|
|

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-Q

(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, 2009

|                                                         |                                                                                               | 
|-------------------------------------------------------- | --------------------------------------------------------------------------------------------- | 
|[  ]                                                     | 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) | (I.R.S. Employer Identification
     No.)

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

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

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.þYes   oNo

Indicate by check mark whether the
registrant has submitted electronically and posted on its corporate Web site, if any,
every Interactive Data File required to be submitted and posted pursuant to Rule 405 of
Regulation S-T during the preceding 12 months (or for such
shorter period that the registrant was required to submit and post such files).  
Yes oNo o

Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer,
or a smaller reporting company. See the definitions of large accelerated filer, accelerated
filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
(Check one):

| |                         |   |                                               |                           |  
| | ----------------------- | - | --------------------------------------------- | ------------------------- | -
| | Large accelerated filer | o |                                               | Accelerated filer         | o
| | Non-accelerated filer   | o | (Do not check if a smaller reporting company) | Smaller reporting company | þ

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

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

|                        |        |                                       
|----------------------- | ------ | --------------------------------------
|Date: November 13, 2009 | Class: | Common Stock, par value $.01 per share
|                        |        | Shares Outstanding: 40,315,743        

|
|

Part I

DERMA SCIENCES, INC.

FORM 10-Q

INDEX

|                               |                                                                                                |                                                                                                                                |  
|------------------------------ | ---------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | -
|Description                    | Page                                                                                          
|Part I  Financial Information
|                               | Item 1.  Financial Statements                                                                  |                                                                                                                               
|                               |                                                                                                | Condensed Consolidated Balance
     Sheets  September 30, 2009 (Unaudited) andDecember 31, 2008                               | 3
|                              
|                               |                                                                                                | Condensed Consolidated Statements of
     Operations  Three months endedSeptember 30, 2009 and September 30, 2008 (Unaudited) | 4
|                              
|                               |                                                                                                | Condensed Consolidated Statements of
     Operations  Nine months endedSeptember 30, 2009 and September 30, 2008 (Unaudited)  | 5
|                              
|                               |                                                                                                | Condensed Consolidated Statements of
     Cash Flows  Nine months endedSeptember 30, 2009 and September 30, 2008 (Unaudited)  | 6
|                              
|                               |                                                                                                | Notes to Condensed Consolidated Financial
     Statements (Unaudited)                                                          | 7
|                               | Item 2.  Managements Discussion and
     Analysis of Financial Conditionor Plan of Operations | 18                                                                                                                            
|                              
|                               | Item 4.  Controls and
     Procedures                                                          | 34                                                                                                                            
|Part II - Other Information   
|                               | Item 6.  Exhibits                                                                              | 35                                                                                                                            

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. FINANCIAL
STATEMENTS

2

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                 |  |                |              |                |  
|---------------------------------------------------------------- |  | -------------- | ------------ | -------------- | -
|Condensed Consolidated Balance Sheets                           
|                                                                 |  | September 30,  | December 31,
|                                                                 |  | 2009           | 2008        
|ASSETS                                                           |  | (Unaudited)    |             
|                                                                
|Current Assets                                                   |  |                |              |                |  
|Cash and cash equivalents                                        |  | $      399,998 |              | $      391,038 |  
|Accounts receivable, net                                         |  | 3,743,290      |              | 3,892,523      |  
|Inventories                                                      |  | 10,789,282     |              | 12,423,042     |  
|Prepaid expenses and other current assets                        |  | 477,712        |              | 397,117        |  
|                                                                
|Total current assets                                             |  | 15,410,282     |              | 17,103,720     |  
|Cash - restricted                                                |  | 2,029,563      |              | 2,014,422      |  
|Equipment and improvements, net                                  |  | 3,873,046      |              | 3,977,853      |  
|Goodwill                                                         |  | 7,119,726      |              | 7,119,726      |  
|Other intangible assets, net                                     |  | 4,322,750      |              | 5,310,129      |  
|Other assets, net                                                |  | 579,216        |              | 681,472        |  
|                                                                
|Total Assets                                                     |  | $ 33,334,583   |              | $ 36,207,322   |  
|                                                                
|LIABILITIES AND SHAREHOLDERS' EQUITY                             | 
|                                                                
|Current Liabilities                                              | 
|Line of credit borrowings                                        |  | 2,835,589      |              | 3,446,605      |  
|Current maturities of long-term debt                             |  | 1,773,401      |              | 1,298,207      |  
|Accounts payable                                                 |  | 2,902,190      |              | 3,614,764      |  
|Accrued expenses and other current liabilities                   |  | 1,233,958      |              | 2,004,493      |  
|                                                                
|Total current liabilities                                        |  | 8,745,138      |              | 10,364,069     |  
|Long-term debt                                                   |  | 2,614,503      |              | 4,065,036      |  
|Other long-term liabilities                                      |  | 104,674        |              | 44,848         |  
|Deferred tax liability                                           |  | 363,141        |              | 340,871        |  
|                                                                
|Total Liabilities                                                |  | 11,827,456     |              | 14,814,824     |  
|                                                                
|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, 2009)     |  | 22,804         |              | 22,804         |  
|Common stock, $.01 par value; 150,000,000 authorized; issued and | 
|outstanding:  40,315,743 at September 30, 2009; 40,140,743 at    | 
|December 31, 2008                                                |  | 403,157        |              | 401,407        |  
|Additional paid-in capital                                       |  | 40,709,352     |              | 40,027,645     |  
|Accumulated other comprehensive income -                         | 
|cumulative translation adjustments                               |  | 1,214,615      |              | 604,465        |  
|Accumulated deficit                                              |  | (20,842,801    | )            | (19,663,823    | )
|                                                                
|Total Shareholders' Equity                                       |  | 21,507,127     |              | 21,392,498     |  
|                                                                
|Total Liabilities and Shareholders' Equity                       |  | $ 33,334,583   |              | $ 36,207,322   |  
|                                                                

See accompanying consolidated notes.

3

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                      |  |                                  |      |                 |  
|--------------------------------------------------------------------- |  | -------------------------------- | ---- | --------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)           | 
|                                                                      |  | Three months ended September 30,
|                                                                      |  | 2009                             | 2008
|                                                                     
|Net Sales                                                             |  | $ 12,882,425                     |      | $ 12,832,574    |  
|Cost of sales                                                         |  | 8,838,154                        |      | 9,006,021       |  
|                                                                     
|Gross Profit                                                          |  | 4,044,271                        |      | 3,826,553       |  
|                                                                     
|Operating Expenses                                                    | 
|Selling, general and administrative                                   |  | 3,677,182                        |      | 4,115,154       |  
|Research and development                                              |  | 70,412                           |      | 84,891          |  
|                                                                     
|Total operating expenses                                              |  | 3,747,594                        |      | 4,200,045       |  
|                                                                     
|Operating income (loss)                                               |  | 296,677                          |      | (373,492        | )
|                                                                     
|Other expense, net:                                                   | 
|Interest expense                                                      |  | 220,839                          |      | 251,256         |  
|Other income                                                          |  | (69,002                          | )    | (1,419          | )
|                                                                     
|Total other expense                                                   |  | 151,837                          |      | 249,837         |  
|                                                                     
|Income (loss) before provision for income taxes                       |  | 144,840                          |      | (623,329        | )
|Provision for income taxes                                            |  | 5,237                            |      | 78,290          |  
|                                                                     
|Net Income (Loss)                                                     |  | $      139,603                   |      | $    (701,619   | )
|                                                                     
|Net income (loss) per common share - basic and diluted                |  | $            0.00                |      | $         (0.02 | )
|                                                                     
|Shares used in computing net income (loss) per common share - basic   |  | 40,315,743                       |      | 40,140,743      |  
|                                                                     
|Shares used in computing net income (loss) per common share - diluted |  | 42,931,301                       |      | 40,140,743      |  
|                                                                     

See accompanying consolidated notes.

4

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                       |  |                                 |      |                  |  
|---------------------------------------------------------------------- |  | ------------------------------- | ---- | ---------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)            | 
|                                                                       |  | Nine months ended September 30,
|                                                                       |  | 2009                            | 2008
|                                                                      
|Net Sales                                                              |  | $  34,877,658                   |      | $  37,641,362    |  
|Cost of sales                                                          |  | 24,051,984                      |      | 27,141,628       |  
|                                                                      
|Gross Profit                                                           |  | 10,825,674                      |      | 10,499,734       |  
|                                                                      
|Operating Expenses                                                     | 
|Selling, general and administrative                                    |  | 11,244,347                      |      | 12,919,124       |  
|Research and development                                               |  | 288,338                         |      | 239,199          |  
|                                                                      
|Total operating expenses                                               |  | 11,532,685                      |      | 13,158,323       |  
|                                                                      
|Operating  loss                                                        |  | (707,011                        | )    | (2,658,589       | )
|                                                                      
|Other expense, net:                                                    | 
|Interest expense                                                       |  | 631,909                         |      | 748,743          |  
|Other income                                                           |  | (112,791                        | )    | (21,897          | )
|                                                                      
|Total other expense                                                    |  | 519,118                         |      | 726,846          |  
|                                                                      
|Loss before benefit for income taxes                                   |  | (1,226,129                      | )    | (3,385,435       | )
|Benefit for income taxes                                               |  | (47,151                         | )    | (3,540           | )
|                                                                      
|Net Loss                                                               |  | $ (1,178,978                    | )    | $ (3,381,895     | )
|                                                                      
|Net loss per common share - basic and diluted                          |  | $          (0.03                | )    | $          (0.09 | )
|                                                                      
|Shares used in computing net loss per common share - basic and diluted |  | 40,231,128                      |      | 38,091,726       |  
|                                                                      

See accompanying consolidated notes.

5

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                            |  |                                 |      |                |  
|----------------------------------------------------------- |  | ------------------------------- | ---- | -------------- | -
|Condensed Consolidated Statements of Cash Flows (Unaudited) | 
|                                                            |  | Nine months ended September 30,
|                                                            |  | 2009                            | 2008
|                                                           
|Operating Activities                                        |  |                                 |      |                |  
|Net loss                                                    |  | $ (1,178,978                    | )    | $ (3,381,895   | )
|Adjustments to reconcile net loss to net                    | 
|cash provided by (used in) operating activities:            | 
|Depreciation of equipment and improvements                  |  | 622,171                         |      | 661,001        |  
|Amortization of intangible assets                           |  | 987,380                         |      | 865,920        |  
|Amortization of deferred financing costs                    |  | 108,512                         |      | 93,583         |  
|Recovery of bad debts                                       |  | (87,044                         | )    | 36,351         |  
|Allowance for sales adjustments                             |  | 630,679                         |      | 504,938        |  
|Provision for inventory obsolescence                        |  | 257,702                         |      | 184,323        |  
|Deferred rent expense                                       |  | 51,529                          |      | (43,808        | )
|Compensation charge for employee stock options              |  | 668,658                         |      | 593,446        |  
|Compensation charge for restricted stock                    |  | 18,148                          |      | 36,315         |  
|Gain on sale of equipment                                   |  | (59,031                         | )    | -              |  
|Deferred income taxes                                       |  | (21,363                         | )    | (3,540         | )
|Changes in operating assets and liabilities:                | 
|Accounts receivable                                         |  | (394,402                        | )    | (882,229       | )
|Inventories                                                 |  | 1,630,394                       |      | (2,804,745     | )
|Prepaid expenses and other current assets                   |  | (70,629                         | )    | 372,001        |  
|Other assets                                                |  | (452                            | )    | (7,661         | )
|Accounts payable                                            |  | (802,634                        | )    | (140,550       | )
|Accrued expenses and other current liabilities              |  | (763,821                        | )    | (1,754,745     | )
|Other long-term liabilities                                 |  | 8,788                           |      | 40,069         |  
|                                                           
|Net cash provided by (used in) operating activities         |  | 1,605,607                       |      | (5,631,226     | )
|                                                           
|Investing Activities                                        | 
|Costs of acquiring businesses                               |  | -                               |      | (120,484       | )
|Purchase of equipment and improvements                      |  | (185,222                        | )    | (353,344       | )
|Refund of acquired business escrow funds                    |  | -                               |      | 1,193,187      |  
|Proceeds from sale of equipment                             |  | 61,000                          |      | -              |  
|                                                           
|Net cash (used in) provided by investing activities         |  | (124,222                        | )    | 719,359        |  
|                                                           
|Financing Activities                                        | 
|Net change in bank line of credit                           |  | (611,016                        | )    | 3,469,395      |  
|Deferred financing costs                                    |  | -                               |      | (269,235       | )
|Long-term debt repayments                                   |  | (975,339                        | )    | (983,335       | )
|Net change in restricted cash                               |  | (15,142                         | )    | (2,004,304     | )
|Proceeds from issuance of stock, net of costs               |  | (9,290                          | )    | 5,728,506      |  
|                                                           
|Net cash (used in) provided by financing activities         |  | (1,610,787                      | )    | 5,941,027      |  
|                                                           
|Effect of exchange rate changes on cash                     |  | 138,362                         |      | (33,544        | )
|                                                           
|Net increase in cash and cash equivalents                   |  | 8,960                           |      | 995,616        |  
|Cash and cash equivalents                                   | 
|Beginning of period                                         |  | 391,038                         |      | 577,096        |  
|                                                           
|End of period                                               |  | $     399,998                   |      | $  1,572,712   |  
|                                                           
|Supplemental disclosures of cash flow information:          | 
|Equipment obtained with capital lease                       |  | $           -                   |      | $       96,324 |  
|Cash paid during the period for:                            | 
|Interest                                                    |  | $     494,704                   |      | $     618,027  |  
|                                                           

See accompanying consolidated notes.

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) is a full line provider of
wound care, wound closure and 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 facilities are located
in St. Louis, Missouri and Houston, Texas, while the Companys Canadian distribution
facility is located in Toronto. The Company has manufacturing facilities in Toronto,
Canada and Nantong, China.

Basis
of Presentation

The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-Q and Article 8 of
Regulation S-X. 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 months ended September 30, 2009, are
not necessarily indicative of the results that may be expected for the year ending
December 31, 2009. Information included in the condensed balance sheet as of December 31,
2008 has been derived from the consolidated financial statements and footnotes thereto for
the year ended December 31, 2008, included in Form 10-K previously filed with the
Securities and Exchange Commission. For further information, refer to that Form 10-K.

Recent
Accounting Pronouncements

Effective
January 1, 2009, the Financial Accounting Standards Board (FASB) issued
new guidance related to assessing whether an equity-linked financial instrument (or
embedded feature) is indexed to an entitys own stock for the purposes of determining
whether such equity-linked financial instrument (or embedded feature) is subject to
derivative accounting. We adopted this new guidance effective January 1, 2009 which
had no impact on the consolidated financial statements.

In
April 2009, the FASB issued additional guidance requiring fair value disclosures in
both interim as well as annual financial statements in order to provide more timely
information about the effects of current market conditions on financial instruments. The
guidance is effective for interim and annual periods ending after June 15, 2009, and
we adopted this guidance commencing with our June 30, 2009 consolidated financial
statements. The implementation of this standard did not have a material impact on our
consolidated balance sheet and operating results.

In
May 2009, the FASB issued new guidance on the reporting of subsequent events which
establishes general standards of accounting for and disclosure of events that occur after
the balance sheet date but before financial statements are issued or are available to be
issued.  This statement sets forth the circumstances under which an entity should
recognize events or transactions occurring after the balance sheet date in its financial
statements. The guidance also requires the disclosure of the date through which an entity
has evaluated subsequent events and the basis for that date  that is, whether that
date represents the date the financial statements were issued or were available to be
issued.  We adopted this standard during the three months ended June 30, 2009 and
have evaluated subsequent event activity through the date and time the quarter ended
September 30, 2009 financial statements were issued on November 13, 2009.

On
July 1, 2009, the FASB issued the FASB Accounting Standards Codification (the
Codification). The Codification became the single source of authoritative
nongovernmental U.S. GAAP, superseding existing literature of the FASB, American Institute
of Certified Public Accountants, Emerging Issues Task Force and other sources. The
Codification was effective for interim and annual periods ending after September 15,
2009. We adopted the Codification for the quarter ended September 30, 2009. There was
no impact on our consolidated balance sheet and results of operations as this change is
disclosure-only in nature.

7

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

In
September 2009, the FASB issued amendments to the accounting and disclosure for revenue
recognition. These amendments, effective for fiscal years beginning on or after
June 15, 2010 (early adoption is permitted), modify the criteria for recognizing
revenue in multiple element arrangements and the scope of what constitutes a non-software
deliverable. The impact of the adoption of these amendments will depend on the nature of
the arrangements that we enter into subsequent to the date we adopt the amendments.

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, 2009 and three and nine months ended
September 30, 2008 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, 2009 and 2008 are outlined below:

|                                 |  |                                  |  |                                 |  |            |  |            | 
|-------------------------------- |  | -------------------------------- |  | ------------------------------- |  | ---------- |  | ---------- | 
|                                 |  | Three Months Ended September 30, |  | Nine Months Ended September 30, | 
|                                 |  | 2009                             |  | 2008                            |  | 2009       |  | 2008       | 
|                                
|Weighted average common shares   |  |                                  |  |                                 |  |            |  |            | 
|outstanding  basic              |  | 40,315,743                       |  | 40,140,743                      |  | 40,231,128 |  | 38,091,726 | 
|Dilutive shares attributable to: | 
|Convertible preferred stock      |  | 2,280,407                        |  |                                |  |           |  |           | 
|Restricted common stock          |  |                                 |  |                                |  |           |  |           | 
|Warrants                         |  | 12,598                           |  |                                |  |           |  |           | 
|Stock options                    |  | 322,553                          |  |                                |  |           |  |           | 
|                                
|Sub-total dilutive shares        |  | 2,615,558                        |  |                                |  |           |  |           | 
|                                
|Weighted average common          | 
|shares outstanding  diluted     |  | 42,931,301                       |  | 40,140,743                      |  | 40,231,128 |  | 38,091,726 | 

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, | 
|                            |  | 2009                             |  | 2008                            |  | 2009       |  | 2008       | 
|Dilutive shares:            |  |                                  |  |                                 |  |            |  |            | 
|Convertible preferred stock |  |                                 |  | 2,280,407                       |  | 2,280,407  |  | 2,280,407  | 
|Restricted common stock     |  |                                 |  | 175,000                         |  |           |  | 175,000    | 
|Warrants                    |  | 8,782,661                        |  | 11,405,259                      |  | 8,795,259  |  | 11,405,259 | 
|Stock options               |  | 9,110,572                        |  | 8,331,480                       |  | 9,433,125  |  | 8,331,480  | 
|                           
|Total dilutive shares       |  | 17,893,233                       |  | 22,192,146                      |  | 20,508,791 |  | 22,192,146 | 

Reclassifications
 Certain reclassifications have been made to prior period reported amounts to
conform with the 2009 presentation.

8

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

2.     Inventories

Inventories
include the following:

|                    |  |                   |  |                  | 
|------------------- |  | ----------------- |  | ---------------- | 
|                    |  | September 30,2009 |  | December 31,2008 | 
|                   
|Finished goods      |  | $   6,867,008     |  | $   9,001,269    | 
|Work in process     |  | 319,128           |  | 443,511          | 
|Packaging materials |  | 642,270           |  | 700,948          | 
|Raw materials       |  | 2,960,876         |  | 2,277,314        | 
|                   
|Total inventory     |  | $ 10,789,282      |  | $ 12,423,042     | 

3.     Line of Credit Borrowings

In
November 2007, the Company entered into a new five-year revolving credit agreement
providing for maximum borrowings of $8,000,000 with a U.S. lender. Advances under the
revolving credit agreement may be drawn, from time to time, up to the amount of 85% of
eligible receivables (as defined) and 44% of eligible inventory (as defined). Interest on
outstanding advances under the revolving credit agreement was payable at the LIBOR monthly
rate (the Base Rate) plus 2.75% (the Base Rate Margin). In
addition, the Company pays a monthly unused line fee of 0.5% per annum on the difference
between the daily average amount of advances outstanding under the agreement and
$8,000,000 together with a monthly collateral management fee of $2,000. Outstanding
balances under the agreement 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.

On
March 31, 2009, the Companys U.S. lender agreed to amend the credit and security
agreement to allow the Company to enter into a forbearance agreement with Western Medical
to postpone payment of its promissory note due April 18, 2009 and to allow subsequent
payments on the subordinated debt beginning in April 2010 provided the Company achieves
predetermined liquidity and free cash flow objectives (as defined) and provided Western
Medical further extends for one year the payment of the principal balance, if any,
remaining on the promissory note after giving effect to the April, 2010 payment. In return
for the amendment, the Company agreed to change its base rate for interest charged to a
three month LIBOR rate from a one month LIBOR rate. Further, effective April 1, 2009 the
base rate margin was increased 150 basis points on the revolving line of credit from 2.75%
to 4.25%, on the term loan from 4.25% to 5.75% and on the portion of the term loan secured
by restricted cash from 2.25% to 3.75%. In addition, the Company is obligated to increase
the revolving loan availability on its revolving line of credit to a minimum of $3,000,000
by December 31, 2009. Failure to achieve the minimum revolving loan availability amount
will result in the base rate changing to the greater of 3.00% or the actual rate in
effect. At September 30, 2009 the effective interest rate was 4.53% and the outstanding
balance was $2,835,589 under the amended credit and security agreement.

The
revolving credit agreement, as amended, is subject to financial covenants which require
maintaining a minimum cumulative EBITDA level and certain ratios of fixed charge coverage,
senior debt leverage and total debt leverage as defined in the agreement. Additional
covenants governing permitted investments, indebtedness and liens, together with payments
of dividends and protection of collateral, are also included in the agreement. The amended
revolving credit agreement contains a subjective acceleration provision whereby the lender
can declare a default upon a material adverse change in the Companys business
operations.

Effective
August 13, 2008, the Companys lender agreed to waive all prior financial and
reporting covenant defaults and amend the existing minimum EBITDA, fixed charge coverage,
senior debt leverage and total debt leverage covenants to allow the Company to continue to
implement its growth strategy in line with the lenders minimum liquidity terms.
Amendment of the covenants was predicated upon the Company segregating $2,000,000 in a
restricted account the use of which is subject to the approval of the lender. The
Companys maximum revolver

9

---

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

borrowing capacity remained
unchanged. The Company incurred fees of $25,000 associated with the granting of the
covenant amendment.

Effective
March 28, 2008, the Companys U.S. lender agreed to waive all prior financial and
reporting covenant defaults and amend the existing minimum EBITDA, fixed charge coverage,
senior debt leverage and total debt leverage covenants, to be measured on a quarterly
basis, to allow the Company to implement its growth strategy. Amendment of the covenants
was predicated upon the Companys commitment to raise a minimum of $3,000,000 by May
1, 2008 from the sale of equity and agreement to limit its maximum revolver borrowing to
the lesser of (a) the revolver loan commitment ($8,000,000) or (b) the borrowing base (as
defined), less $1,500,000. Not less than $3,000,000 of the equity infusion was required to
be applied to the outstanding revolver balance which amount is credited as a component of
EBITDA for covenant compliance purposes. The Company incurred fees of $250,000 associated
with the granting of the covenant amendment, together with related expenses of $10,829
which are included as additions to deferred financing costs. In March 2008, the equity
infusion requirement was met (see Note 5).

4.     Long-Term Debt

Long-term
debt consists of the following:

|                          |  |                   |  |                  | 
|------------------------- |  | ----------------- |  | ---------------- | 
|                          |  | September 30,2009 |  | December 31,2008 | 
|                         
|U.S. term loan            |  | $ 3,800,000       |  | $ 4,700,000      | 
|Promissory note           |  | 500,000           |  | 500,000          | 
|Capital lease obligations |  | 87,904            |  | 163,243          | 
|                         
|Total debt                |  | 4,387,904         |  | 5,363,243        | 
|                         
|Less:  current maturities |  | 1,773,401         |  | 1,298,207        | 
|                         
|Long-term debt            |  | $ 2,614,503       |  | $ 4,065,036      | 

U.S.
Term Loan

In
November 2007, the Company entered into a five-year $6,000,000 term loan agreement with a
U.S. lender. On March 31, 2009 the term loan agreement was amended. Under the amended
agreement interest on the term loan is payable at the LIBOR three month rate plus 5.75%,
(6.03% at September 30, 2009) and on the portion of the term loan secured by restricted
cash 3.75% (4.03% at September 30, 2009). Monthly payments of principal in the amount of
$100,000 together with interest are due under the amended agreement. The amended agreement
is 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
amended term loan agreement is subject to financial covenants which require maintaining a
minimum cumulative EBITDA level and certain ratios of fixed charge coverage, senior debt
leverage and total debt leverage as defined in the agreement. Additional covenants
governing permitted investments, indebtedness and liens, together with payments of
dividends and protection of collateral, are also included in the amended agreement. The
amended term loan agreement contains a subjective acceleration provision whereby the
lender can declare a default upon a material adverse change in the Companys business
operations.

Effective
August 13, 2008 and March 28, 2008, the foregoing financial covenants were amended as
described in the fourth and fifth paragraphs under the heading Line of Credit Borrowings
(see Note 3).

10

---

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

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 promissory note originally provided for the payment of simple interest of 12% in 11
quarterly installments of $15,000 and a final payment of accrued interest of $15,000 and
the principal balance of $500,000 on April 18, 2009.

On
March 31, 2009, the Company entered into a Forbearance Agreement (the
Agreement) with Western Medical to postpone payment of its $500,000 promissory
note due April 18, 2009. The Company will continue to make interest payments when due and
a final payment of the principal plus accrued interest through the date of payment on
April 14, 2010. In consideration for the postponement, the Company agreed to grant Western
Medical warrants to purchase 50,000 shares of the Companys common stock at the
market price on the date of execution of the Agreement. The value of the warrants is being
recognized as interest expense over the postponement period.

Capital
Lease Obligations

The
Company has two capital lease obligations for certain office furniture and distribution
equipment totaling $87,904 as of September 30, 2009. The capital lease obligations bear
interest at annual rates ranging from 6.8% to 9.6% with the longest lease term expiring in
February 2011.

5.     ShareholdersEquity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at September 30,
2009. 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,
2009. 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,
2009. 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,
2009. 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

Effective
May 12, 2009, 175,000 shares of common stock were issued to outside directors upon vesting
of compensatory restricted stock granted on May 12, 2006.

In
March 2008, the Company raised $5,610,871 (net of $489,129 in commission and other
offering expenses) from the private sale of 6,100,000 shares of common stock at a price of
$1.00 per share, together with 3,050,000 five-year warrants to purchase one share of
common stock at a price of $1.20 per share. In addition, the placement agent for the
shares sold received 142,500 five-year warrants to purchase one share of common stock at
$1.20 per share. The proceeds were used to meet the minimum equity infusion requirements
associated with the

11

---

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

Companys March 28, 2008
amended bank covenants, support the Companys strategic growth initiatives and
increase working capital.

In
January 2008, the Company issued 210,988 shares of common stock as follows: (a) 100,000
shares in consideration of $105,000 upon exercise of series G warrants, (b) 19,800 shares
in consideration of $12,375 upon exercise of 19,800 stock options, and (c) 91,188 shares
upon cashless exercise of 178,200 stock options.

Stock
Purchase Warrants

At
September 30, 2009, the Company had warrants outstanding to purchase 8,795,259 shares of
the Companys common stock as outlined below:

|       |  |                    |  |                |  |                 | 
|------ |  | ------------------ |  | -------------- |  | --------------- | 
|Series |  | Number of Warrants |  | Exercise Price |  | Expiration Date | 
|      
|H      |  | 2,655,098          |  | $ 1.00         |  | April 30,2011   | 
|I      |  | 754,806            |  | $ 0.72         |  | April 30, 2011  | 
|J      |  | 2,142,855          |  | $ 0.77         |  | May 31, 2013    | 
|K      |  | 3,192,500          |  | $ 1.20         |  | April 1, 2013   | 
|L      |  | 50,000             |  | $ 0.39         |  | March 31, 2014  | 
|      
|Total  |  | 8,795,259          | 

Stock
Options

The
Company has a stock option plan under which options to purchase a maximum of 10,000,000
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. Under the
plan, options to purchase 1,662,500 and 360,000 shares of common stock were granted to
officers, directors, agents and employees for the nine months ended September 30, 2009 and
2008, respectively, with exercise prices ranging from $0.36 to $1.11 per share. For the
nine months ended September 30, 2009 and 2008, 15,000 and 10,000 respectively of plan
options were forfeited and for the nine months ended September 30, 2008, 198,000 plan
options were exercised. As of September 30, 2009, options to purchase 7,777,125 shares of
the Companys common stock were issued and outstanding under the plan.

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, 2009 and 2008, 237,000 and 44,000 non-plan options
expired, respectively. As of September 30, 2009, non-plan options to purchase 1,656,000
shares of the Companys common stock were issued and outstanding.

12

---

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

A
summary of the Companys stock option activity and related information for the nine
months ended September 30, 2009 and 2008 follows:

|                            |  |           |   |                               |  |           |   |                               | 
|--------------------------- |  | --------- | - | ----------------------------- |  | --------- | - | ----------------------------- | 
|                            |  | 2009      |   | 2008                          | 
|                           
|                            |  | Options   |   | WeightedAverageExercise Price |  | Options   |   | WeightedAverageExercise Price | 
|                           
|Outstanding  January 1     |  | 8,022,625 |   | $ 0.69                        |  | 8,223,480 |   | $ 0.78                        | 
|Granted                     |  | 1,662,500 |   | $ 0.38                        |  | 360,000   |   | $ 0.92                        | 
|Forfeited                   |  | (15,000   | ) | $ 0.70                        |  | (10,000   | ) | $ 1.22                        | 
|Expired                     |  | (237,000  | ) | $ 1.11                        |  | (44,000   | ) | $ 3.22                        | 
|Exercised                   |  | -         |   | $   -                         |  | (198,000  | ) | $ 0.63                        | 
|                           
|Outstanding  September 30  |  | 9,433,125 |   | $ 0.63                        |  | 8,331,480 |   | $ 0.78                        | 
|                           
|Exercisable at September 30 |  | 6,791,250 |   | $ 0.67                        |  | 6,358,980 |   | $ 0.81                        | 

During
the nine months ended September 30, 2009 and 2008 the fair value of each service and
performance based option award was estimated at the date of grant using the Black-Scholes
option pricing model. The weighted-average assumptions used during the three and nine
months ended September 30, 2009 and 2008 were as follows:

|                             |                                 |                                |        |        
|---------------------------- | ------------------------------- | ------------------------------ | ------ | -------
|                             | Three Months EndedSeptember 30, | Nine Months EndedSeptember 30,
|                            
|                             | 2009                            | 2008                           | 2009   | 2008   
|                            
|Risk-free interest rate      | 2.88%                           | 3.30%                          | 2.31%  | 3.08%  
|Volatility factor            | 83.73%                          | 107.5%                         | 92.16% | 118.07%
|Dividend yield               | 0%                              | 0%                             | 0%     | 0%     
|Expected option life (years) | 6.25                            | 6.25                           | 6.25   | 6.25   
|Contractual life (years)     | 10                              | 10                             | 10     | 10     

In
both 2009 and 2008, 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 2009 and 2008, 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. The Company uses a seventy-five month volatility period to coincide with
the expected stock option life. Based on guidance from Staff Accounting Bulletin 107 and
110, a stock option life of 6.25 years was utilized under the simplified method. 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 expire or are
cancelled before becoming fully vested, the Company assumed an annualized forfeiture rate
of 1.0% for all options. 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.

13

---

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

The
weighted average fair value per share of options granted during the nine months ended
September 30, 2009 and 2008 was $0.29 and $0.80, respectively. During the nine months
ended September 30, 2009 and 2008, stock option compensation expense was recorded using
the fair value method under SFAS 123R as follows:

|                                             |  |                                 |  |                                |  |           |  |           | 
|-------------------------------------------- |  | ------------------------------- |  | ------------------------------ |  | --------- |  | --------- | 
|                                             |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30, | 
|                                            
|                                             |  | 2009                            |  | 2008                           |  | 2009      |  | 2008      | 
|                                            
|Cost of sales                                |  | $  23,327                       |  | $  16,158                      |  | $  73,764 |  | $  42,170 | 
|Selling, general and administrative expenses |  | 169,461                         |  | 170,318                        |  | 594,894   |  | 551,276   | 
|                                            
|Total stock option compensation expense      |  | $192,788                        |  | $186,476                       |  | $668,658  |  | $593,446  | 

As
of September 30, 2009, there was $582,257 of unrecognized compensation cost related to
nonvested service based awards, $39,375 nonvested performance based awards and $52,941
nonvested market based awards granted under the plan. That cost is expected to be
recognized over the options remaining weighted average vesting period of 1.47 years
for service and performance based options and 0.15 years for market based options.

For
the nine months ended September 30, 2009 and 2008, no income tax benefit was recognized
related to stock option activity.

Restricted
Common Stock

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

On
May 12, 2006, 175,000 shares of restricted common stock were granted to non-employee
members of the Companys board of directors and vested 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 or $0.83 per share. The fair market value of the grant was recognized
as compensation expense over the three-year service period. For the nine months ended
September 30, 2009 and 2008, $18,148 and $36,315 was recorded in operating expense
respectively for these grants. On May 12, 2009 all of the outstanding restricted common
stock became fully vested.

Shares
Reserved for Future Issuance

At
September 30, 2009, 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         |  | 2,222,875  | 
|Common stock options outstanding                 |  | 9,433,125  | 
|Common stock warrants outstanding (series H - L) |  | 8,795,259  | 
|Restricted common stock available for grant      |  | 2,325,000  | 
|                                                
|Total common stock shares reserved               |  | 25,056,666 | 

14

---

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

6.     Comprehensive Income (Loss)

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

|                                        |  |                                 |  |                                |   |              |   |              |  
|--------------------------------------- |  | ------------------------------- |  | ------------------------------ | - | ------------ | - | ------------ | -
|                                        |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30, |  
|                                       
|                                        |  | 2009                            |  | 2008                           |   | 2009         |   | 2008         |  
|                                       
|Net income (loss) as reported           |  | $ 139,603                       |  | $ (701,619                     | ) | $ (1,178,978 | ) | $ (3,381,895 | )
|Other comprehensive income (loss):      | 
|Foreign currency translation adjustment |  | 363,948                         |  | (267,176                       | ) | 610,150      |   | (454,698     | )
|                                       
|Comprehensive income (loss)             |  | $ 503,551                       |  | $ (968,795                     | ) | $   (568,828 | ) | $ (3,836,553 | )

7.     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, adhesive strips, ointments and sprays. Wound closure and specialty
securement device products include wound closure strips, nasal tube fasteners and a
variety of catheter fasteners. The skin care segment consists of 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 completely outsourced. Wound closure-specialty
securement devices are significantly manufactured in-house. Internally, the segments are
managed at the gross profit level. The aggregation or allocation of other costs by segment
is not practical.

Segment
sales, gross profit and other related information for 2009 and 2008 are as follows:

|               |  |                                       |  |                                           |  |           |  |             |   |                  |  
|-------------- |  | ------------------------------------- |  | ----------------------------------------- |  | --------- |  | ----------- | - | ---------------- | -
|               |  | Three Months Ended September 30, 2009 |  |                                           |  |          
|              
|               |  | Wound Care                            |  | Wound Closure-SpecialtySecurement Devices |  | Skin Care |  | Other Costs |   | Total    Company |  
|              
|Net sales      |  | $ 12,289,311                          |  | $   409,565                               |  | $183,549  |  | -           |   | $ 12,882,425     |  
|              
|Gross profit   |  | 3,765,137                             |  | 231,070                                   |  | 48,064    |  | -           |   | 4,044,271        |  
|Total expenses |  | -                                     |  | -                                         |  | -         |  | $(3,904,668 | ) | (3,904,668       | )
|              
|Net income     |  | $      139,603                        | 

15

---

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

|               |  |                                       |   |                                           |  |           |  |              |   |                  |  
|-------------- |  | ------------------------------------- | - | ----------------------------------------- |  | --------- |  | ------------ | - | ---------------- | -
|               |  | Three Months Ended September 30, 2008 |   |                                           |  |          
|              
|Net sales      |  | $ 12,237,599                          |   | $   388,024                               |  | $206,951  |  | -            |   | $ 12,832,574     |  
|              
|Gross profit   |  | 3,559,460                             |   | 206,085                                   |  | 61,008    |  | -            |   | 3,826,553        |  
|Total expenses |  | -                                     |   | -                                         |  | -         |  | $(4,528,172  | ) | (4,528,172       | )
|              
|Net loss       |  | $    (701,619                         | )
|              
|              
|               |  | Nine Months Ended September 30, 2009  |   |                                           |  |          
|              
|               |  | Wound Care                            |   | Wound Closure-SpecialtySecurement Devices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $ 33,023,590                          |   | $1,307,327                                |  | $546,741  |  | -            |   | $ 34,877,658     |  
|              
|Gross profit   |  | 9,969,307                             |   | 714,272                                   |  | 142,095   |  | -            |   | 10,825,674       |  
|Total expenses |  | -                                     |   | -                                         |  | -         |  | $(12,004,652 | ) | (12,004,652      | )
|              
|Net loss       |  | $(1,178,978                           | )
|              
|              
|               |  | Nine Months Ended September 30, 2008  |   |                                           |  |          
|              
|Net sales      |  | $ 35,696,657                          |   | $1,357,431                                |  | $587,274  |  | -            |   | $ 37,641,362     |  
|              
|Gross profit   |  | 9,591,468                             |   | 742,020                                   |  | 166,246   |  | -            |   | 10,499,734       |  
|Total expenses |  | -                                     |   | -                                         |  | -         |  | $(13,881,629 | ) | (13,881,629      | )
|              
|Net loss       |  | $(3,381,895                           | )

The
following table presents net sales by geographic region.

|              |                                 |                                |      |      | 
|------------- | ------------------------------- | ------------------------------ | ---- | ---- | 
|              | Three Months EndedSeptember 30, | Nine Months EndedSeptember 30, |     
|             
|              | 2009                            | 2008                           | 2009 | 2008 | 
|             
|United States | 72%                             | 72%                            | 72%  | 70%  | 
|Canada        | 23%                             | 24%                            | 22%  | 25%  | 
|Other         | 5%                              | 4%                             | 6%   | 5%   | 

For the
nine months ended September 30, 2009, the Company has a major U.S. customer comprising 14%
of U.S. sales and 5% of U.S. operations trade accounts receivable at September 30, 2009.
The Companys wholly owned Canadian subsidiary sells to one customer who serves as
its exclusive third party distributor and comprises 100% of Canada operations trade
accounts receivable at September 30, 2009.

8. Income Taxes

The
Company recorded a $47,151 and $3,540 foreign income tax benefit for the nine months ended
September 30, 2009 and 2008 respectively, based on the operating results of the
Companys wholly owned Canadian subsidiary. The 2009 benefit was comprised of $25,788
current foreign tax benefit and $21,363 deferred

16

---

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

foreign tax benefit while the 2008
benefit was all deferred. No benefit was realized for the Companys net loss from
U.S. operations in the nine months ended September 30, 2009 and 2008 due to uncertainties
surrounding the Companys ability to utilize its net operating loss carry forwards.

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. 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.

9.     Reverse Stock Split

On
September 24, 2009 the Board of Directors unanimously adopted a resolution approving and
recommending to shareholders for their approval a proposal to grant discretionary
authority to the Board of Directors to amend the Companys certificate of
incorporation in order to: (i) effect a reverse split of the Companys common and
preferred shares (the Reverse Split) at any time within one year after the
date of shareholder approval, at any whole number ratio between 1 for 5 and 1 for 10, with
the exact exchange ratio and timing of the Reverse Split to be determined by the Board of
Directors, and (ii) effect a reduction of the Companys authorized common and
preferred shares by a factor corresponding to the Reverse Split exchange ratio (the
Proposal). On or about October 6, 2009, a Notice of Special Meeting of
Shareholders (Proxy Statement) was sent to shareholders of record as of October 1, 2009,
notifying them of the Proposal and the Special Meeting of Shareholders on November 23,
2009.

With
the exception of a minimum share price, the Company believes it meets the criteria for
listing on one of the national market exchanges. The Reverse Split is designed to enable
the Company to meet the minimum share price requirement. If and when the Proposal is
approved, the Company plans to seek a listing for its common stock on a national market.
The Company believes the Reverse Split could enhance the appeal of its common stock to the
financial community. The Company believes that a number of individual and institutional
investors are reluctant or unable to invest in OTC Bulletin Board companies or companies
with relatively low per share values. The reduction in the number of issued and
outstanding shares of common stock effected by the Reverse Split, together with the
anticipated increased stock price resulting from the Reverse Split, could promote a
broader market for the Companys common stock than that which currently exists.

17

---

Index

Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations

Quarter Ended September 30, 2009
Compared to Quarter Ended September 30, 2008

Overview of Consolidated Operating
Results

The
2009 and 2008 operating results include Derma Sciences, Inc. and our subsidiaries. Unless
otherwise indicated by the context, the terms U.S. operations and Canadian operations are
used throughout this discussion in reference to the U.S. operations and the operations of
Derma Sciences Canada Inc., respectively.

The
following table highlights the quarter ended September 30, 2009 versus 2008 operating
results:

|                                            |  |                             |   |               |   |           |   |         | 
|------------------------------------------- |  | --------------------------- | - | ------------- | - | --------- | - | ------- | 
|                                            |  | Quarter Ended September 30, |  
|                                            |  | 2009                        |   | 2008          |   | Variance  |  
|                                           
|Gross Sales                                 |  | $ 15,356,917                |   | $ 15,468,607  |   | $(111,690 | ) | (0.7%)  | 
|Sales adjustments                           |  | (2,474,492                  | ) | (2,636,033    | ) | (161,541  | ) | (6.1%)  | 
|                                           
|Net sales                                   |  | 12,882,425                  |   | 12,832,574    |   | 49,851    |   | 0.4%    | 
|Cost of sales                               |  | 8,838,154                   |   | 9,006,021     |   | (167,867  | ) | (1.9%)  | 
|                                           
|Gross profit                                |  | 4,044,271                   |   | 3,826,553     |   | 217,718   |   | 5.7%    | 
|                                           
|Selling, general and administrative expense |  | 3,677,182                   |   | 4,115,154     |   | (437,972  | ) | (10.6%) | 
|Research and development expense            |  | 70,412                      |   | 84,891        |   | (14,479   | ) | (17.1%) | 
|Interest expense                            |  | 220,839                     |   | 251,256       |   | (30,417   | ) | (12.1%) | 
|Other income, net                           |  | (69,002                     | ) | (1,419        | ) | (67,583   | )
|                                           
|Total expenses                              |  | 3,899,431                   |   | 4,449,882     |   | (550,451  | ) | (12.4%) | 
|                                           
|Income/(loss) before income taxes           |  | 144,840                     |   | (623,329      | ) | 768,169   |  
|                                           
|Provision for income taxes                  |  | 5,237                       |   | 78,290        |   | (73,053   | )
|                                           
|Net income/(loss)                           |  | $      139,603              |   | $    (701,619 | ) | $ 841,222 |  

Gross to Net Sales Adjustments

Gross
sales are adjusted for trade rebates, distributor fees (in Canada), sales incentives,
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. Non-exclusive distributors generally carry one months
inventory. Our exclusive distributor in Canada normally carries two and one-half to three
and one-half months inventory. As distributor inventory is depleted via sales, it is
replenished via purchases from us. Rebates are processed and submitted for credit on a
timely basis consistent with distributor sales. To minimize their cash outflow invested in
rebates, distributors generally strive to optimize the rebate credit submission process.

Historical
trends of sales subject to rebate and rebates received are evaluated monthly, by
distributor, on a three month, six month and twelve 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.

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

18

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Index

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.

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, |  
|                       |  | 2009                        |   | 2008         |  
|                      
|Gross Sales            |  | $ 15,356,917                |   | $ 15,468,607 |  
|                      
|Trade rebates          |  | (1,820,697                  | ) | (1,920,398   | )
|Distributor fees       |  | (266,783                    | ) | (291,178     | )
|Sales incentives       |  | (164,711                    | ) | (173,980     | )
|Returns and allowances |  | (118,355                    | ) | (128,459     | )
|Cash discounts         |  | (103,946                    | ) | (122,018     | )
|                      
|Total adjustments      |  | (2,474,492                  | ) | (2,636,033   | )
|                      
|Net sales              |  | $ 12,882,425                |   | $ 12,832,574 |  

Trade rebates
decreased in 2009 versus 2008 due principally to lower Canadian sales subject to rebate
which, in turn, resulted from lower demand as a result of the exclusive Canadian
distributor reducing its inventory, unfavorable exchange and a slight increase in sales
not subject to rebate. U.S. rebates increased slightly due to an increase in regular and
private label sales subject to rebate, coupled with an increase in the percentage of
rebates to sales due to list price increases (without a commensurate increase in contract
pricing). The decrease in distribution fee expense is commensurate with the change in
Canadian net sales upon which it is based, coupled with a small increase in the amount of
sales not subject to the fee. The decrease in sales incentive expense relates principally
to lower incentive related traditional wound care sales. The sales returns and allowances
decrease is principally due to the non-recurrence of higher FAD integration related
returns and allowances in 2008. The decrease in cash discounts principally reflects lower
U.S. sales subject to cash discount.

Rebate Reserve Roll Forward

A
three month roll forward of the trade rebate accruals at September 30, 2009 and 2008 are
outlined below:

|                              |  |                             |   |             |  
|----------------------------- |  | --------------------------- | - | ----------- | -
|                              |  | Quarter Ended September 30, |  
|                              |  | 2009                        |   | 2008        |  
|                             
|Beginning balance  June 30   |  | $ 2,309,304                 |   | $ 3,050,302 |  
|Rebates paid                  |  | (1,759,195                  | ) | (2,096,119  | )
|Rebates accrued               |  | 1,820,697                   |   | 1,920,398   |  
|                             
|Ending balance  September 30 |  | $ 2,370,806                 |   | $ 2,874,581 |  

The
$61,502 increase in the trade rebate reserve balance for the three months ended September
30, 2009 principally reflects a higher level of sales subject to rebate during the quarter
and a slight delay in the submission of rebates for payment. There has been no other
discernable change in the nature of our business as it relates to the accrual and
subsequent payment of rebates.

19

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Index

Net Sales and Gross Margin

The
following table highlights the September 30, 2009 versus 2008 product line net sales and
gross profit:

|               |  |                             |  |              |  |             |   |        | 
|-------------- |  | --------------------------- |  | ------------ |  | ----------- | - | ------ | 
|               |  | Quarter Ended September 30, | 
|               |  | 2009                        |  | 2008         |  | Variance    |  
|              
|Net Sales      |  | $ 12,882,425                |  | $ 12,832,574 |  | $    49,851 |   | 0.4%   | 
|              
|Cost of sales  |  | 8,838,154                   |  | 9,006,021    |  | (167,867    | ) | (1.9%) | 
|              
|Gross Profit   |  | $  4,044,271                |  | $  3,826,553 |  | $ 217,718   |   | 5.7%   | 
|              
|Gross Profit % |  | 31.4%                       |  | 29.8%        | 

Consolidated
net sales increased $49,851, or 0.4% (1.5% adjusted for exchange), in 2009 versus 2008.
Canadian net sales decreased $184,310, or 6.0%, to $2,893,529 in 2009 from $3,077,839 in
2008. This decrease was driven by unfavorable exchange of $147,865 associated with a 5.4%
weakening of the Canadian dollar and lower sales of $36,445. Inventory rationalization on
the part of our exclusive Canadian distributor is principally responsible for the lower
sales. Real growth as measured by sales of our products reported by our exclusive
distributor, unadjusted for foreign exchange, approximated 3.0%. U.S. net sales increased
$234,161, or 2.4%, to $9,988,896 in 2009 from $9,754,735 in 2008. The increase was driven
by higher advanced wound care sales of $942,859 and private label sales of $407,382
partially offset by lower FAD sales of $1,069,599 and traditional wound care sales of
$51,333. Sales of the balance of our core line of products were essentially flat quarter
to quarter. The higher advanced wound care sales reflect continued growth of MEDIHONEY
together with the balance of the product line in response to our focused sales and
marketing effort. Gross U.S. MEDIHONEY sales increased $373,392, or 98.5%, to $752,560 in
2009 versus $379,168 in 2008. BIOGUARD, our new novel anti-microbial advanced wound care
product launched in June, recorded gross sales of $339,413 in its first full quarter.
XTRASORB and MedEfficiency also exhibited strong growth during the quarter. The private
label increase was attributable to increased demand from a number of our key customers.
The lower FAD sales reflect lower demand and customers reducing their inventories in
response to the economy and lost business. The lower traditional wound care sales reflect
lower demand. While unfavorable to prior year, both FAD and traditional wound care third
quarter sales represented a 8.9% and 7.2% improvement respectively, over second quarter
sales. Excluding FAD, U.S. sales increased $1,303,760, or 24.2%.

Consolidated
gross profit increased $217,718, or 5.7%, in 2009 versus 2008. The consolidated gross
profit margin percentage increased to 31.4% in 2009 from 29.8% in 2008. Canadian gross
profit decreased $339,616, or 31.7%, to $730,813 in 2009 from $1,070,429 in 2008. The
Canadian gross profit margin percentage decreased to 25.3% in 2009 from 34.8% in 2008. The
decrease in Canadian 2009 gross profit dollars reflects the lower sales and gross profit
margin percentage. The decrease in Canadian gross profit margin percentage principally
reflects the adverse effect of price erosion coupled with higher product costs partially
offset by the favorable impact of higher production volumes on overhead absorption and
lower overhead spending in 2009 versus 2008. U.S. gross profit increased $557,334, or
20.2%, to $3,313,458 in 2009 from $2,756,124 in 2008. The U.S. gross profit margin
percentage increased to 33.2% in 2009 from 28.3% in 2008. The increase in U.S. gross
profit dollars reflects the higher sales and gross profit margin percentage. The increase
in gross profit margin percentage is attributable to the improvement in FAD margin due to
the discontinuation of higher cost domestic manufacturing in the fourth quarter 2008,
favorable mix on the non-FAD sales driven principally by growth of the higher margined
advanced wound care business and lower freight costs, partially offset by higher product
costs. Excluding FAD, favorable product mix partially offset by higher product costs
served to increase U.S. margin dollars $599,517, or 33.7%, and the gross profit percentage
to 35.6% from 33.1%.

20

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Index

Selling, General and Administrative
Expenses

The
following table highlights September 30, 2009 versus 2008 selling, general and
administrative expenses by type:

|                           |  |                             |  |              |  |             |   |         | 
|-------------------------- |  | --------------------------- |  | ------------ |  | ----------- | - | ------- | 
|                           |  | Quarter Ended September 30, | 
|                           |  | 2009                        |  | 2008         |  | Variance    |  
|                          
|Distribution               |  | $    443,592                |  | $    428,301 |  | $    15,291 |   | 3.6%    | 
|Marketing                  |  | 371,624                     |  | 405,588      |  | (33,964     | ) | (8.4%)  | 
|Sales                      |  | 1,306,140                   |  | 1,501,476    |  | (195,336    | ) | (13.0%) | 
|General and administrative |  | 1,555,826                   |  | 1,779,789    |  | (223,963    | ) | (12.6%) | 
|                          
|Total                      |  | $ 3,677,182                 |  | $ 4,115,154  |  | $ (437,972  | ) | (10.6%) | 

Selling,
general and administrative expenses decreased $437,972, or 10.6%, in 2009 versus 2008,
including a decrease of $30,720 in Canadian selling, general and administrative expenses
attributable to exchange.

Distribution
expense increased $15,291, or 3.6%, in 2009 versus 2008. Expenses in Canada decreased
$6,075 (including a $2,951 benefit related to exchange) while expenses in the U.S
decreased $21,366. The U.S. increase was principally driven by higher lease costs in St.
Louis and Houston, partially offset by lower compensation and operating expenses.

Marketing
expense decreased $33,964, or 8.4%, in 2009 versus 2008. Expenses in Canada decreased
$20,645 (including a $1,433 benefit related to exchange) while expenses in the U. S.
decreased $13,319. The decrease in Canada reflects lower sampling and show expenses in
2009 versus 2008 in connection with the launch of Medihoney. The U.S. decrease stems from
the planned reduction in advanced wound care clinical personnel, consulting, trade show
and promotion expense in 2009 in order to align costs with available financial resources.

Sales
expense decreased $195,336, or 13.0%, in 2009 versus 2008. Expenses in Canada decreased
$5,194 (including a $9,435 benefit related to exchange) while expenses in the U.S.
decreased $190,142. Excluding exchange, expenses in Canada increased $4,241 due to higher
consulting and group purchasing organization (rate increase) expenses, partially offset by
lower travel and commission expenses. The U.S. decrease was attributable to lower
compensation expenses associated with open (timing related) sales representative
positions, the non-recurrence of incremental integration related compensation expenses in
customer service, lower FAD broker commissions due to lower sales and lower travel and
sample expenses due to cost reduction initiatives. Offsetting these decreases were higher
sales tracing expense associated with implementation of a more structured sales tracing
program in 2008.

General
and administrative expense decreased $223,963, or 12.6%, in 2009 versus 2008. Expenses in
Canada increased $31,877 (including a $16,901 benefit related to exchange) while expenses
in the U.S. decreased $255,840. Excluding exchange, the $48,778 increase in Canada
reflects principally higher timing related employee benefit, Sarbanes Oxley consulting and
depreciation expenses. The U.S. decrease principally reflects the non-recurrence of a
significant provision for bad debts in 2008, coupled with lower compensation and benefit,
travel, investor relations and other operating expenses due to cost reduction initiatives
and lower legal expenses, partially offset by higher FAD acquisition related intangible
asset amortization expense.

Research and Development Expense

Research
and development expense decreased $14,479 to $70,412 in 2009 from $84,891 in 2008. The
decrease reflects the timing of expenses associated with ongoing patent related legal and
development costs associated with the DSC127 Phase II clinical trial initiated in the
first quarter 2008.

Interest Expense

Interest
expense decreased $30,417 to $220,839 in 2009 from $251,256 in 2008. The decrease is
attributable to lower interest rates coupled with lower line of credit and term loan
borrowing levels in 2009 versus 2008, partially offset by higher loan related fees.

21

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Index

Other Income

Other
income increased $67,583 to $69,002 in 2009 from $1,419 in 2008. The main
driver for the increase was higher exchange gains in Canada, partially offset by higher
miscellaneous net expense.

Income Taxes

We
recorded a $5,237 tax provision for 2009 consisting of a $3,895 current foreign tax
provision and a $1,342 deferred foreign tax benefit based on the our Canadian
subsidiarys operating results. No tax benefit was recorded for our U.S. operations in
2009 due to uncertainty surrounding our ability to use available net operating loss carry
forwards and net deferred tax assets. We recorded a $78,290 deferred foreign tax expense
in 2008 related to our Canadian subsidiarys operating results.

Due
to uncertainties surrounding our ability to use our 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.

Net Income (Loss)

We
generated net income of $139,603, or $0.00 per share (basic and diluted), in 2009 compared
to a net loss of $701,619, or $0.02 per share (basic and diluted), in 2008.

22

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Index

Nine Months Ended September 30, 2009
Compared to Nine Months Ended September 30, 2008

Overview

The
following table highlights the nine months ended September 30, 2009 versus 2008 operating
results:

|                                            |  |                                 |   |               |   |              |   |         | 
|------------------------------------------- |  | ------------------------------- | - | ------------- | - | ------------ | - | ------- | 
|                                            |  | Nine Months Ended September 30, |  
|                                            |  | 2009                            |   | 2008          |   | Variance     |  
|                                           
|Gross Sales                                 |  | $  41,668,350                   |   | $  45,524,044 |   | $ (3,855,694 | ) | (8.5%)  | 
|Sales adjustments                           |  | (6,790,692                      | ) | (7,882,682    | ) | (1,091,990   | ) | (13.9%) | 
|                                           
|Net sales                                   |  | 34,877,658                      |   | 37,641,362    |   | (2,763,704   | ) | (7.3%)  | 
|Cost of sales                               |  | 24,051,984                      |   | 27,141,628    |   | (3,089,644   | ) | (11.4%) | 
|                                           
|Gross profit                                |  | 10,825,674                      |   | 10,499,734    |   | 325,940      |   | 3.1%    | 
|                                           
|Selling, general and administrative expense |  | 11,244,347                      |   | 12,919,124    |   | (1,674,777   | ) | (13.0%) | 
|Research and development expense            |  | 288,338                         |   | 239,199       |   | 49,139       |   | 20.5%   | 
|Interest expense                            |  | 631,909                         |   | 748,743       |   | (116,834     | ) | (15.6%) | 
|Other income, net                           |  | (112,791                        | ) | (21,897       | ) | (90,894      | )
|                                           
|Total expenses                              |  | 12,051,803                      |   | 13,885,169    |   | (1,833,366   | ) | (13.2%) | 
|                                           
|Loss before income taxes                    |  | (1,226,129                      | ) | (3,385,435    | ) | 2,159,306    |   | 63.8%   | 
|                                           
|Provision for income taxes                  |  | (47,151                         | ) | (3,540        | ) | (43,611      | ) |         | 
|                                           
|Net loss                                    |  | $ (1,178,978                    | ) | $ (3,381,895  | ) | $  2,202,917 |   | 65.1%   | 

Gross to Net Sales Adjustments

Gross
to net sales adjustments comprise the following:

|                       |  |                                 |   |              |  
|---------------------- |  | ------------------------------- | - | ------------ | -
|                       |  | Nine Months Ended September 30, |  
|                       |  | 2009                            |   | 2008         |  
|                      
|Gross Sales            |  | $ 41,668,350                    |   | $ 45,524,044 |  
|                      
|Trade rebates          |  | (4,934,121                      | ) | (5,831,141   | )
|Distributor fees       |  | (711,980                        | ) | (887,655     | )
|Sales incentives       |  | (453,411                        | ) | (359,581     | )
|Returns and allowances |  | (384,403                        | ) | (452,702     | )
|Cash discounts         |  | (306,777                        | ) | (351,603     | )
|                      
|Total adjustments      |  | 6,790,692                       |   | 7,882,682    |  
|                      
|Net sales              |  | $ 34,877,658                    |   | $ 37,641,362 |  

Trade rebates
decreased in 2009 versus 2008 due principally to lower Canadian sales subject to rebate
which, in turn, resulted from lower demand as a result of the exclusive Canadian
distributor reducing its inventory, unfavorable exchange, and a slight increase in sales
not subject to rebate. U.S. rebates increased due to an increase in regular and private
label sales subject to rebate, coupled with an increase in the percentage of rebates to
sales due to list price increases (without a commensurate increase in contract pricing).
The decrease in distribution fee expense is commensurate with the change in Canadian net
sales upon which it is based. The increase in sales

23

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Index

incentive expense relates
principally to an expansion of the FAD sales incentive program together with an increase
in the level of sales subject to incentives. The sales returns and allowances decrease is
principally due to the non-recurrence of higher FAD integration related returns and
allowances in 2008. The decrease in cash discounts reflects lower U.S. sales subject to
cash discount.

Rebate Reserve Roll Forward

A
nine month roll forward of the trade rebate accruals at September 30, 2009 and 2008 is
outlined below:

|                              |  |                                 |   |             |  
|----------------------------- |  | ------------------------------- | - | ----------- | -
|                              |  | Nine Months Ended September 30, |  
|                              |  | 2009                            |   | 2008        |  
|                             
|Beginning balance  January 1 |  | $ 2,660,086                     |   | $ 2,407,709 |  
|Rebates paid                  |  | (5,223,401                      | ) | (5,364,269  | )
|Rebates accrued               |  | 4,934,121                       |   | 5,831,141   |  
|                             
|Ending balance  September 30 |  | $ 2,370,806                     |   | $ 2,874,581 |  

The
$289,280 decrease in the trade rebate reserve balance for the nine months ended September
30, 2009 reflects the timing of payment of U.S. private label rebates coupled with a
reduction in the Canadian reserve due to lower sales to the exclusive Canadian distributor
in response to the distributors plan to reduce its investment in inventory. There
has been no other discernable change in the nature of the our business year-to-date as it
relates to the accrual and subsequent payment of rebates.

Net Sales and Gross Margin

The
following table highlights the September 30, 2009 versus 2008 product line net sales and
gross profit:

|               |  |                                 |  |             |  |              |   |         | 
|-------------- |  | ------------------------------- |  | ----------- |  | ------------ | - | ------- | 
|               |  | Nine Months Ended September 30, | 
|               |  | 2009                            |  | 2008        |  | Variance     |  
|              
|Net Sales      |  | $34,877,658                     |  | $37,641,362 |  | $(2,763,704  | ) | (7.3%)  | 
|              
|Cost of sales  |  | 24,051,984                      |  | 27,141,628  |  | (3,089,644   | ) | (11.4%) | 
|              
|Gross Profit   |  | $10,825,674                     |  | $10,499,734 |  | $    325,940 |   | 3.1%    | 
|              
|Gross Profit % |  | 31.0%                           |  | 27.9%       | 

Consolidated
net sales decreased $2,763,704, or 7.3% (4.1% adjusted for exchange), in 2009 versus 2008.
Canadian net sales decreased $1,730,747, or 18.1%, to $7,843,218 in 2009 from $9,573,965
in 2008. This decrease was driven by unfavorable exchange of $1,231,370 associated with a
14.8% weakening of the Canadian dollar and lower sales of $499,377. Inventory
rationalization on the part of the Companys exclusive Canadian distributor is
principally responsible for the lower sales. Real growth as measured by sales of the
Companys products reported by its exclusive distributor, unadjusted for foreign
exchange, approximated 7.1%. U.S. net sales decreased $1,032,957, or 3.7%, to $27,034,440
in 2009 from $28,067,397 in 2008. The decrease was driven by lower FAD sales of
$3,527,817, or 27.4% and traditional wound care sales of $358,331, or 7.2%, partially
offset by higher advanced wound care sales of $1,965,451, or 60.5% and private label sales
of $961,105, or 19.3%. Specialty fixation, burn care and skin care and bathing sales were
down $73,365, or 3.8%, period to period. The lower FAD sales reflect the non-recurrence of
higher sales in 2008 due to integration related backorder fulfillment, lower demand and
customers rationalizing their inventory in 2009 in response to the economy and lost
business. The lower traditional wound care sales reflect the non-recurrence of a spot sale
(customers normal supplier was unable to supply) realized in 2008 and lower demand.
The higher advanced wound care sales reflect continued growth of MEDIHONEY together with
the balance of the product line in response to the Companys focused sales and
marketing effort. Gross U.S. MEDIHONEY sales increased $928,433, or 95.9%, to $1,896,503
in 2009 versus $968,070 in 2008. BIOGUARD, our new novel anti-microbial advanced wound
care product launched in June, recorded gross sales of $397,871 in its first four months.
Algicell AG, XTRASORB and MedEfficiency have also

24

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Index

exhibited strong growth in 2009. The
increase in private label sales reflects improved demand from a number of our core
customers, coupled with some modest new business that is expected to contribute to the
private label segments future growth. Excluding FAD, U.S. sales increased $2,494,860, or
16.4%.

Consolidated
gross profit increased $325,940, or 3.1%, in 2009 versus 2008. The consolidated gross
profit margin percentage increased to 31.0% in 2009 from 27.9% in 2008. Canadian gross
profit decreased $766,008, or 26.7%, to $2,104,664 in 2009 from $2,870,672 in 2008. The
Canadian gross profit margin percentage decreased to 26.8% in 2009 from 30.0% in 2008. The
decrease in Canadian 2009 gross profit dollars reflects the lower sales and gross profit
margin percentage decrease. The change in Canadian gross profit margin percentage
principally reflects the adverse effect of price erosion coupled with higher product
costs, partially offset by the favorable impact of higher production volumes on labor
efficiency and overhead absorption and lower overhead spending in 2009 versus 2008. U.S.
gross profit increased $1,091,947, or 14.3%, to $8,721,010 in 2009 from $7,629,063 in
2008. The U.S. gross profit margin percentage increased to 32.3% in 2009 from 27.2% in
2008. The increase in U.S. gross profit dollars reflects the increase in gross profit
margin percentage, partially offset by the lower sales. The increase in gross profit
margin percentage is principally attributable to the improvement in FAD margin due to the
discontinuation of higher cost domestic manufacturing in the fourth quarter 2008, growth
of the higher margined advanced wound care business and lower freight costs, partially
offset by higher product costs. Excluding FAD, favorable product mix partially offset by
higher product costs served to increase U.S. margin dollars $1,150,340, or 22.5%, and the
gross profit percentage to 35.4% from 33.6%.

Selling, General and Administrative
Expenses

The
following table highlights September 30, 2009 versus 2008 selling, general and
administrative expenses by type:

|                           |  |                                 |  |               |  |              |   |         | 
|-------------------------- |  | ------------------------------- |  | ------------- |  | ------------ | - | ------- | 
|                           |  | Nine Months Ended September 30, | 
|                           |  | 2009                            |  | 2008          |  | Variance     |  
|                          
|Distribution               |  | $   1,331,067                   |  | $   1,450,481 |  | $   (119,414 | ) | (8.2%)  | 
|Marketing                  |  | 1,201,411                       |  | 1,414,977     |  | (213,566     | ) | (15.1%) | 
|Sales                      |  | 3,743,003                       |  | 4,284,762     |  | (541,759     | ) | (12.6%) | 
|General and administrative |  | 4,968,866                       |  | 5,768,904     |  | (800,038     | ) | (13.9%) | 
|                          
|Total                      |  | $ 11,244,347                    |  | $ 12,919,124  |  | $ (1,674,777 | ) | (13.0%) | 

Selling,
general and administrative expenses decreased $1,674,777, or 13.0%, in 2009 versus 2008,
including a decrease of $285,941 in Canadian selling, general and administrative expenses
attributable to exchange.

Distribution
expense decreased $119,414, or 8.2%, in 2009 versus 2008. Expenses in Canada decreased
$102,164 (including a $34,806 benefit related to exchange) while expenses in the U.S
decreased $17,250. The decrease in Canada was driven by the non-recurrence of incremental
expense related to the buy out of the former distribution center lease in the second
quarter 2008. The U.S. decrease was driven by the non-recurrence of incremental FAD
related integration expenses in Houston incurred in 2008, partially offset by higher lease
costs in Houston and St. Louis together with higher personnel and operating costs in St.
Louis in support of the growing non-FAD business.

Marketing
expense decreased $213,566, or 15.1%, in 2009 versus 2008. The decrease is attributable to
a U.S. decrease of $196,177 coupled with a decrease in Canada of $17,389 (including a
$12,012 benefit related to exchange). The U.S. decrease stems from a planned reduction in
advanced wound care clinical personnel, consulting, travel and trade show and promotion
expense, partially offset by higher product development expense in 2009 in order to align
costs with available financial resources, coupled with an increase in FAD related
marketing reflecting implementation of a full marketing plan in 2009 versus a partial
transition related plan in 2008. The Canada expense decrease reflects lower advanced wound
care promotion expense, partially offset by higher product sampling expenses.

Sales
expense decreased $541,759, or 12.6%, in 2009 versus 2008. Expenses in Canada decreased
$118,493 (including a $79,314 benefit related to exchange) while expenses in the U.S.
decreased $423,269. Expenses in Canada decreased principally due to lower
sales commission due to a change in the sales commission

25

---

Index

program in 2009, direct
representative commission due to lower sales and lower travel costs due to cost reduction
initiatives, partially offset by higher increased rate related group purchasing
organization fees. The U.S. decrease was attributable to lower compensation and
commission expenses associated with open (timing related) sales representative positions
and the non-recurrence of incremental integration related compensation expenses in
customer service, lower FAD broker commissions due to lower sales, lower travel expenses
due to cost reduction initiatives, lower recruiting expenses together with the
non-recurrence in 2009 of FAD integration related expenses. Offsetting these decreases
were higher equity based compensation, regional show and sales tracing expenses
associated with the implementation of a more structured sales tracing program in 2008.

General
and administrative expense decreased $800,038, or 13.9%, in 2009 versus 2008. Expenses in
Canada decreased $165,765 (including a $159,809 benefit related to exchange) while
expenses in the U.S. decreased $634,273. Adjusted for exchange, the $5,956 decrease in
Canada reflects lower compensation due a change in staffing, travel, recruiting and
operating expenses, partially offset by higher equity based compensation, benefits,
insurance and accounting expenses. The U.S. decrease principally reflects lower bad debt
expense of $247,400 due to the non-recurrence of a significant provision for bad debts in
the third quarter of 2008, lower travel of $156,200, investor relations of $134,200 and
compensation of $27,400 expenses due to cost reduction initiatives, non-recurring and
lower legal expenses of $95,600 and non-recurring recruiting expense of $45,700, together
with lower other professional service fees of $27,700 due principally to timing and other
net operating costs of $65,300 due to non-recurrence and cost savings initiatives,
partially offset by incremental intangible asset amortization expense of $165,300 related
to the FAD acquisition.

Research and Development Expense

Research
and development expense increased $49,139 to $288,338 in 2009 from $239,199 in 2008. The
increase reflects higher ongoing patent related legal and development costs associated
with the DSC127 Phase II clinical trial initiated in the first quarter 2008, partially
offset by lower consulting expenses.

Interest Expense

Interest
expense decreased $116,834 to $631,909 in 2009 from $748,743 in 2008. The decrease is
principally attributable to lower interest rates coupled with lower line of credit and
term loan borrowing levels, partially offset by higher loan related fees and lower
interest income in 2009 versus 2008.

Other Income

Other
income increased $90,894 to $112,791 in 2009 from $21,897 in 2008. The main
drivers for the increase were $66,500 of gains on miscellaneous asset sales associated
with the closure of the FAD manufacturing operation together with lower exchange losses,
partially offset by lower royalty income and other miscellaneous income in 2009 versus
2008.

Income Taxes

We
recorded a $47,151 tax benefit for 2009 consisting of a $25,788 current foreign tax
benefit and a $21,363 deferred foreign tax benefit based on our Canadian subsidiarys
operating results. No tax benefit was recorded for our U.S. operations in 2009 due to
uncertainty surrounding our ability to use available net operating loss carry forwards and
net deferred tax assets. We recorded a $3,540 deferred foreign tax benefit in 2008 related
to our Canadian subsidiarys operating results.

Due
to uncertainties surrounding our ability to use our 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.

Net Loss

We
generated a net loss of $1,178,978, or $0.03 per share (basic and diluted), in 2009
compared to a net loss of $3,381,895, or $0.09 per share (basic and diluted), in 2008.

26

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Index

Liquidity and Capital
Resources

Cash Flow and Working Capital

Quarterly
financial performance has improved steadily in 2009 culminating with net income of
$139,603 in the third quarter after losses in the first and second quarters. We reported a
$1,178,978 net loss for the first nine months of 2009 versus a $3,381,895 net loss in the
first nine months of 2008. While sales are lower in 2009, gross profit dollars and margin
percentage increased due to a favorable sales mix (principally reflecting the growth of
the higher margined advanced wound care business), the elimination of higher cost FAD
domestic manufacturing in the fourth quarter 2008 and improved manufacturing performance
in Canada, partially offset by higher product costs. Operating expenses were reduced as
planned, to better align costs with revenues.

The
launch of a number of new products bodes well for the future growth of our higher-margined
advanced wound care product line. While overall FAD sales declined in the first nine
months of 2009 versus 2008, we believe that the FAD product line represents a solid growth
opportunity. Sales for the balance of our product lines are expected to remain relatively
stable. Further, we continue to actively pursue distributors in several countries to
increase our international sales.

Improving
financial performance and other steps taken to improve cash management have served to
improve our liquidity. Operating cash flow has improved in the first nine months of 2009
versus the full year 2008. This is attributable to a significant reduction in net operating
assets and liabilities employed, together with a lower net loss. In 2008, we increased
our investment in inventory approximately $3,600,000. In 2009 this trend was reversed.
Through September 2009 inventories have been reduced approximately $1,630,000. Operating
cash flow is expected to continue to improve over the next twelve months given the
expected improvement in financial performance and continuation of our inventory reduction
initiative.

At
September 30, 2009 and December 31, 2008, we had cash and cash equivalents on hand of
$399,998 and $391,038, respectively. The $8,960 increase in cash reflects net cash
provided by operating activities of $1,605,607 and cash provided as a result of exchange
rate changes of $138,362. These increases were essentially offset by cash used in
financing activities of $1,610,787 and cash used in investing activities of $124,222.

Net
cash provided by operating activities of $1,605,607 stems from $1,998,363 cash provided
from operations (net loss plus non-cash items), together with $392,756 cash used from the
net change in operating assets and liabilities. The increase in cash provided from
operations reflects the non-cash items, partially offset by the operating loss. Lower
accounts payable, accrued liabilities and higher accounts receivable, partially offset by
lower inventory were the main drivers behind the net change in operating assets and
liabilities. The decrease in accounts payable reflects a significant reduction in payables
related to inventory purchases (consistent with the plan to reduce inventory), lower
overall spending levels and timing. The decrease in accrued expenses and other current
liabilities principally reflects payment of 2008 year end accruals and timing related
changes. The increase in accounts receivable reflects higher third quarter sales. The
reduced investment in inventory reflects our plan to reduce inventory levels whenever
possible, without compromising customer service requirements.

Net
cash used in investing activities of $124,222 reflects capital expenditures of $185,222,
less receipt of $61,000 cash from the sale of assets associated with the discontinuation
of FAD domestic manufacturing. Capital expenditures are down in 2009 versus 2008 and no
significant non discretionary expenditures are anticipated over the next twelve months.

Net
cash used in financing activities of $1,610,787 reflects regularly scheduled debt payments
of $975,339, pay down of outstanding line of credit borrowings of $611,016, an increase in
restricted cash of $15,142 and costs related to the issuance of stock of $9,290.

Working
capital decreased $74,507, or 1.1%, at September 30, 2009 to $6,665,144 from $6,739,651 at
December 31, 2008. Excluding the reclassification of the $500,000 promissory note from
long term to current debt in the second quarter 2009, working capital increased $425,493
in the first nine months of 2009 and increased by $702,812 in the third quarter. Working
capital of this magnitude is considered sufficient to support ongoing operations.

27

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Index

Financing Arrangements

On
March 31, 2009, our U.S. lender agreed to amend the credit and security agreement to allow
us to enter into a forbearance agreement with Western Medical to postpone payment of our
$500,000 promissory note due April 2009, for one year until April 2010 and to allow
subsequent payments on the subordinate debt beginning in April 2010. The Western Medical
note payments are conditioned on our achieving predetermined liquidity and free cash flow
(as defined) objectives and Western Medicals further extending for one year the
payment of the principle balance, if any, remaining on the promissory note after giving
effect to the April 2010 payment. In return for the amendment, we agreed to change our
base rate for interest charged to a three month LIBOR rate from a one month LIBOR rate (an
estimated increase of approximately 50 basis points) and increase our base rate margin by
150 basis points effective April 1, 2009. Using market rates as of the date of the
amendment, the estimated cost of the change in interest rates is approximately $15,000 per
month.

In
August 2008, we and our U.S. lender modified the terms of our five-year revolving credit
and security agreement. The modified terms amend the existing minimum EBITDA, fixed charge
coverage, senior debt coverage and total debt coverage covenants. Amendment of the
covenants was predicated on our depositing $2,000,000 in a blocked account controlled by
the U.S. lender. Our maximum revolver borrowing capacity remained unchanged at the lesser
of (a) the revolver loan commitment ($8,000,000) or (b) the borrowing base (as defined),
less $1,500,000.

With
cash on hand of $399,998, together with available revolver capacity of $1,725,641, we have
$2,125,639 of available liquidity at September 30, 2009, versus $662,806 at June 30, 2009.

Prospective Assessment

Our
strategic objective is to in-license, develop and launch novel higher margined advanced
wound care products while utilizing our core business (to the extent possible) to fund
this objective. In addition, we will continue to evaluate external opportunities to
leverage our core capabilities for growth. To the extent we determine that we cannot
finance our growth initiatives internally, we will evaluate the feasibility of doing so
via the sale of equity.

As
a result of these efforts, we launched ALGICELL® AG in November 2006. We launched our
first MEDIHONEY product in October 2007. This product represents the first of its kind and
interest in the product has been high. Sales have increased steadily and current
indications are that the planned MEDIHONEY based line of products could result in
significant incremental sales. We recently launched four new products to complement our
existing advanced wound care product line, the MedEfficiency line of Total Contact Cast
systems (October 2008), XTRASORB (November 2008), MOBILITY 1 (January 2009) and BIOGUARD,
our novel anti-microbial infection control product in June 2009. BIOGUARD, XTRASORB and
MedEfficiency have been well received in the marketplace and have exhibited steady growth.
We continue to work on our pipeline and have identified several products that are capable
of contributing to future sales growth. We anticipate our core business sales will remain
relatively stable over the near term.

In
recognition of our financial condition in the fourth quarter of 2008, we initiated the
following actions:

|1. |  | While
not compromising the overall integrity of the advanced wound care growth strategy,
prospective plans in terms of sales and marketing resources were scaled back to more
affordable levels resulting in an immediate reduction of expense. We have implemented a
process to better measure the ongoing return on sales and marketing resources deployed.
Assuming the existing resources in place are generating the expected return, we will
prospectively expand our investment in sales and marketing resources in support of our
advanced wound care growth strategy, as financial conditions allow. We presently have ten
direct sales representatives in place and have hired several independent representatives
on a commission only basis to cover open territories.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2. |  | The
FAD business represents a growth opportunity. In addition to its core business
opportunities, the FAD business will serve as a platform for introducing our existing
advanced and traditional wound care products to new customers and markets, especially the
retail market. The FAD is presently working on a number of opportunities for sales
growth. We began to realize the savings associated with discontinuing the FADs
higher cost U.S. production in the fourth quarter 2008. In addition, the FAD is working
to firm up a cost effective supply chain for its adhesive bandages and first aid related
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

28

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Index

| | products.
The expanded supply chain is expected to be fully operational within the next six months,
at which time we expect to be able to further reduce our product costs and improve
liquidity by reducing the level of inventory required to support the existing level of
business.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3. |  | Steps
were taken to identify and eliminate all non-essential operating costs. No salary
increases or bonuses are planned until our performance and liquidity improves.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. |  | We
made a significant investment in DSC 127 beginning in December 2007. While the launch of
DSC 127 is several years away, we believe the market potential for this product is
considerable. The product began Phase II trials in early 2008 to achieve proof of
principle in a human model. The Phase II trials are expected to be completed by the fourth
quarter of 2010. The projected cost to complete the Phase II trials is approximately $1,800,000
including $1,072,010 incurred through September 2009. We plan to continue with this
investment and anticipate spending approximately $727,990 to complete the Phase II
trial over the next fifteen months.
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The results
of the Phase II trial will determine the efficacy and safety of the product and further
refine its market potential. The cost of the Phase III trial and bringing the product to
market are expected to be significant. Should we decide to proceed with the DSC 127
development plan after completion of Phase II, we plan to fund the additional development
costs out of available cash flow or the sale of equity. Alternatively, we may determine
to sublicense or sell the rights to the compound.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

With
the planned improvement in operations and modest expected working capital requirements,
together with the available cash on hand and available borrowing capacity as of September
30, 2009, we anticipate having sufficient liquidity in place to meet our operating needs
and debt covenants for the foreseeable future.

Our
Common Stock is traded on the OTC Bulletin Board under the symbol DSCI. We
have paid no cash dividends in respect of our Common Stock and do not intend to pay cash
dividends in the near future.

Additional Financial Information

Forward Looking Statements

Statements
that are not historical facts, including statements about our 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 us,
there may also be other reasonable estimates or assumptions. We believe, however, that
given current facts and circumstances, it is unlikely that applying any such other
reasonable judgment would cause a material adverse effect on the consolidated results of
operations, financial position or cash flows for the periods presented. Our most critical
accounting policies are described below.

Revenue Recognition and Adjustments
to Revenue

We
sell our products through our own direct sales force and through independent distributors
and manufacturers representatives. The primary end users of our products are nursing
homes, hospitals, clinics and home healthcare agencies. We recognize revenue from the sale
of our products when persuasive evidence of an arrangement exists, delivery has occurred,
the sales price is fixed and determinable, and collectability is reasonably assured, which
is generally at the time of shipment or receipt by our customers, depending on the terms
of the

29

---

Index

related sales or distribution
agreement. When we recognize revenue from the sale of our products, we simultaneously
adjust revenue for estimated trade rebates and distribution fees (in Canada), and
estimates of returns and allowances, cash discounts and other sales incentives.

A
trade rebate represents the difference between the invoice price to the
wholesaler/distributor and the end users contract price. These rebates are estimated
monthly based on historical experience, distributor rebate submission trends, estimated
distributor inventory levels, and existing contract sales terms with our distributors and
end users. We have a contract with our exclusive Canadian distributor and we pay a fixed
fee based on sales subject to the fee (as defined) for distribution services in Canada.
Because the services performed by the distributor cannot be separated from the purchase of
our products by the distributor, we treat this distribution fee as a reduction of revenue.
The distribution fee is accrued monthly based on net sales to the distributor multiplied
by the ratio of recent historical distributor fee expense to net sales. The percentage of
distributor fee expense to net sales is re-evaluated quarterly for reasonableness.

Sales
incentives represent credits granted to specific customers based on attainment of
pre-determined sales objectives. Sales incentives are accrued monthly in accordance with
the terms of the underlying sales incentive agreement and actual customer sales. Sales
incentive agreements are generally for a period of one year.

We
provide our customers certain limited return rights and we have a formal returned goods
policy that guides the disposition of returns with our customers. We follow the accounting
guidance outlined in paragraph 605-15-25 of the FASB Accounting Standards Codification as
it relates to the recognition of revenue at the time of sale when the right of return
exists. We accrue for sales returns and allowances and cash discounts monthly based on
current sales and historical activity. We do not offer our customers price protection
rights or concessions. Returns were approximately 1% of gross sales in both 2009 and 2008.

We
continually monitor the factors that influence rebates and fees, returns and allowances,
and other discounts and sales incentives and make adjustments as necessary.

Goodwill

At
September 30, 2009, we had $7,119,726 of goodwill consisting of $4,679,684 relating to the
FAD acquisition in November 2007 and $2,440,042 relating to the Western Medical
acquisition in April 2006. We assess the impairment of goodwill annually in the fourth
quarter or whenever events or changes in circumstances indicate that the carrying value of
goodwill may not be recoverable. The assessment is performed using the two-step process
required by FASB accounting guidance relating to goodwill. The first step is a review for
potential impairment, while the second step measures the amount of the impairment, if any.
The first step of the goodwill impairment test compares the fair value of a reporting unit
with its carrying amount, including goodwill. For 2008 and 2007, the first step of our
goodwill impairment test reflected a fair value in excess of the carrying value of our
reporting units. Accordingly, we did not perform the second step of this test during these
periods.

The
cash generating unit level or reporting unit at which we test goodwill for impairment is
the operating segment level as that term is used in FASB accounting guidance relating to
segment reporting. We have three operating segments: wound care, wound closure 
specialty securement devices and skin care. Products are allocated to each segment based
on the nature and intended use of the product. All of our goodwill has been allocated to
the wound care segment as the business acquisitions which gave rise to the goodwill were
wound care businesses.

For
2008 and 2007 and consistent with prior periods, we estimated the fair value of our wound
care segment, using the income approach, where we use a discounted cash flow
model (DCF) in preparing our goodwill impairment assessment. This approach
calculates fair value by estimating the after-tax cash flows attributable to a reporting
unit and then discounting these after-tax cash flows to a present value using a
risk-adjusted discount rate. We selected this method as being the most meaningful in
preparing our goodwill assessments because we believe the income approach most
appropriately measures our income producing assets.

Significant
estimates used in the fair value calculation include: (i) estimates of future revenue and
expense growth, (ii) future estimated effective tax rates, (iii) future estimated capital
expenditures, (iv) future required investments in working capital, (v) average cost of
capital, and (vi) the terminal value of the reporting unit.

30

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Index

The
amount and timing of future cash flows within our DCF analysis is based on our five year
forecast. Beyond our five year forecast we assumed a terminal value to calculate the value
of cash flows beyond the last projected period in our DCF analysis. Annual revenue growth
rates in our DCF model reflect expected growth in our advanced wound care products as well
as growth in the products which we gained access to when we acquired FAD in November of
2007 as we introduce these products across our existing customer base. The weighted
average cost of capital used to discount cash flows for the annual 2008 goodwill
impairment test was estimated to be 17%.

Over
time, our wound care segment has become an increasingly significant portion of our overall
business. For the year ended December 31, 2008, our wound care segment accounted for
approximately 95% of our consolidated revenue which is consistent with the results we are
experiencing in 2009. Given the significance of this segment to our overall results, we
also look to our publicly traded market value, which we may adjust in consideration of an
appropriate control premium, as an indicator of the fair value of our wound care segment
and the reasonableness of our DCF model.

There
have been no substantial changes to the methodology employed, significant assumptions or
calculations applied in the first step of the goodwill impairment test over the past
several years.

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

Share-based
payment transactions with employees, such as grants of stock options and restricted stock,
are recognized in the financial statements based on their fair value at the grant date and
recognized as compensation expense over their vesting periods. We estimate the fair value
of stock options as of the date of grant using the Black-Scholes or binomial/lattice
pricing model (as applicable) and restricted stock based on the quoted market price.
Significant judgments and estimates are used to value the equity-based compensation,
particularly surrounding Black-Scholes or binomial/lattice pricing model assumptions such
as stock price volatility and expected option lives, as well as expected option forfeiture
rates.

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-K filed with the Securities and Exchange
Commission:

We have a history of losses and can
offer no assurance of future profitability.

We
incurred losses of $3,961,937 in 2008, $2,284,605 in 2007, $1,099,990 in 2005, $2,338,693
in 2004, $2,581,337 in 2000, $2,998,919 in 1999 and $1,178,978 for the nine months ended
September 30, 2009 (unaudited). At September 30, 2009, we had an accumulated deficit of
$20,842,801 (unaudited). We cannot offer any assurance that we will be able to generate
sustained or significant future earnings.

Our liquidity may be dependent upon
amounts available under our existing line of credit or amounts available through
additional debt or equity financings.

We
have a history of operating losses and negative cash flow from operating activities. As
such, we have utilized funds from offerings of our equity securities and lines of credit
to fund our operations. We have taken steps to improve our overall liquidity and believe
we have sufficient liquidity to meet our needs for the foreseeable future. However, in the
event our cash flow from operating activities is insufficient to meet our requirements, we
may be forced either to refinance our current line of credit or seek additional equity
financing. The sale of additional securities could result in additional dilution to our
shareholders. The incurrence of indebtedness would result in increased debt service
obligations and could result in operating and financing covenants that would restrict our

31

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Index

operations. There can be no
assurance that such financing would be available or, if available, that such financing
could be obtained upon terms acceptable to us.

Our foreign operations are essential
to our economic success and are subject to various unique risks.

Our
future operations and earnings will depend to a large extent on the results of our
operations in Canada and our ability to maintain a continuous supply of basic wound care
products from our operations in China and suppliers in China and Mexico. While we do not
envision any adverse change to our operations in Canada, China or Mexico, adverse changes
to these operations, as a result of political, governmental, regulatory, economic,
exchange rate, labor, logistical or other factors, could have an adverse effect on our
future operating results.

Approximately forty percent of our
products are sourced from third parties.

Approximately
forty percent of our products are sourced in raw, semi-finished and finished form directly
from third party suppliers. None of these suppliers presently account for more than ten
percent of our sales. We maintain good relations with our third party suppliers. There are
several third party suppliers available for each of our products. If a current supplier
were unable or unwilling to continue to supply our products, sale of the affected products
could be delayed for the period necessary to secure a replacement.

The technology utilized in many of
our advanced wound care products is licensed from third parties and could become
unavailable.

Many
of our advanced wound care products utilize technology that we license on an exclusive
basis from third parties. These products include Medihoney dressings, Bioguard dressings,
Mobility1 pneumatic compression devices and MedEfficiency total contact casts. The
licensing agreements that we have with the owners of these technologies are of limited
duration and renewals of the agreements are in the discretion of the licensors. In
addition, the maintenance of the license agreements requires that we meet various minimum
sales and minimum royalty requirements. If we fail to meet the minimum sales or minimum
royalty requirements of a given license agreement, there is a possibility that the
agreement will be cancelled or not renewed or that our exclusivity under the license
agreement will be withdrawn. If any of these events were to occur, our ability to sell the
products utilizing the licensed technology could be lost or compromised and our revenues
and potential profits could be adversely affected.

Our stock price has been volatile and
this volatility is likely to continue.

Historically,
the market price of our common stock has been volatile. The high and low prices for the
years 2004 through 2008 and the first nine months of 2009 are set forth in the table
below:

| |                                                  |  |       |  |       | 
| | ------------------------------------------------ |  | ----- |  | ----- | 
| | Derma Sciences, Inc.Trading Range  Common Stock | 
|
| | Year                                             |  | Low   |  | High  | 
|
| | 2004                                             |  | $0.43 |  | $1.90 | 
| | 2005                                             |  | $0.42 |  | $0.78 | 
| | 2006                                             |  | $0.45 |  | $0.90 | 
| | 2007                                             |  | $0.58 |  | $1.40 | 
| | 2008                                             |  | $0.20 |  | $1.35 | 
| | 2009(*)                                          |  | $0.24 |  | $0.85 | 
| |                                                  |  |       |  |       | 
| | (*) January 1 through September 30.              | 

Events
that may affect our common stock price include:

| |  |  | Quarter
to quarter variations in our 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;
| | - |  | ------------------------------------------------------------------------

32

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Index

| |  |  | Fluctuations
in stock market prices and trading volumes of similar companies;
| | - |  | -----------------------------------------------------------------------------

| |  |  | Discussion
of us or our stock price by the financial and scientific press and in online investor
communities;
| | - |  | -------------------------------------------------------------------------------------------------------------

| |  |  | Additions
or departures of key personnel;
| | - |  | -----------------------------------------

| |  |  | Changes
in third party reimbursement policies;
| | - |  | ----------------------------------------------

| |  |  | The
introduction of new products either by us or by our competitors; and
| | - |  | ------------------------------------------------------------------------

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

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

If members of our management and
their affiliates were to exercise all warrants and options held by them, and if
substantially all of the authorized but unissued restricted stock awards that were granted
to members of management and were to vest, members of management and their affiliates
could acquire effective control of us.

The
executive officers and directors, together with institutions with which they are
affiliated, own substantial amounts of our common stock, together with outstanding options
and warrants to purchase our common stock. In addition, we have adopted, and our
shareholders have approved, a restricted stock plan pursuant to which our outside
directors and executive officers may be awarded up to 2,500,000 shares of restricted
stock. Outside directors have been awarded to date 175,000 shares of restricted common
stock. Depending upon the warrants and options exercised by outside investors, if
directors, executive officers and affiliates were to exercise their options and warrants,
and if additional shares of restricted stock are awarded to our directors and executive
officers and such awards vest, members of management and their affiliates could obtain
effective control of us. As a result, these officers, directors and affiliates would be in
a position to significantly influence our strategic direction, the composition of our
board of directors and the outcome of fundamental transactions requiring shareholder
approval.

Our common stock does not have a
vigorous trading market and you may not be able to sell your securities when desired.

We
have a limited active public market for our common shares. We cannot assure you that a
more active public market will develop thereby allowing you to sell large quantities of
our shares. Consequently, you may not be able to readily liquidate your investment.

If we effect a reverse stock split,
the liquidity of our common stock and market capitalization could be adversely affected.

On
September 24, 2009, our board of directors voted unanimously, subject to shareholder
approval to be considered at the special meeting of shareholders to be held on November
23, 2009, to approve an amendment to our articles of incorporation to give the board of
directors authorization to effect a reverse stock split, and reduction in the authorized
shares of our common stock issued and outstanding, in a ratio of from one-for-five to
one-for-ten.

A
reverse stock split is often viewed negatively by the market and, consequently, can lead
to a decrease in our price per share and overall market capitalization.  If we
implement a reverse stock split and if the per share market price does not increase
proportionately as a result of the reverse split, then our value as measured by our market
capitalization will be reduced, perhaps significantly.

33

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Index

Item 4. 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, 2009. 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 nine months ended September 30, 2009, 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.

34

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Index

Item 6. Exhibits

All
exhibits required by Item 601 of Regulation S-K and required hereunder, as filed with the
Securities and Exchange Commission in Form 10-K on March 31, 2009, 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 13, 2009 | By:                  | /s/ John E. Yetter                         | 
|                          |                      | John E. Yetter, CPAChief Financial Officer | 

35

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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