care
line consists of bath sponges, skin cleansers, soaps, hair and body washes and
moisturizers.

The
following table highlights the quarters ended September 30, 2007 versus 2006 operating
results:

|                            |  |  |   |                             |   |   |                |   |          |          |   |  |      |     
|--------------------------- |  |  | - | --------------------------- | - | - | -------------- | - | -------- | -------- | - |  | ---- | ----
|                            |  |  |   | Quarter Ended September 30, |   |  
|                            |  |  |   | 2007                        |   |   | 2006(Restated) |   | Variance
|                           
|Gross Sales                 |  |  | $ | 10,128,908                  |   | $ | 9,192,908      |   | $        | 936,000  |   |  | 10   | .2% 
|Sales adjustments           |  |  |   | (2,072,506                  | ) |   | (1,586,057     | ) |          | (486,499 | ) |  | 30   | .7% 
|                           
|Net sales                   |  |  |   | 8,056,402                   |   |   | 7,606,851      |   |          | 449,551  |   |  | 5    | .9% 
|Cost of sales               |  |  |   | 5,341,799                   |   |   | 4,959,232      |   |          | 382,567  |   |  | 7    | .7% 
|                           
|Gross profit                |  |  |   | 2,714,603                   |   |   | 2,647,619      |   |          | 66,984   |   |  | 2    | .5% 
|Gross profit percentage     |  |  |   | 33.7                        | % |   | 34.8           | %
|Operating expenses          |  |  |   | 2,658,998                   |   |   | 2,098,057      |   |          | 560,941  |   |  | 26   | .7% 
|Interest expense            |  |  |   | 45,577                      |   |   | 106,505        |   |          | (60,928  | ) |  | (57  | .2%)
|Other (income) expense, net |  |  |   | (7,468                      | ) |   | 21,558         |   |          | (29,026  | ) |  | (134 | .6%)
|                           
|Total expenses              |  |  |   | 2,697,107                   |   |   | 2,226,120      |   |          | 470,987  |   |  | 21   | .2% 
|Income before income taxes  |  |  |   | 17,496                      |   |   | 421,499        |   |          | (404,003 | ) |  |     |     
|Provision for income taxes  |  |  |   | 7,642                       |   |   | 19,000         |   |          | (11,358  | ) |  |     |     
|                           
|Net income                  |  |  | $ | 9,854                       |   | $ | 402,499        |   | $        | (392,645 | ) |  |     |     

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, distribution fees (in Canada), sales incentives,
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. The Companys
exclusive distributor in Canada normally carries three to four months 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
September

25

---



Index

30, 2007, the trade rebate reserve
would be overstated by approximately $262,500. If the normal rebate cycle were one month
greater than estimated at September 30, 2007, the trade rebate reserve would be
understated by approximately $525,000. 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.

The
Company currently pays its exclusive Canadian distributor a fixed fee of 10% on net sales
subject to the fee (as defined) for distribution services in Canada. The distribution fee
is accrued each month based on net sales to the distributor times the ratio of estimated
percentage of distribution fee expense to net sales based on past history. The percentage
of distributor fee expense to net sales is re-evaluated quarterly for reasonableness.

Sales
incentives are credits granted to specific customers based upon attainment of
pre-determined sales objectives. The agreements are generally for a period of one year.

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 are accrued monthly based on recent historical activity.

Gross
to net sales adjustments comprise the following:

|                       |  |  |   |                             |   |   |                |  
|---------------------- |  |  | - | --------------------------- | - | - | -------------- | -
|                       |  |  |   | Quarter Ended September 30, |  
|                       |  |  |   | 2007                        |   |   | 2006(Restated) |  
|                      
|Gross Sales            |  |  | $ | 10,128,908                  |   | $ | 9,192,908      |  
|                      
|Trade rebates          |  |  |   | (1,683,613                  | ) |   | (1,234,285     | )
|Distribution fees      |  |  |   | (276,785                    | ) |   | (244,526       | )
|Sales incentives       |  |  |   | (24,305                     | ) |   | (40,932        | )
|Medicaid rebates       |  |  |   | (1,753                      | ) |   | (2,562         | )
|Returns and allowances |  |  |   | (26,144                     | ) |   | (8,318         | )
|Cash discounts         |  |  |   | (59,906                     | ) |   | (55,434        | )
|                      
|Total adjustments      |  |  |   | (2,072,506                  | ) |   | (1,586,057     | )
|                      
|Net sales              |  |  | $ | 8,056,402                   |   | $ | 7,606,851      |  

Trade rebates
increased in the third quarter 2007 versus 2006 due to higher rebate intensive Canadian
sales partially offset by an increase in the overall rebate percentage due to renewal of
buying group contracts at lower selling prices coupled with a stable level of sales
subject to rebate (contract business) in other areas of the Companys
business. The increase in distribution fee expense is commensurate with the increase in
Canadian net sales upon which it is based. The decrease in sales incentive expense
principally reflects the renegotiation of several sales incentive programs during the
quarter. Medicaid rebates have been insignificant given a continuing trend towards lower
levels of Medicaid reimbursed sales. Sales returns and allowances increased in 2007 due to
the higher level of sales and timing. Cash discounts increased commensurate with the sales
increase and as a result of a slight increase in the percentage of cash discounts to
sales, as a larger portion of the sales growth continues to come from customers that have
historically taken advantage of the Companys discount terms.

Rebate Reserve Roll
Forward

A
quarterly roll forward of the trade rebate accruals at September 30, 2007 and 2006 is
outlined below:

26

---



Index

|                              |  |  |   |                             |   |   |                |  
|----------------------------- |  |  | - | --------------------------- | - | - | -------------- | -
|                              |  |  |   | Quarter Ended September 30, |  
|                              |  |  |   | 2007                        |   |   | 2006(Restated) |  
|                             
|Beginning balance - June 30   |  |  | $ | 2,279,810                   |   | $ | 2,363,164      |  
|Rebates paid                  |  |  |   | (1,427,501                  | ) |   | (1,507,933     | )
|Rebates accrued               |  |  |   | 1,683,613                   |   |   | 1,234,285      |  
|                             
|Ending balance - September 30 |  |  | $ | 2,535,922                   |   | $ | 2,089,516      |  

The
$256,112 increase in the third quarter 2007 trade rebate reserve reflects an increase in
the Canadian rebate reserve due to higher sales of the Companys products to its
exclusive distributor versus the distributors sales to its customers coupled with
higher principally timing related US rebate payments. 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 $273,648 decrease in the third quarter 2006 trade
rebate reserve reflects a $121,293 decrease in the Canadian reserve due principally to
lower sales, higher U.S. rebate payments to one major customer partially offset by
incremental reserve requirements associated with the acquisition of the Western Medical
business in April 2006.

Net Sales and Gross Margin

The
following table highlights the September 30, 2007 versus 2006 product line net sales and
gross profit:

|                          |  |  |   |                             |  |   |                |  |          |          |   |  |     |     
|------------------------- |  |  | - | --------------------------- |  | - | -------------- |  | -------- | -------- | - |  | --- | ----
|                          |  |  |   | Quarter Ended September 30, |  |  
|                          |  |  |   | 2007                        |  |   | 2006(Restated) |  | Variance
|                         
|Product Line Net Sales   
|                         
|Wound care                |  |  | $ | 7,339,625                   |  | $ | 6,719,834      |  | $        | 619,791  |   |  | 9   | .2% 
|Wound closure-specialty   |  | 
|securement devices        |  |  |   | 509,638                     |  |   | 630,624        |  |          | (120,986 | ) |  | (19 | .2%)
|Skin care                 |  |  |   | 207,139                     |  |   | 256,393        |  |          | (49,254  | ) |  | (19 | .2%)
|                         
|Total                     |  |  | $ | 8,056,402                   |  | $ | 7,606,851      |  | $        | 449,551  |   |  | 5   | .9% 
|                         
|Product Line Gross Profit |  | 
|                         
|Wound care                |  |  | $ | 2,371,000                   |  | $ | 2,333,284      |  | $        | 37,716   |   |  | 1   | .5% 
|Wound closure-specialty   |  | 
|securement devices        |  |  |   | 303,112                     |  |   | 301,123        |  |          | 1,989    |   |  | 0   | .7% 
|Skin care                 |  |  |   | 40,491                      |  |   | 13,212         |  |          | 27,279   |   |  | 206 | .5% 
|                         
|Total                     |  |  | $ | 2,714,603                   |  | $ | 2,647,619      |  | $        | 66,984   |   |  | 2   | .5% 

Consolidated
net sales increased $449,551, or 5.9%, to $8,056,402 in 2007 from $7,606,851 in 2006.
Canadian net sales increased $342,411 or 13%, to $2,978,601 in 2007 from $2,636,190 in
2006. The increase was driven by favorable exchange of $196,844 associated with a 6.9%
strengthening of the Canadian dollar, along with higher sales of $145,567 to the exclusive
Canadian distributor as a result of lower than normal second quarter purchases to
rebalance its inventory. Real growth as measured by sales of the Companys products
reported by the distributor approximated 3.4% in local currency. U.S. net
sales increased $107,140 or 2.2%, to $5,077,801 in 2007 from $4,970,662 in 2006. The
increase was driven by advanced wound care new product (silver alginate) growth, and
continuing private label growth, partially offset by a decline in the wound-closure
specialty devices attributable to the discontinuation of a private label agreement and a
continuing decline in skin care sales.

Consolidated
gross profit increased $66,984, or 2.5%, to $2,714,603 in 2007 from $2,647,619 in 2006.
Consolidated gross profit margin percentage decreased to 33.7% in 2007 from 34.8% in
2006. Canadian gross profit decreased $42,196 or 5.6%, to $712,684 in 2007 from $754,880
in 2006. Canadian gross profit margin percentage

27

---



Index

decreased to 23.9% in 2007 from
28.6% in 2006. The decrease in Canadian 2007 gross profit dollars reflects the ongoing
sales price erosion in the Canadian traditional wound care market coupled with lower
volume throughput that adversely impacted manufacturing performance, partially offset by
the benefit of moving certain basic wound care products to China production facilities at
a lower cost and a strengthening Canadian dollar. U.S. gross profit increased $109,179,
or 5.8%, to $2,001,919 in 2007 from $1,892,740 in 2006. U.S. gross profit margin
percentage increased to 39.4% in 2007 from 38.1% in 2006. The improvement in U.S. gross
profit margin dollars reflects the impact of higher sales and the improved gross profit
margin percentage. The increase in gross profit margin percentage is principally
attributable to favorable product mix. Higher margined specialty fixation device and new
product sales together with improved traditional wound care margins due to lower product
costs were the primary contributors.

Wound
care sales consisting of basic and advanced wound care products increased $619,791, or
9.2%, in 2007 versus 2006. Basic wound care sales increased $246,389 or 5.3%. This
increase was driven by an increase in Canadian basic wound care sales of $342,411
partially offset by a U.S. sales decrease of $96,022. The Canadian sales increase was
principally attributable to favorable foreign exchange of $196,844 (6.9% Canadian dollar
strengthening) and timing related higher sales to the Companys exclusive Canadian
distributor as a result of lower than normal second quarter purchases to rebalance its
inventory. The U.S. sales performance principally reflects a lower demand for conforming
bandages and non-adherent impregnated dressings. Advanced wound care sales increased
$373,402 or 17.9%. The increase was principally driven by U.S. private label, silver
dressings and new product sales growth, partially offset by lower demand for the Derma
line of products. The Companys new silver alginate product launched in November 2006
generated sales of approximately $188,000 in the third quarter versus $258,000 in the
first half of 2007, continuing a steady quarterly growth trend.

Wound
care gross profit increased $37,716 or 1.5%, in 2007 versus 2006. Gross profit margin
percentage decreased to 32.3% in 2007 from 34.7% in 2006. The gross profit margin dollar
increase reflects the sales increase and margin decrease. The margin percentage decrease
is principally attributable to unfavorable product mix partially mitigated by favorable
product cost improvement.

Wound
closure-specialty securement device sales decreased $120,986 or 19.2%, in 2007 versus
2006. The decrease is principally due to the discontinuation of a private label agreement.
Core sales decreased 3% in 2007 versus 2006.

Wound
closure-specialty securement device gross profit increased $1,989 or 0.7%, in 2007 versus
2006. Gross profit margin percentage increased to 59.5% in 2007 from 47.7% in 2006. The
gross profit margin percentage improvement is due to the flow through of lower product
costs associated with bringing the manufacture of these products in-house.

Skin
care sales decreased $49,254 or 19.2%, in 2007 versus 2006 due to continuing competitive
pressure. Skin care gross profit improved $27,279 or 206.5%, in 2007 versus 2006. The main
driver for the gross profit dollar improvement was the elimination of the monthly carrying
costs associated with the lease on the former skin care manufacturing facility that
expired in January 2007.

Operating Expense

The
following table highlights September 30, 2007 versus 2006 operating expenses by type:

|                       |  |  |   |                             |  |   |                |  |          |         |  |  |     |    
|---------------------- |  |  | - | --------------------------- |  | - | -------------- |  | -------- | ------- |  |  | --- | ---
|                       |  |  |   | Quarter Ended September 30, |  |  
|                       |  |  |   | 2007                        |  |   | 2006(Restated) |  | Variance
|                      
|Distribution           |  |  | $ | 240,424                     |  | $ | 179,157        |  | $        | 61,267  |  |  | 34  | .2%
|Marketing              |  |  |   | 288,276                     |  |   | 122,224        |  |          | 166,052 |  |  | 135 | .9%
|Sales                  |  |  |   | 717,870                     |  |   | 520,121        |  |          | 197,749 |  |  | 38  | .0%
|General administrative |  |  |   | 1,412,428                   |  |   | 1,276,555      |  |          | 135,873 |  |  | 10  | .6%
|                      
|Total                  |  |  | $ | 2,658,998                   |  | $ | 2,098,057      |  | $        | 560,941 |  |  | 26  | .7%

28

---



Index

Operating
expense increased $560,941 or 26.7%, to $2,658,998 in 2007 from $2,098,057 in 2006
including an increase of $32,216 attributable to exchange associated with a 6.9%
strengthening of the Canadian dollar on the Canadian operations.

Distribution
expense increased $61,267, or 34.2%, in 2007 versus 2006. Expenses in Canada increased
$51,878 while expenses in the U.S increased $9,389. The increase in Canada was principally
attributable to higher lease, real estate taxes, utility, and maintenance expenses. In
December 2006, the Company leased additional square footage adjacent to its existing
facility to accommodate increased manufacturing and warehousing requirements. The U.S.
increase was mostly due to incremental personnel to handle increasing requirements
associated with the sales growth, coupled with higher rent partially offset by lower
supply expenses.

Marketing
expense increased $166,052, or 135.9%, in 2007 versus 2006. The increase was principally
attributable to a higher level of shows attended, higher compensation and benefits
associated with an employee promotion in 2006 and the hiring of a Director of Clinical
Affairs (new position) in February 2007. Also contributing were planned increases in
promotion, product development, consulting and clinical advisory board expense in support
of the Companys growth initiatives.

Sales
expense increased $197,749, or 38.0%, in 2007 versus 2006. Expenses in Canada increased
$41,349 (including $9,869 expense related to exchange) while expenses in the U.S.
increased $156,400. Excluding exchange, the $31,480 increase in Canada was mostly due to
higher General Purchasing Organization fees and to a lesser extent higher compensation and
benefits expenses partially offset by lower travel expenses. The U.S. increase was
attributable to an expansion of the sales force starting in June 2007 from two to nine
representatives by the end of September 2007 and associated recruiting fees of $43,800,
together with normal year-on-year compensation and benefit increases, higher commission,
bonus, sample, travel and sales volume related administrative expenses, partially offset
by lower Western Medical related sales consulting expense due to a lower fee structure
(versus 2006).

General
administrative expense increased $135,873, or 10.6%, in 2007 versus 2006. Expenses in
Canada increased $129,963 (including $19,693 expense related to exchange) while expenses
in the U.S. increased $5,910. The increase in Canada principally reflects normal
year-on-year compensation and benefit increases, higher travel and incremental
Sarbanes-Oxley costs. The U.S. increase principally reflects incremental personnel costs
(one finance position), share based compensation expense of $29,000, directors fees
of $24,750 and Sarbanes-Oxley fees of $40,000, coupled with higher travel expenses of
$20,500, and investor relations expenses of $12,000, together with normal year-on-year
compensation and benefit increases. These increases were for the most part offset by a
decrease in bonus accrual of approximately $136,000 and bad debt expense of approximately
$30,000.

Interest Expense

Interest
expense decreased $60,928 or 57.2%, to $45,577 in 2007 from $106,505 in 2006. Interest
expense in Canada decreased $3,800 while interest expense in the U.S. decreased $57,129.
The decrease in Canada reflects lower outstanding term loan balances in 2007 versus 2006
partially offset by higher interest rates. The U.S. decrease is principally due to lower
line of credit (despite higher interest rates) and term loan (fully paid off in December
2006) interest due to lower borrowing balances in 2007 versus 2006 as a result of the
Companys improved U.S. cash flow. Partially offsetting these decreases were
incremental promissory note interest and deferred finance fee amortization expense related
to the Western Medical acquisition in April 2006.

Other Income/Expense

Other
income net increased $29,026 to $7,468 income in 2007 from $21,558 expense in 2006. The
main driver for the other income increase was the non-recurrence of a fixed asset
write-off in 2006.

Income Taxes

The
Company recorded a $7,642 deferred foreign income tax provision for the third quarter 2007
based on the Companys Canadian operating results. No income tax provision was made
for the Companys U.S. operations in the third quarter 2007 due to a cumulative net
operating loss for the year-to-date coupled with available net operating loss carry
forwards. The Company recorded a $19,000 provision for income taxes in the third quarter
2006 principally related to estimated federal alternative minimum taxes payable.

29

---



Index

Based
on projected operating results and available net operating loss carry forwards, the U.S.
effective tax rate is projected to be insignificant in 2007. In Canada, the effective tax
rate is projected to be 34% in 2007. For the most part, tax expense in Canada is projected
to be deferred in nature as net operating loss carry forwards are utilized to offset taxes
payable.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net
deferred tax assets has been provided. Effective December 31, 2006 the Companys
Canadian subsidiary, based on recent operating profitability and projected profitable
operations going forward, realized its net operating loss carry forwards and deferred tax
assets and liabilities.

Net Income (Loss)

The
Company generated net income of $9,854 or $0.00 per share (basic and diluted), in the
third quarter 2007 compared to net income of $402,499, or $0.02 income per share basic and
$0.01 per share diluted, in the third quarter 2006.

30

---



Index

NINE MONTHS ENDED SEPTEMBER 30, 2007
COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2006.

Results of Operations

Overview

The
following table highlights the nine months ended September 30, 2007 versus 2006 operating
results:

|                                  |  |  |   |                                 |   |   |                |   |          |            |   |  |      |     
|--------------------------------- |  |  | - | ------------------------------- | - | - | -------------- | - | -------- | ---------- | - |  | ---- | ----
|                                  |  |  |   | Nine Months Ended September 30, |   |  
|                                  |  |  |   | 2007                            |   |   | 2006(Restated) |   | Variance
|                                 
|Gross Sales                       |  |  | $ | 29,483,863                      |   | $ | 24,700,417     |   | $        | 4,783,446  |   |  | 19   | .4% 
|Sales adjustments                 |  |  |   | (6,000,406                      | ) |   | (4,500,035     | ) |          | (1,500,371 | ) |  | 33   | .3% 
|                                 
|Net sales                         |  |  |   | 23,483,457                      |   |   | 20,200,382     |   |          | 3,283,075  |   |  | 16   | .3% 
|Cost of sales                     |  |  |   | 15,299,228                      |   |   | 13,193,264     |   |          | 2,105,964  |   |  | 16   | .0% 
|                                 
|Gross profit                      |  |  |   | 8,184,229                       |   |   | 7,007,118      |   |          | 1,177,111  |   |  | 16   | .8% 
|Gross profit percentage           |  |  |   | 34.9                            | % |   | 34.7           | %
|Operating expenses                |  |  |   | 8,042,109                       |   |   | 5,939,328      |   |          | 2,102,781  |   |  | 35   | .4% 
|Interest expense                  |  |  |   | 143,387                         |   |   | 298,700        |   |          | (155,313   | ) |  | (52  | .0%)
|Other expense/(income), net       |  |  |   | 42,230                          |   |   | (26,048        | ) |          | 68,278     |   |  | (262 | .0%)
|                                 
|Total expenses                    |  |  |   | 8,227,726                       |   |   | 6,211,980      |   |          | 2,015,746  |   |  | 32   | .4% 
|(Loss) income before income taxes |  |  |   | (43,497                         | ) |   | 795,138        |   |          | (838,635   | ) |  |     |     
|Provision for income taxes        |  |  |   | 195,165                         |   |   | 19,000         |   |          | 176,165    |   |  |     |     
|                                 
|Net (loss) income                 |  |  | $ | (238,662                        | ) | $ | 776,138        |   | $        | (1,014,800 | ) |  |     |     

Gross to Net Sales
Adjustments

Gross
to net sales adjustments comprise the following:

|                       |  |  |   |                                        |   |   |                |  
|---------------------- |  |  | - | -------------------------------------- | - | - | -------------- | -
|                       |  |  |   | Nine Months Ended  Ended September 30, |  
|                       |  |  |   | 2007                                   |   |   | 2006(Restated) |  
|                      
|Gross Sales            |  |  | $ | 29,483,863                             |   | $ | 24,700,417     |  
|                      
|Trade rebates          |  |  |   | (4,712,686                             | ) |   | (3,476,404     | )
|Distribution fees      |  |  |   | (782,033                               | ) |   | (734,207       | )
|Sales incentives       |  |  |   | (133,958                               | ) |   | (107,129       | )
|Medicaid rebates       |  |  |   | (4,884                                 | ) |   | (9,690         | )
|Returns and allowances |  |  |   | (177,730                               | ) |   | (38,882        | )
|Cash discounts         |  |  |   | (189,115                               | ) |   | (133,723       | )
|                      
|Total adjustments      |  |  |   | (6,000,406                             | ) |   | (4,500,035     | )
|                      
|Net sales              |  |  | $ | 23,483,457                             |   | $ | 20,200,382     |  

Trade
rebates increased significantly in the first nine months 2007 versus 2006 due to higher
rebate intensive Canadian sales coupled with an increase in the overall rebate percentage
due to renewal of buying group contracts at lower selling prices and continuing growth of
rebate intensive U.S. private label sales. The increase in distribution fee expense is
commensurate with the increase in Canadian net sales upon which it is based. The increase
in sales incentive expense principally relates to the acquisition of the Western Medical
business in April 2006, which utilizes sales incentives to a greater degree than in the
Companys other product lines. A continuing trend towards lower levels of Medicaid
reimbursed sales is responsible for the lower level of Medicaid rebates.

31

---



Index

Sales returns and allowances
increased in 2007 due to the higher level of sales and the Companys decision to
accept certain returns during the nine month period from a customer. Cash discounts
increased commensurate with the sales increase and as a result of a slight increase in
the percentage of cash discounts to sales, as a larger portion of the sales growth
continues to come from customers that have historically taken advantage of the Companys
discount terms.

Rebate Reserve Roll
Forward

A
nine month roll forward of the trade rebate accruals at September 30, 2007 and 2006 is
outlined below:

|                              |  |  |   |                                        |   |   |                |  
|----------------------------- |  |  | - | -------------------------------------- | - | - | -------------- | -
|                              |  |  |   | Nine Months Ended  Ended September 30, |  
|                              |  |  |   | 2007                                   |   |   | 2006(Restated) |  
|                             
|Beginning balance - January 1 |  |  | $ | 1,817,558                              |   | $ | 1,566,590      |  
|Rebates paid                  |  |  |   | (3,994,322                             | ) |   | (2,953,478     | )
|Rebates accrued               |  |  |   | 4,712,686                              |   |   | 3,476,404      |  
|                             
|Ending balance - September 30 |  |  | $ | 2,535,922                              |   | $ | 2,089,516      |  

The
$718,364 increase in the first nine months 2007 trade rebate reserve reflects a $483,835
increase to $1,957,903 in the Canadian rebate reserve. This increase is due to the impact
of a high level of sales to the Companys exclusive distributor in the first quarter
coupled with an increase in the distributors inventory level that resulted in a
build-up of the reserve. An increase in the overall rebate percentage in Canada due to
renewal of buying group contracts at lower selling prices coupled with incremental U.S.
reserve requirements associated with the growing rebate related private label business
also contributed. 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 $522,926 increase in the first nine months 2006 trade rebate reserve reflects a
$483,730 increase in the Canadian reserve due principally to higher sales, lower U.S.
rebate payments due to continuation of extended payment terms with a large customer and
incremental reserve requirements associated with the acquisition of the Western Medical
business in April 2006.

Net Sales and Gross Margin

The
following table highlights the September 30, 2007 versus 2006 product line net sales and
gross profit:

|                          |  |  |   |                                 |  |   |                |  |          |           |   |  |     |     
|------------------------- |  |  | - | ------------------------------- |  | - | -------------- |  | -------- | --------- | - |  | --- | ----
|                          |  |  |   | Nine Months Ended September 30, |  |  
|                          |  |  |   | 2007                            |  |   | 2006(Restated) |  | Variance
|                         
|Product Line Net Sales   
|                         
|Wound care                |  |  | $ | 21,055,665                      |  | $ | 17,547,680     |  | $        | 3,507,985 |   |  | 20  | .0% 
|Wound closure-specialty   |  | 
|securement devices        |  |  |   | 1,772,309                       |  |   | 1,805,296      |  |          | (32,987   | ) |  | (1  | .8%)
|Skin care                 |  |  |   | 655,483                         |  |   | 847,406        |  |          | (191,923  | ) |  | (22 | .6%)
|                         
|Total                     |  |  | $ | 23,483,457                      |  | $ | 20,200,382     |  | $        | 3,283,075 |   |  | 16  | .3% 
|                         
|Product Line Gross Profit |  | 
|                         
|Wound care                |  |  | $ | 7,044,363                       |  | $ | 6,086,167      |  | $        | 958,196   |   |  | 15  | .7% 
|Wound closure-specialty   |  | 
|securement devices        |  |  |   | 1,036,703                       |  |   | 892,827        |  |          | 143,876   |   |  | 16  | .1% 
|Skin care                 |  |  |   | 103,163                         |  |   | 28,124         |  |          | 75,039    |   |  | 266 | .8% 
|                         
|Total                     |  |  | $ | 8,184,229                       |  | $ | 7,007,118      |  | $        | 1,177,111 |   |  | 16  | .8% 

32

---



Index

Consolidated
net sales increased $3,283,075, or 16.3%, to $23,483,457 in 2007 from $20,200,382 in
2006. Canadian net sales increased $511,643, or 6.3%, to $8,593,113 in 2007 from
$8,081,470 in 2006. This increase was driven by growth of $321,054 and favorable exchange
of $190,589 associated with a 2.2% strengthening of the Canadian dollar. The increase was
principally attributable to higher sales to the Companys exclusive Canadian
distributor to rebalance its inventory, partially offset by price erosion associated with
the renewal of bid contracts beginning in the fourth quarter 2006 at lower overall
selling prices and lower private label sales to the distributor. Real growth as measured
by sales of the Companys products reported by the distributor approximated 6.7% in
local currency. U.S. net sales increased $2,771,432, or 22.9%, to $14,890,344 in 2007
from $12,118,912 in 2006. The increase was driven by the addition of incremental Western
Medical sales of approximately $1,932,000, continued private label growth and new product
(silver alginate) sales growth of $453,000 partially offset by continued sales decline in
the skin care and the Derma line of products. Excluding Western Medical sales, U.S. sales
increased $839,039, or 9.3%.

Consolidated
gross profit increased $1,177,111, or 16.8%, to $8,184,229 in 2007 from $7,007,118 in
2006. Company gross profit margin percentage increased to 34.9% in 2007 from 34.7% in
2006. Canadian gross profit increased $88,411, or 3.8%, to $2,411,860 in 2007 from
$2,323,449 in 2006. Canadian gross profit margin percentage decreased to 28.1% in 2007
from 28.8% in 2006. The improvement in Canadian 2007 gross profit dollars reflects the
combined impact of higher sales, improvement in manufacturing performance, the benefit of
moving certain basic wound care products to China production facilities at a lower cost
and the strengthening Canadian dollar, partially offset by ongoing price erosion in the
Canadian traditional wound care market. U.S. gross profit increased $1,088,701, or 23.3%,
to $5,772,369 in 2007 from $4,683,668 in 2006. Gross profit margin percentage increased
to 38.8% in 2007 from 38.6% in 2006. The improvement in U.S. gross profit margin dollars
reflects the impact of higher sales. The increase in gross profit margin percentage is
principally attributable to favorable product mix. Continued growth of the lower margined
private label business is the primary contributor to the increase in gross profit
dollars. Excluding Western Medical, gross profit increased $183,277, or 6%, and the gross
profit margin percentage would have been 32.9%.

Wound
care sales consisting of basic and advanced wound care products increased $3,507,985, or
20.0%, in 2007 versus 2006. Basic wound care sales increased $1,735,469, or 14.4%. This
increase was driven by an increase in Canadian basic wound care sales of $511,643 together
with a U.S. sales increase of $1,223,826. The Canadian sales growth was driven principally
by higher sales to the Companys exclusive Canadian distributor due to improving
demand and the distributors rebalancing of its inventory earlier in the year,
partially offset by price erosion and lower private label sales to the distributor. The
U.S. sales performance reflects incremental Western Medical sales of approximately
$1,154,000 coupled with modest growth for the balance of the basic wound care line.
Advanced wound care sales increased $1,772,516 or 32.4%. This increase was principally
driven by U.S. private label, silver dressings and new product sales growth, partially
offset by lower demand for the Derma line of products. Sales of the Companys new
silver alginate product launched in November 2006 were $453,000 in the first nine months
of 2007.

Wound
care gross profit increased $958,196, or 15.7%, in 2007 versus 2006. Gross profit margin
percentage decreased to 33.5% in 2007 from 34.7% in 2006. The gross profit margin dollar
increase reflects the sales increase and margin decrease. The margin percentage decrease
is principally attributable to unfavorable product mix partially mitigated by favorable
product cost improvement.

Wound
closure-specialty securement device sales decreased $32,987, or (1.8%) in 2007 versus
2006. The decrease is principally due to the discontinuation of a private label supply
agreement partially offset by a prior year backorder fulfillment in the first quarter
2007.

Wound
closure-specialty securement device gross profit increased $143,876, or 16.1%, in 2007
versus 2006. Gross profit margin percentage increased to 58.5% in 2007 from 49.5% in 2006.
The increase in gross profit margin dollars reflects the improved gross profit margin
percentage. The gross profit margin percentage improvement is due to the flow through of
lower product costs associated with bringing the manufacture of these products in-house in
the second half of 2006.

Skin
care sales decreased $191,923, or 22.6%, in 2007 versus 2006 due to continuing competitive
pressure. Skin care gross profit improved $75,039 to $103,163 in 2007 from $28,124 in
2006. The main driver for the gross profit dollar improvement was the elimination of the
monthly carrying costs associated with the lease on the former skin care manufacturing
facility that expired in January 2007.

33

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Index

Operating Expense

The
following table highlights September 30, 2007 versus 2006 operating expenses by type:

|                       |  |  |   |                                 |  |   |                |  |          |           |  |  |     |    
|---------------------- |  |  | - | ------------------------------- |  | - | -------------- |  | -------- | --------- |  |  | --- | ---
|                       |  |  |   | Nine Months Ended September 30, |  |  
|                       |  |  |   | 2007                            |  |   | 2006(Restated) |  | Variance
|                      
|Distribution           |  |  | $ | 676,495                         |  | $ | 512,547        |  | $        | 163,948   |  |  | 32  | .0%
|Marketing              |  |  |   | 956,206                         |  |   | 391,398        |  |          | 564,808   |  |  | 144 | .3%
|Sales                  |  |  |   | 1,955,784                       |  |   | 1,575,693      |  |          | 380,091   |  |  | 24  | .1%
|General administrative |  |  |   | 4,453,624                       |  |   | 3,459,690      |  |          | 993,934   |  |  | 28  | .7%
|                      
|Total                  |  |  | $ | 8,042,109                       |  | $ | 5,939,328      |  | $        | 2,102,781 |  |  | 35  | .4%

Operating
expense increased $2,102,781, or 35.4%, to $8,042,109 in 2007 from $5,939,328 in 2006
including an increase of $34,476 attributable to exchange associated with a 2.2%
strengthening of the Canadian dollar on the Canadian operations.

Distribution
expense increased $163,948, or 32.0%, in 2007 versus 2006. Expenses in Canada increased
$121,434 (including $2,796 expense related to exchange) while expenses in the U.S
increased $42,514. The increase in Canada was principally attributable to higher lease,
real estate taxes, utility and maintenance expenses. In December 2006, the Company leased
additional space adjacent to its existing facility to accommodate increased manufacturing
and warehousing requirements. The U.S. increase was principally attributable to
incremental warehouse personnel (compensation and benefits) and operating costs required
to support the sales growth. Increased resources required to integrate the Western Medical
acquisition into the Companys existing business beginning in April 2006 also
contributed.

Marketing
expense increased $564,808, or 144.3%, in 2007 versus 2006. The increase was attributable
to higher compensation and benefits associated with an employee promotion in 2006, the
hiring of a Director of Clinical Affairs (new position) in February 2007 together with
associated recruiting costs and higher share based compensation costs. Also contributing
were planned increases in trade show attendance, promotion, product development,
consulting and clinical advisory board expense in support of the Companys growth
initiatives.

Sales
expense increased $380,091, or 24.1%, in 2007 versus 2006. Expenses in Canada increased
$50,616 (including $9,269 expense related to exchange) while expenses in the U.S.
increased $329,475. The Canada increase was due to higher compensation and benefits,
buying group administrative fees (sales volume related) and sample expenses partially
offset by lower travel and bid expenses. The U.S. increase was principally attributable to
an expansion of the sales force starting in June from two to nine sales representatives
and associated recruiting fees of $125,400, together with the relocation of customer
service to corporate headquarters in June 2007, together with a higher level of operating
costs associated therewith. Incremental consulting and customer service (personnel
related) expenses associated with the integration of the Western Medical business into the
Company in 2006 also contributed.

General
administrative expense increased $993,934, or 28.7%, in 2007 versus 2006. Expenses in
Canada increased $243,381 (including $22,052 expense related to exchange) while expenses
in the U.S. increased $750,553. The increase in Canada principally reflects Sarbanes
Oxley consulting (compliance program commenced in December 2006) expenses of
approximately $75,000, higher accounting, tax and audit fees of approximately $52,000,
share based compensation expense of approximately $39,000, coupled with normal
year-to-year compensation and benefit cost increases, partially offset by lower bad debt
expense. The U.S. increase principally reflects incremental intangible amortization
expense of approximately $147,000 related to the Western Medical acquisition, share based
employee and director compensation expense of approximately $126,000, incremental
technology licensing expense of $125,000, Sarbanes Oxley consulting expenses of
approximately $130,000, higher accounting, tax and audit fees of approximately $72,000,
higher travel expenses of approximately $70,000, higher investor relations and public
relations related expenses of approximately $33,000, incremental directors fees of
approximately $54,000, and normal year-to-year compensation and benefit cost increases,
partially offset by the non-recurrence of $32,000 worth of one-time Western Medical
transition related expense incurred in 2006 and by a

34

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Index

decrease in bonus accrual of
approximately $103,000 (due to a lower projected bonus payout percentage in 2007 versus
2006).

Interest Expense

Interest
expense decreased $155,313, or 52%, to $143,387 in 2007 from $298,700 in 2006. Interest
expense in Canada decreased $11,283 while interest expense in the U.S. decreased $144,030.
The decrease in Canada reflects lower outstanding term loan balances in 2007 versus 2006
partially offset by higher interest rates. The U.S. decrease is principally due to lower
line of credit (despite higher interest rates) and term loan (fully paid off in December
2006) interest due to lower borrowing balances in 2007 versus 2006 as a result of the
Companys improved U.S. cash flow and the non-recurrence of a one-time fee of $20,000
paid in March 2006 for loan covenant violation waivers. Partially offsetting these
decreases were incremental promissory note interest and deferred finance fee amortization
expense related to the Western Medical acquisition in April 2006.

Other Income/Expense

Other
expense net increased $68,278 to $42,230 expense in 2007 from $26,048 income in 2006. The
main driver for the other expense increase was the non-recurrence of a $64,971 gain
recorded in 2006 associated with the favorable settlement of a supplier liability. Higher
temporary container storage costs and lower royalty income, also contributed.

Income Taxes

The
Company recorded a $195,165 deferred foreign income tax provision for the first nine
months of 2007 based on the Companys Canadian operating results. No income tax
provision was made for the Companys U.S. operations in the first nine months of 2007
due to a net operating loss coupled with available net operating loss carry forwards. The
Company recorded a $19,000 provision for income taxes in the third quarter 2006
principally related to estimated federal alternative minimum taxes payable associated with
operating results for the nine months ended September 30, 2006.

Based
on projected operating results and available net operating loss carry forwards, the U.S.
effective tax rate is projected to be insignificant in 2007. In Canada, the effective tax
rate is projected to be 34% in 2007. For the most part, tax expense in Canada is projected
to be deferred in nature as net operating loss carry forwards are utilized to offset taxes
payable.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net
deferred tax assets has been provided. Effective December 31, 2006 the Companys
Canadian subsidiary, based on recent operating profitability and projected profitable
operations going forward, realized its net operating loss carry forwards and deferred tax
assets and liabilities.

Net Income (Loss)

The
Company generated a net loss of $238,662, or ($0.01) per share (basic and diluted), in the
first nine months of 2007 compared to net income of $776,138, or $0.04 income per
share-basic and $0.03 income per share-fully diluted in the first nine months of 2006.

Liquidity and Capital
Resources

Operational Overview

Net
sales increased 15.3%, (16.3% adjusted for foreign exchange), in 2007 over 2006. This
growth was driven by a sales increase in the U.S. of 22.9%, together with an increase in
Canadian sales of 6.3% (4% adjusted for foreign exchange). Sales growth in the U.S. was
driven by incremental sales associated with the Western Medical business (acquired April
18, 2006) of $1,932,000 and continued growth of the private label business. Sales of the
Companys new silver alginate product were approximately $453,000 in the first nine
months of 2007. The product has exhibited steady quarter-to quarter growth since its
launch in November 2006. Skin care sales continue to deteriorate in the face of
competitive pressure and a reduction of resources allocated to support the line. Sales for

35

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Index

the balance of the U.S. product
lines were essentially flat year-on-year. Excluding Western Medical sales, U.S. sales
growth was 9.3%. Canadian sales growth in the first nine months of 2007 was modest,
increasing 6.3% (4% excluding foreign exchange). This reflects a very competitive
marketplace for the Companys line of traditional wound care products that make up
the majority of Canadian sales. Unit volume growth and successful product cost reduction
efforts have enabled the Company to remain competitive in an environment of declining
prices for its products. In Canada, the Company continues 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 exclusive distributor to
capitalize on sales growth opportunities presented by this relationship. Real growth as
measured by sales of the Companys products reported by the distributor
approximated 6.7% in local currency for the first nine months of 2007.

The
Company has realized significant product cost improvement over the last several years as a
result of its manufacturing and sourcing initiatives. The saving generated by these
initiatives has helped mitigate the adverse impact of price erosion and foreign exchange
on a large portion of the Companys business and served to sustain or improve its
gross profit dollars and margin percentage. Prospectively, this trend will become
increasingly more difficult to perpetuate. The significant investment in manufacturing
infrastructure over the past few years and incremental volume associated with growth of
the private label business and new products has enabled the Company to improve the
efficiency of its Canadian manufacturing operations. This trend is expected to continue.
Product cost savings associated with implementation of China and other sourcing
initiatives have been another contributor to the Companys cost reduction success
through the third quarter of 2007. Current market conditions in China and, to a lesser
extent, in other markets portend increasing product cost pressure. The Company will
continue to seek opportunities to lower product costs wherever possible.

Operating
expenses increased 35.4% (34.8% adjusted for foreign exchange) in 2007 over 2006 in line
with expectations. The increase is attributable to incremental technology licensing
expense, Western Medical costs (intangible asset amortization, planned sales and marketing
expenses), planned increases in distribution, marketing and sales expenses in support of
the Companys growth initiatives and higher professional service fees as a result of
increasing regulatory requirements. Excluding these expenses, growth in the balance of
operating expenses is in line with inflation and continues to be closely monitored.

The
Company has reported a loss of $238,662 for the first nine months of 2007. This reflects
the Companys commitment to growth as a significant investment in incremental sales
and marketing resources together with product development and licensing costs has been
made during the year. Not unexpectedly, but also contributing, has been a significant
increase in mandated Sarbanes-Oxley and audit related costs to stay compliant with
increasingly stringent regulatory and external reporting requirements. The Company
anticipates this trend will continue in the near term. With a stable core business,
continued growth of the private label business and as the recently launched new products
gain traction in the marketplace coupled with ongoing manufacturing and operating expense
management, the Company anticipates a return to profitability going forward.

On
July 23, 2007, the Company received clearance from the U.S. Food and Drug Administration
to market and sell its Active Leptospermum Absorbent Dressing. On June 14, 2007, the
Company announced that it had obtained clearance from Health Canada to market and sell its
line of Active Leptospermum Honey based dressings. On February 13, 2006, the Company
entered into an exclusive licensing, manufacturing and sales agreement to manufacture and
sell a line of Leptospermum Honey based wound care products in North and South America
within the medical-surgical marketplace. In accordance with the agreement, the Company
will purchase its requirements for active Leptospermum honey from the licensor at agreed
upon pricing and will pay the licensor an agreed upon sales based royalty. Further,
effective for twelve-month periods beginning July 23, 2008 and thereafter, the agreement
requires that the Company meet minimum sales targets in order to maintain exclusivity. The
Company launched its first Leptospermum Honey based product in the U.S. and Canada in
October 2007.

On
March 23, 2007 (the effective date), the Company entered into an exclusive patent and
technology license agreement for the rights in the U.S. and Canada to certain proprietary
anti-microbial technology. The Company anticipates utilizing this technology in a series
of its wound care products. In consideration for the license, the Company paid a license
fee of $50,000 and agreed to make additional advance royalty payments in the amount of
$25,000 each, three months, six months and nine months after the effective date of the
agreement and is obligated to pay sales based royalties upon commercial launch of the
product(s) employing this technology and meet certain minimum sales thresholds to
maintain exclusivity. The $125,000 non-refundable license and advanced royalty payments
were expensed. The Company anticipates use of this technology will provide a significant
near

36

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Index

term commercial opportunity.
Approval of this technology is moving through the regulatory process. The Company expects
to launch products employing this technology in 2008.

On
November 8, 2006, the Company entered into an exclusive license and distribution agreement
for the rights in the U.S. and Canada to an intermittent pneumatic compression device
representing a significant advancement in the treatment of patients with various vascular
diseases or lymphedema. In consideration for the license, the Company is obligated to
purchase the product from the licensee at agreed upon prices and meet certain minimum
purchase thresholds to maintain exclusivity. The Company is presently working to obtain
reimbursement code approval for this product and undertaking studies to
support the features and benefits of the device. The Company expects to launch this
product in 2008.

Cash Flow and Working
Capital

At
September 30, 2007 and December 31, 2006, the Company had cash and cash equivalents on
hand of $674,871 and $1,285,943, respectively. The $611,072 decrease in cash reflects net
cash used by operating activities of $217,548, net cash used in investing activities of
$599,290, net cash used in financing activities of $304,678 and cash provided as a result
of exchange rate changes of $75,348.

Net
cash used in operating activities of $217,548 stems from $1,835,123 cash provided from
operations (net loss plus non-cash items), partially offset by $1,617,575 cash used from
the net change in operating assets and liabilities. The increase in cash provided from
operations is associated with significant capital expenditures over the last couple of
years (resulting in higher levels of depreciation expense), a significant increase in
amortizable intangibles in connection with the Western Medical acquisition, higher rebate
reserves in the U.S. and Canada due to increases in rebate intensive sales and the
commencement of expensing of share based compensation beginning in 2006 thereby increasing
the magnitude of non-cash charges. Higher inventory and the timing related decrease in
accounts payable, were the main drivers behind the net change in ongoing operating assets
and liabilities. The changes in prepaid expenses, other assets and accrued liabilities
resulting in a net use of funds are for the most part timing related. The significant
increase in inventory reflects an increase and rebalancing of the U.S. finished goods
inventory to improve customer service and replenish inventory levels that were lower than
normal due to unexpected production delays caused by the equipment and facility
improvements activities that took place at the Companys manufacturing operation in
Canada in the second half of 2006. Also contributing was an OEM customer component and
finished goods inventory build in Canada to meet agreed upon safety stock requirements,
new product inventory builds and timing related excess finished goods in Canada due to
early delivery of product from China.

Net
cash used in investing activities of $599,290 principally reflects $424,200 cash used for
purchases of equipment at the Companys manufacturing operation in Canada to expand
manufacturing capability in response to growth and/or efficiency opportunities and a new
trade show booth to support the Companys growing sales and marketing activities and
new office furniture for the Companys headquarters together with $175,090 of
out-of-pocket business acquisition costs.

Net
cash used in financing activities of $304,678 reflects cash used to make regularly
scheduled debt payments, including the final payment of the Canadian term loan in
September 2007.

Working
capital increased $1,131,917, or 19.6%, at September 30, 2007 to $6,899,966 from
$5,768,049 at December 31, 2006. Working capital of this magnitude is considered
sufficient to support ongoing operations.

Financing Arrangements

In
December 2006, the Company renewed its annual revolving credit facility agreement with its
Canadian lender for a maximum principal amount of $502,000 ($500,000 Canadian). Maximum
potential advances under the agreement at September 30, 2007 were zero. Advances
outstanding against the agreement were zero at September 30, 2007. The Company terminated
its revolving credit facility agreement with its Canadian lender on October 10, 2007.

In
addition, the Canadian lender has granted Derma Sciences Canada Inc. a $754,000 ($750,000
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

37

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Index

advance shall be amortized and
repaid over sixty months. Prepayment of advances, in whole or in part, is not permitted
during the eighteen months following initial disbursement. Prepayment thereafter is
permitted in whole or once per annum in part with thirty days written notice and payment
of the greater of the following premium: (i) 3% of the principal amount prepaid; or (ii)
three months interest on such principal at the loan interest rate in effect on the date
prepayment is made. As of September 30, 2007, there were no outstanding advances against
the line. The Company terminated its non-revolving term line of credit with its Canadian
lender on October 10, 2007.

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 September 30, 2007 were $3,363,000. Advances
outstanding against the line were $11,607 at September 30, 2007, leaving an additional
$3,351,393 available for borrowing. The Company terminated its revolving credit facility
agreement with its U.S. lender on November 9, 2007.

Prospective Assessment

The
Companys objective is to in-license, develop and launch novel higher margined
advanced wound care products while utilizing its core business (to the extent possible) to
fund this objective. In addition, the Company will continue to evaluate external
opportunities to leverage its core capabilities for growth. Beginning in 2005, the Company
expanded its product in-licensing and development efforts. As a result of these efforts,
the Company launched its silver alginate product in November 2006. Sales of this product
have increased each quarter since its launch. The Company launched its first honey product
in October 2007. This product represents the first of its kind in the marketplace and
interest in the product has been high. A line of follow-on honey products is planned. The
Company expects to launch two additional novel products in 2008. The Company anticipates
core business sales will remain stable.

The
Company has realized significant product cost improvement over the last several years as a
result of its manufacturing and sourcing initiatives. The savings generated by these
initiatives has helped mitigate the adverse impact of price erosion and foreign exchange
on a large portion of the Companys business. Cost improvements will become
increasingly more difficult to realize in the future due to anticipated market conditions.
The Company will continue to seek opportunities to lower product costs wherever possible
and plans to better leverage its opportunities for price increases to the extent market
conditions permit. Going forward, as the higher margined new products gain traction in the
marketplace, they will contribute positively to the Companys overall gross profit
margins.

The
Company continually evaluates the personnel, infrastructure and regulatory resources
needed to support its strategic objectives. While resource requirements are expected to
increase, the Company will continue to closely monitor operating expenses and limit these
expenses as necessary to support planned growth.

Capital
expenditures will continue to be limited to those projects capable of generating an
acceptable level of return and those necessary to support existing operations. The Company
will continue to focus on inventory levels with the objective of optimizing customer
service levels while minimizing its investment in inventory.

On
November 2, 2007, the Company entered into a license agreement covering certain
Angiotensin Analog Technology. Up-front license and development costs will approximate
$2,000,000 in the first twenty-six months of the development plan through completion of
Phase II clinical studies. These costs are expected to be funded through the
Companys ongoing internal cash flow and available credit lines. The license and
development plan may be terminated at any time. The results of the Phase II studies will
determine the efficacy and safety of the compound and further refine its market potential.
The cost of Phase III studies and bringing the product to market are significant. Should
the decision be made to proceed with the development plan after completion of Phase II,
the Company plans to fund the additional development costs out of available cash flow,
available credit lines or additional equity, as needed, or sell the rights to the
compound.

On
November 8, 2007, the Company purchased the assets of the first aid division of NutraMax
Products, Inc. in a debt and equity transaction valued at $15,000,000. The acquisition
was financed through the sale of $6,000,000 equity and debt of $9,000,000. The debt
consisted of a $6,000,000 term loan and an initial $3,000,000 draw down against an
$8,000,000 revolving line of credit provided by a new lender. The first aid division is a
leading manufacturer and marketer of adhesive strips and related first aid products. The
latest NutraMax estimate of

38

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Index

first aid division sales, gross
profit and pretax income for the twelve months ended September 2007, was $16,500,000,
$3,800,000 and $1,850,000, respectively.

Maximum
potential advances under the new credit and security agreement as of November 9, 2007 were
$7,000,000. The Company anticipates using the balance available of $4,000,000 as of
November 9, 2007 on the new revolving line of credit to finance the up-front Angiotensin
Analog Technology license fee and ongoing development costs as well as for general working
capital purposes.

The
Company believes that available funds from operations and available lines of credit will
be sufficient to satisfy the Companys foreseeable liquidity requirements through the
next twelve months.

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, 2007:

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

Up
to 15,343,791 shares of the Companys common stock are potentially issuable upon the
conversion, exercise or vesting of outstanding convertible preferred stock, warrants,
options and restricted stock awards (derivative securities). The shares of
common stock potentially issuable upon conversion, exercise or vesting of derivative
securities are substantial compared to the 25,258,335 shares of common stock
outstanding at September 30, 2007.

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

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

The
Company incurred a net loss of $238,662 (unaudited) in the first nine months of 2007,
earned net income of $668,739 in 2006, $22,241 in 2003, $61,368 in 2002 and $192,398 in
2001 and incurred losses of $1,099,990 in 2005, $2,338,693 in 2004, $2,581,337 in 2000 and
$2,998,919 in 1999. At September 30, 2007, the Company had an accumulated deficit of
$13,655,943 (unaudited). Although the Company achieved profitability in 2006, 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 2006 and the first ten months of 2007 are set forth in
the table below:

39

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Index

| |                                            |       |       | 
| | ------------------------------------------ | ----- | ----- | 
| | Derma SciencesTrading 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 | $0.90 | 
| | 2007(*)                                    | $0.60 | $0.95 | 
| |                                            |       |       | 
| | (*) January 1 through October 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; and
| | - |  | ---------------------------------------------------------------------------------

| |  |  | The
loss of a major customer.
| | - |  | -----------------------------

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

Additional Financial
Information

Forward Looking Statements

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

Critical Accounting
Policies

Estimates
and assumptions are required in the determination of sales deductions for trade rebates,
sales incentives, 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.

40

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Index

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 and distribution fees (in
Canada). 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. The Company pays its exclusive Canadian distributor a fixed fee based
on sales subject to the fee (as defined) for distribution services in Canada. The
distribution fee is accrued monthly based on the estimated percentage of distribution fee
expense to net sales. If the assumptions used to calculate these rebates and fees 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 fees and makes adjustments as necessary.

Goodwill

At
September 30, 2007, the Company had $2,441,542 of goodwill relating to the Western Medical
acquisition in April 2006. The goodwill is included in the wound care segment for
reporting purposes. 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 supercedes
Accounting Principles Board Opinion 25 Accounting for Stock Issued to
Employees. Under APB 25, the Company used the intrinsic value method for
employee stock options and did not record any expense because option exercise prices
equaled the market value at the date of grant. SFAS 123R requires that new, modified and
unvested share-based payment transactions with employees, such as grants of stock options
and restricted stock, be recognized in the financial statements based on their fair value
at the grant date and recognized as compensation expense over their vesting periods. The
Company estimates the fair value of stock options as of the date of grant using the
Black-Scholes pricing model and restricted stock based on the quoted market price. The
Company adopted SFAS 123R using the modified prospective method and, accordingly, prior
period financial statements were not revised. The Company recognized stock-based employee
compensation of $402,572 and $146,191 in the nine months ended September 30, 2007 and
2006, respectively, under SFAS 123R.

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Index

Item 3.  CONTROLS AND PROCEDURES

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of September 30, 2007. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective for gathering, analyzing
and disclosing the information the Company is required to disclose in the reports it files
under the Securities Exchange Act of 1934, within the time periods specified in the
SECs rules and forms.

During
the three months ended September 30, 2007, 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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Index

Part II  Other
Information

Item 1. Legal Proceedings

None.

Item 6. Exhibits

All
exhibits required by Item 601 of Regulation S-B and required hereunder, as filed with the
Securities and Exchange Commission in Form 10-KSB on March 31, 2007, are incorporated
herein by reference.

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

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

|                          |                      |                                            | 
|------------------------- | -------------------- | ------------------------------------------ | 
|                          | DERMA SCIENCES, INC. |                                           
|Dated:  November 12, 2007 | By:                  | /s/ John E. Yetter                         | 
|                          |                      | John E. Yetter, CPAChief Financial Officer | 

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Index

EXHIBIT INDEX

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