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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

(Mark One)

|/x/ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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For the fiscal year ended: May 31, 2001

or

|/ / | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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For the transition period from  to

Commission File Number: 0-23996

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SCHMITT INDUSTRIES, INC.(Exact name of registrant as specified in its charter)

Oregon(State or other jurisdiction of
incorporation or organization)

91-1151989(IRS Employer Identification Number)2765 N.W. Nicolai Street
Portland, Oregon(Address of principal executive offices)

97210(Zip Code)


(503) 227-7908(Registrant's telephone number, including area code)

Securities
registered pursuant to Section 12(b) of the Act:

Title of each classNone

Name of each exchange on which registeredNone


Securities
registered pursuant to Section 12(g) of the Act:

Common Stockno par value(Title of each class)

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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. Yes /x/  No / /

Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /x/

As
of August 1, 2001, the aggregate market value of the registrant's Common Stock held by nonaffiliates of the registrant was $4,628,704 based on the closing sales price of the
registrant's Common Stock on the Nasdaq National Market. On that date, there were 7,495,974 shares of Common Stock outstanding.

Portions
of the registrant's definitive Proxy Statement for its 2001 Annual Meeting of Shareholders are incorporated by reference into Part III hereof.

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PART I

Item 1. Business

Introduction

The Company (an Oregon corporation) designs, assembles and markets computer-controlled balancing equipment primarily to the machine tool industry. Through its
wholly owned subsidiaries, Schmitt Measurement Systems, Inc. ("SMS"), a Montana corporation and Acuity Research Incorporated ("ARI") a California corporation, the Company designs, manufactures
and markets precision laser measurement systems. The Company acquired its original balancing equipment technology pursuant to a series of agreements from 1987 through 1991. The Company substantially
enhanced and advanced the patented technology since that time. The Company also sells and markets its products in Europe through its wholly owned subsidiaries, Schmitt Europe Ltd.
("SEL"), located in the United Kingdom and Schmitt Europa GmbH ("SEG"), located in Germany. The Company's executive offices are located at 2765 N.W. Nicolai Street, Portland, Oregon
97210, and its telephone number is (503) 227-7908.

Balancing Products

The Company's principal product is the Schmitt Dynamic Balance System (the "SBS System"), consisting of a computer control unit, sensor, spindle-mounting
adapter, and balance head. It is designed to be an inexpensive, yet highly accurate, permanent installation on grinding machines. Currently, the SBS System is beginning to be evaluated by
manufacturers for additional applications including large electric motors, industrial fans, industrial brushing devices, turbines and similar devices.

The
SBS System is fully automated, eliminating the need to pre-balance such devices as grinding wheels. This reduces machine setup time and ensures a smoother and more
efficient operation. Operating on a principle of mass compensation for wheel imbalance, the balance head contains two movable eccentric weights, each driven by electric motors through a precision gear
train. These weights are repositioned
to offset any imbalance in a grinding wheel or other application. Imbalance or vibration is picked up by the sensor that feeds a signal to a controller that filters the signal by revolutions per
minute. The controller then drives the balance head weights in a direction that reduces the amplitude of the vibration signal. When the weights are positioned to achieve the lowest vibration level,
the balance cycle is complete.

Notable
features of the SBS System include its ability to fit almost all machines, ease of installation, compact and modular construction, ability to balance a wheel while on a
machine, virtual elimination of wheel vibration, automatic monitoring of balancing, display in both English and metric systems, instrument grade calibration, short balance process, measurement of both
displacement and/or velocity and minimal user maintenance.

Benefits
to the system user include improved quality of finished parts, ease of product adaptation, minimal downtime, complete and ready installation, elimination of static balancing,
longer life of the grinding wheel, diamond dressings and spindle bearings, the ability to balance within 0.02 microns and its adaptability to all types of machines.

Precision
grinding is necessary in all major manufacturing areas including the automotive industry (camshafts, crankshafts, valves), bearings (roller and tapered types), ceramics
(precision shaping), electric motors (shafts), pumps (shafts and turbines), aircraft (engine parts), and general manufacturing. That industry has an established worldwide presence in all
industrialized countries and is expanding as a method of material removal and processing. Therefore, the Company believes there may be an

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increase in market growth and the need for automatic balancing. Within the industry there are three major market segments:



The
acquisition of SEG added the SEG internal spindle, ring and water balancer designs to the Company's worldwide product line. These proven designs allow Schmitt to provide products
to a broad range of machine applications.

In
Fiscal 1999, 2000 and 2001, net sales of the Company's balancing products totaled $7,377,879, $7,244,969 and $6,030,030 respectively. Net sales of balancing products accounted for
93% of the Company's revenue in Fiscal 1999, 82% in Fiscal 2000 and 80% in Fiscal 2001. See Note 9 to Consolidated Financial Statements.

Competition:

Management believes the SBS System is one of few fully automatic balancing systems marketed in the world. Most competitive products require special setup and
training or calibration to the specific machine. The Company believes the SBS System is currently the only balancing product that fits all machines with wheel sizes from 6 to 48 inches in diameter and
a spindle rpm of 500 through 7,500.

Competitive
products come from European companies located in Switzerland, Germany, Spain and Italy. These competitors produce electromechanical balancers similar to the SBS System and
water balancers similar to the SEG system. The Company considers these companies, with their established European base, to be the major competitors. These balancers have electronic deficiencies that
render them less effective in solving essential balancing requirements. They cannot achieve the consistent low balance levels at 500-rpm (low speed) or at 7,500 rpm (high speed) as the SBS
system can. In addition,

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these balancers have inferior brush and cable assemblies that cause down time and high maintenance. Finally, none of these companies can currently compete effectively with the Company in providing
mounting adapters for all grinding machines.

Water
balancers are the oldest on the market and are employed in the SEG-installed systems. They require expensive plumbing and water chambers to be machined into the
wheel hub while the SBS System does not. They are currently priced about 1.25 times the level of the SBS System. When installed, the grinding machines must be disassembled and parts remachined or
replaced within the spindle assembly. This can be a one to two day process and a time far longer than required to install the SBS system. The water system is "tuned" or "calibrated" to the machine by
a factory service technician while the SBS system can be installed by the operator. Water systems work at mid- and high-speeds but cannot balance in low rpm environments while
SBS products work in both environments. Water systems require periodic monitoring while the SBS systems require little or no operator monitoring.

The
SBS System list price is $7,995 worldwide. Water balancers produced by German companies other than SEG are priced at $9,000 to $11,000, and electromechanical systems are priced at
$8,000 to $10,000 worldwide. Management market surveys indicate customers perceive the value of an automatic balancer to be approximately $8,000; therefore, Company pricing is geared to obtaining a
dominant market position and meeting competitive supplier prices. The market strategy is to establish the SBS System as the foremost product with the best quality, reliability and performance and
superior economic value.

Measurement Products

The Company manufactures and markets a line of laser-based, precision measurement systems and operates a precision laser light scatter measurement laboratory.
Light scatter technology involves using lasers, optics and detectors to throw a beam of light on a material sample and record its reflection/transmission. Analysis of light scatter information can
determine material characteristics such as surface roughness, defects and dimensional sizing without introducing contaminants and causing changes to the tested material. The principal products of SMS
are laser-based measurement products and technology applicable to both industrial and military markets. The Company has used the patents, patent applications, trademarks and other proprietary
technology to focus marketing efforts into industrial markets, including electronics, computer disk and silicon wafer manufacturers.

SMS
operates four product lines: laser-based light-scatter measurement, dimensional sizing, research and other laser alignment products plus a light-scatter measurement laboratory.

Disk and Wafer products:

These products use proprietary laser light scatter technology to perform non-contact surface measurement tests that quantify surface
micro-roughness in a rapid, accurate, repeatable and non-destructive manner. Products are sold to manufacturers of disk drives and silicon wafers, both industries with fabrication
processes that require precise and reliable measurements.

Computer
hard disks require exact manufacturing control and a narrow tolerance band for acceptable roughness. The read/write head flies over the disk drive surface on a cushion of air
generated when the rough surface of the rotating disk pulls air under the head. The head may stick or bind to the disk when the surface is too smooth. If it is too rough, the head will fly too far
from the disk surface, causing a reduction in data density or storage capacity. The DUV and TMS product series meet the challenges of disk drive manufacturers. Customers include Seagate Substrates,
Western Digital and Komag, Inc.

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The original TMS-2000 (Texture Measurement System) product, the world's fastest and most accurate non-contact texture measurement system, revolutionized
disk-manufacturing technology. The product (used on aluminum substrates) is currently used worldwide by most major disk drive manufacturers and provides fast, accurate and repeatable
microroughness measurements and quadruples production throughput when compared to other testing devices.

The
TMS-2000-DUV product measures the surface microroughness of glass rather than aluminum substrates. Manufacturers require the technology and products to
measure surface roughness of these substrates to the same exact levels as those that measure aluminum. The Deep Ultra-violet light (DUV) technology and product uses the patented light scatter
technology to measure the surface roughness of glass substrates to levels less than one Angstrom (the point of a needle is one million Angstroms in diameter).

The
capabilities of these products were enhanced significantly in Fiscal 2000 with the development and introduction of the "RC" series. This light scatter technology simultaneously
measures disk surface roughness in two directions, radially, when the read/write head is moving to another disk sector and circumferentially, when the read/write head is processing information on the
disk. The two separate roughness levels are required for proper head operation. This measurement method is not possible through any other cost effective measurement means. Surface roughness can now be
measured to levels below 0.5 Angstroms.

The
TMS-2000W and TMS-3000W (Texture Measurement Systems) provide fast, accurate, repeatable measurements for manufacturers of silicon wafers, computer chips
and memory devices. This industry demands manufacturing precision to increase performance and capacity and these products help achieve these goals. Silicon wafers are carefully cut and polished to
provide the base upon which a computer or memory chip is produced. Therefore, chip manufacturing is extremely dependent on the beginning surface roughness of the wafer. Since all silicon wafers
exhibit a microscopic level of surface roughness, stemming from chemical deposition, grinding, polishing, etching, or any number of other production techniques, some method of measuring these
surface characteristics is required. The wafer measurement products provide a way for SMS customers in this industry to quantify and control their manufacturing process. The system provides
measurements to a few hundredths of an Angstrom, a level unachievable by other testing devices.

Testing Laboratory:

The Company provides a highly advanced measurement services laboratory to a wide variety of industrial and commercial businesses that require precise
measurements only advanced laser light scatter technology can provide. The laboratory uses CASI Scatterometers for measuring surface roughness. The true value of the laboratory is not only its
extremely precise measurement capability but also the test item is not altered, touched or destroyed. Thus, the laboratory is widely used by manufacturers of critical optical components in aerospace
and defense systems, including such companies as Aerojet, AT&T Bell Labs, Eastman Kodak, General Electric, IBM, NASA and dozens of other industrial companies, universities and government agencies.

ARI
develops and assembles laser distance sensors for industrial and OEM use. Applications include steel casting, paper production, medical imaging, crane control and micron-level
part and surface inspection. Presently, there are three product lines, the AR4000 distance measurement sensor, the AR4000 Line Scanner and the AR600 series of triangulating laser displacement sensors.

The
AccuRange 4000 is an optical distance measurement sensor for most diffuse reflective surfaces. It operates by emitting a collimated laser beam that is reflected from the target
surface and collected by a sensor. The sensor is suitable for a wide variety of distance measurement applications that demand high accuracy and fast response times. Notable features include the
operating range for most surfaces (zero to fifty feet), fast response time (50 kHz maximum sample rate), compact and

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lightweight power design and has a tightly collimated output beam for small spot size. The product has three output beam configurations available: visible infrared, eye safe infrared and reflective
tape targets. It is ideally suited to level and position measurement, machine vision, autonomous vehicle navigation and 3D imaging applications.

The
AR4000 Line Scanner is used with the AccuRange 4000 to scan and collect distance data over a full circle. The scanner consists of a balanced, rotating mirror and motor with
position encoder and mounting hardware for use with the AccuRange 4000. The scanner deflects the beam 90 degrees, sweeping it through a full circle as it rotates. The product can scan at rates of up
to 2600 lines per minute, sweeps the laser beam through a full 360 degrees and is both compact and lightweight.

The
AR600 series is a family of triangulating laser displacement sensors with excellent accuracy and sensitivity. The sensor projects a beam of visible laser light that creates a spot
on the target surface. Reflected light from the surface is viewed from an angle by a line scan camera and the target's distance is computed from the image pixel data. The line includes 11 models
measuring displacements from 1/8" to 50" and accuracy's down to .00015" (4 microns). They can operate on all types of surfaces at speeds up to 1250 samples/second. The product is
extremely sensitive and can detect glass and liquid surfaces and also detect multiple surfaces of transparent materials, allowing great flexibility in specialized applications.

Research Products:

CASI Scatterometers are sold to companies and institutions involved in research efforts. A Scatterometer uses ultraviolet or infrared laser light as a
nondestructive probe to measure surface quality, optical performance, smoothness, appearance, defects and contamination on a wide variety of materials. These products are measurement instruments
providing customers with precise roughness measurements of optical surfaces, diffuse materials, semiconductor wafers, magnetic storage media and precision-machined surfaces, as well as surfaces
affecting the cosmetic appearance of consumer products. Customers include Boeing, The U.S. Navy and Rockwell Collins North America.

Other Measurement Products:

The μScan System is a portable device consisting of a hand-held control unit, an interchangeable measurement head and a
separate charging unit. To perform a measurement, the operator places the measurement head on the objective area and presses a button. Each measurement takes less than five seconds with results
displayed and stored in system memory. The μScan can store 700 measurements in 255 files and provides the capability to program pass/fail criteria. Software is available for
control, analysis and file conversion. From a single measurement, a user can determine RMS surface roughness, reflectance and scatter light levels (BRDF) on flat or curved surfaces under any lighting
conditions.

In
Fiscal 1999, 2000 and 2001, net sales of Measurement products totaled $579,844, $1,609,287 and $1,550,124 respectively and accounted for 7%, 18% and 20% of the Company's total
sales in Fiscal 1999, 2000 and 2001 respectively.

Business and Marketing Strategy

The Company designs, assembles and markets all of its products with operations divided into a number of different areas. The Vice President of Operations
directs the production, and is responsible for all assembly, purchasing and production engineering as well as the technical services division that provides technical support to customers. The Product
Marketing Division, managed by the President/CEO, is responsible for the sale of SBS System products. Three Marketing Managers are responsible for domestic sales while a fourth is responsible for
sales in Mainland China, Taiwan and Korea. The Company also has one person who performs field service/sales. The President/CEO is responsible for

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European sales and oversees the efforts of the Marketing Managers. Finally, there is a research and development group supervised directly by the President/CEO and the Vice President of Operations.

The
Company markets and sells the SBS System in a variety of ways. First, the Company uses the channels provided by independent manufacturer's representatives and distributors. There
are currently approximately 25 individuals and/or organizations in the United States acting in one of these capacities. Independent sales agents are paid a 10% commission; distributors are sold
products at a 15% discount.

Second,
worldwide trade shows have proven to be an excellent source of business. Company representatives, usually one or more of the Marketing Managers and/or the President/CEO,
attend these events along with local Company representatives. These individuals operate a display booth featuring an SBS System demonstration stand and product and technical literature.
Representatives from all facets of the Company's target markets attend these trade shows.

Third,
original equipment manufacturers (OEMs) include the SBS System on the machine tools they produce. Users thus purchase the SBS System concurrently with the machine tools.
Conversely, end users of grinding machines that have purchased the SBS system directly from the Company, and after enjoying the benefits of the products, often request that SBS products be included
with the new equipment they order from OEMs. The SBS Systems are often installed by machine builders prior to displaying their own machine tools at various trade shows and these samples often
become endorsements that prove beneficial to the Company's sales efforts.

In
the United States, most products are shipped directly to customers from the Company's distribution center in Portland, Oregon. Where the Company has distributors, the product is
shipped to the distributor, who in turn pays the Company directly and then delivers and installs the product for the end user. Western European distribution to customers is handled by shipping the
product directly from the Company's Portland headquarters to the European subsidiaries, who in turn sell and distribute the products to the end users.

Similar
to the parent company, SMS uses a variety of methods to market and sell its products. First, a Marketing Manager, under the direction of the President/CEO, directs the overall
marketing efforts. Second, the Company uses an independent manufacturer's representative group to market and sell products to various customers in the Western United States. That group is paid a 20%
commission on units they are responsible for selling. Third, the Company has a distribution agreement with a company in Japan that is the exclusive distributor for the promotion and sale of SMS
products in Japan, Korea, Malaysia, Singapore, the Philippines and Taiwan. Fourth, trade shows represent a significant amount of marketing/sales effort. The President/CEO attends these events along
with various Company representatives. These individuals operate a display booth featuring SMS product demonstrations and product and technical literature. Representatives from all facets of the market
to which the Company directs its sales efforts attend these trade shows.

Finally,
one of the best marketing channels is the testing laboratory. Once customers see the capabilities of the technology, it leads to orders for the Company's laser based light
scatter measurement products.

All
SMS products are assembled in the Portland, Oregon facility and shipped worldwide directly to customers.

Acuity
exclusively markets and sells its products through a worldwide network of manufacturer's representatives and distributors. The President of ARI, under the direction of the
Company's President/CEO, directs the overall marketing efforts. There are seven representatives in North America and seven located in companies throughout the world. The United States representatives
receive a 15% commission while the foreign representatives receive a 25% commission on all units they sell. Management of both the Company and ARI will also attend trade shows where the products are

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displayed and demonstrated. All ARI products are assembled in the Menlo Park, California facility and shipped worldwide directly to customers.

The
SBS, SMS and ARI customer bases consist of over 250, 200 and 300 companies respectively.

Manufacturing

There are no unique sources of supply or raw materials in any product lines. Essential electronic components, available in large quantities from various
suppliers, are assembled into the Balancing and
Measurement electronic control units under the Company's quality and assembly standards. Company-owned software and firmware are coupled with the electronic components to provide the basis of the
Company's various electronic control units. Management believes several supply sources exist for all electronic components and assembly work incorporated into its electronic control systems. The
primary outside supplier of electronic assemblies is Viasystems, Inc. of Beaverton, Oregon, a custom supplier of assembled electronic products for several Pacific Northwest companies. In the
event of supply problems, the Company believes that two or three alternatives could be developed within 30 days to supplement or replace Viasystems.

Mechanical
parts for the Company's products are produced to the customers' drawings and specifications by high quality CNC machine shops. The Company is not dependent on any one
supplier of mechanical components. Principal suppliers of components for the Company's products include MacKay Manufacturing of Spokane, Washington; OEM Manufacturing of Corvallis, Oregon; Eagle
Industries of Newberg, Oregon; and Forest City Gear of Roscoe, Illinois.

The
Company uses in-house skilled assemblers to construct and test vendor-supplied components. Component inventory of finished vendor-supplied parts is held on Company
property to assure adequate flow of parts to meet customer order requirements. Inventory is monitored by a computer control system designed to assure timely re-ordering of components.

In-house
personnel assemble various products and test all finished components before placing them in the finished goods inventory. Finished goods inventory is maintained
via computer to assure timely shipment and service to customers. All customer shipments are from the finished goods inventory.

In
November 1996, the Company's Quality Control Program received full ISO-9001 certification. This certification was renewed in November 2000.

Proprietary Technology

The Company's success depends in part on its proprietary technology, which the Company attempts to protect through patents, copyrights, trademarks, trade
secrets and other measures.

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The
Company has U.S. patents covering its SBS, SMS and ARI products, processes and methods which the Company believes provide it with a competitive advantage. The Company has a policy
of seeking patents where appropriate on inventions concerning new products and improvements developed as part of its ongoing research, development and manufacturing activities. While patents provide
certain legal rights of enforceability, there can be no assurance the historic legal standards surrounding questions of validity and enforceability will continue to be applied or that current defenses
as to issued patents will, in fact, be considered substantial in the future. There can be no assurance as to the degree and range of protection any patent will afford and whether patents will be
issued or the extent to which the Company may inadvertently infringe upon patents granted to others.

"SBS"
and "SMS" are registered trademarks and are affixed to all products and literature created in the Company's balancer and measurement product lines, respectively.

The
Company manufactures its SBS products under copyright protection in the U.S. for electronic board designs. Encapsulation of the finished product further protects the Company's
technologies including software.

The
Company also relies upon trade secret protection for its confidential and proprietary information. There can be no assurance that others will not independently develop
substantially equivalent proprietary information and techniques or otherwise gain access to the Company's trade secrets or disclose such technology or that the Company can meaningfully protect its
trade secrets.

While
the Company pursues patent, trademark, trade secret and copyright protection for products and various marks, it also relies on know-how and continuing technology
advancement, manufacturing capabilities, affordable high-quality products, new product introduction and direct marketing efforts to develop and maintain its competitive position.

Product Development

In Fiscal 1997, the Company began an aggressive research and development program to expand the product lines and capabilities of SBS and SMS products. That
policy has been incorporated into the operations of ARI as well. The goal of this program is to expand the product base in historic markets and to enter new market areas so as to reduce reliance on
historic market segments. Since that fiscal year, the Company has continued to develop the following new balancing and laser measurement products.

The
SB-4500 unit is now a multi-function unit providing the versatility to control several activities including all of Schmitt's balancer products. It controls balancing
in applications with speeds ranging from 300 to 30,000 rpm compared to a range of 500 to 10,000 rpm with the prior Schmitt product. Vibrations are measured to 0.02 microns or 0.75 millionths of
an inch, a ten-fold performance improvement over the prior control unit. It also allows customers to balance their grinding machines faster, reducing costly down time and increasing
factory throughput. This generation of computer control allows the future addition of new Schmitt products.

The
AEMS (Acoustical Emissions Monitoring System) is controlled by the SB-4500 control unit and monitors the customers' dressing and grinding processes by direct
measurement of machine-generated acoustic signals. By monitoring the high frequency sound signal generated by contact between the wheel and work piece, the system automatically determines when wheel
contact is made. Users can eliminate the "gap" time from their grinding process and also automatically detect the beginning of a wheel "crash" and immediately signal the grinder to stop before real
damage occurs. The benefits of the AEMS product to the customer include time savings from quick and easy setups, improved dressing and grinding process, and elimination of expensive part and machine
damage.

The
disk drive industry presented the Company with the challenge of developing the technology and products to measure the surface roughness of glass substrates, the disk drive media
of the future.

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Existing SMS technology was modified to produce the required light scatter information to provide the necessary measurements. The engineering staff developed the DUV (Deep Ultra-violet light)
technology to measure surface microroughness of glass substrates to the same precise levels as existing products and at levels required by the industry. This technology compliments existing products
and provides the Company the ability to supply solutions for all media used by the disk drive industry.

Companies
that grind production rolls used in such industries such as steel, brass, copper, printing and paper face a long, slow manual process to assure these rolls are ground to
required dimensions and smoothness required before they can be used. Industry problems include improper roll alignment during grinding, the time-consuming manual measurements during
grinding and the need for expensive periodic re-grinding of used rolls. All can result in costly factory down time. The solution to these problems is the Schmitt Precision Roll Monitor.
Using patented laser light scatter technology, the computer controlled system measures rolls to exact dimensions established by the customer. Evaluated are the roll alignment in the grinder, roll
diameter compared to established requirements and surface mircroroughness. A process that has been totally manual will now become fully automated and much more accurate. The shipment of the first
product using this new laser-based technology occurred in fiscal 2001.

During
Fiscal 1999, 2000 and 2001, the Company's research and development expense totaled $462,136, $380,601 and $327,474 respectively.

Business Risks

This annual report includes "forward-looking statements" as that term is defined in Section 21E of the Securities Exchange Act of 1934. Forward-looking
statements can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "will," "should," "seeks," "approximately," "intends," "plans," "estimates," "anticipates,"
or "hopeful," or the negative of those terms or other comparable terminology, or by discussions of strategy, plans or intentions. For example, this outlook section contains numerous forward-looking
statements. All forward-looking statements in this report are made based on management's current expectations and estimates, which involve risks and uncertainties, including those described in the
following paragraphs. Among these factors are the following: changes in demand for company products; new products may not be developed to satisfy changes in consumer demands; failure to protect
intellectual property rights could adversely affect future performance an growth: and production time and the overall cost of products could increase if any of the primary suppliers are lost or if any
primary supplier increased the prices of raw materials. Such risks and uncertainties could cause actual results to be materially different from those in the forward-looking statements. Readers are
cautioned not to place undue reliance on the forward-looking statements in this Annual Report. We assume no obligation to update such information.

Changes in demand for Company products:

During the fiscal 2001 the Company experienced soft market demand for its Balancing Products. While the specific reasons are difficult to pinpoint, these can
generally be attributed to economic conditions in the United States, specifically those in the grinding machine industry, the primary market for the Company's Balancer products. Based upon
management's analysis, the decline in sales does not appear from a shift in the customer base to competitor products.

Management
has responded to these soft market conditions in several ways. First, it appears there is a significant portion of the marketplace that is not using the automatic balancing
products of the Company or any of its competitors. In response to this, in the fourth fiscal quarter another field salesperson was hired. In addition, as market conditions improve in fiscal 2002 and
beyond, consideration will be given to hiring additional sales staff. Second, the Company will devote a significant part of its R&D efforts in fiscal 2002 and 2003 toward developing products that will
both

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broaden the scope of products offered to the current customer base and offer products for new markets so as to reduce the reliance on historic markets. Third, Management initiated a restructuring plan
in Europe in the fourth fiscal quarter of 2001 that is intended to increase worldwide operating
efficiency. All engineering design and manufacturing operations are now consolidated in the United States, a step that is expected to reduce operating costs. In addition, all European operations are
now focused totally on marketing and sales. Finally, Management will continue to evaluate all operating costs and seek to reduce costs where necessary.

The
Measurement segment has relied heavily upon sales to disk drive and silicon wafer manufacturers. Conditions in those markets have adversely affected sales beginning in fiscal 1999
and those conditions declined further in fiscal 2001. Demand for disk drives is largely tied to demand for personal computers and because of this concentration in a single market that industry is
tightly linked to the success of the personal computer market. Demand for personal computers has always been seasonal and cyclical and during fiscal 2001, personal computer manufacturers warned of
lower sales expectations with many taking steps to significantly reduce costs. As a result of these market conditions, demand for drives have fallen and the market is faced with excess manufacturing
capacity. Consequently the operations of those companies have suffered and one of the results has been reduced capital spending. This has resulted in minimal demand for the Company's TMS products and
sales are at historic low levels. Industry forecasts are for these conditions to continue in the foreseeable future

The
semiconductor industry is also highly cyclical and is currently facing a down cycle. Beginning in Fiscal 1998 and through Fiscal 2001 the industry experienced significant declines
in the product pricing and customers reduced demand forecasts and manufacturers reduced prices to maintain high capacity utilization. These trends appear to have been due primarily to the Asian
financial crisis during that period and excess personal computer inventories. Beginning in fiscal 2001 the semiconductor industry experienced backlog cancellations, resulting in slower revenue growth.
Industry forecasts are for these conditions to continue for the remainder of calendar 2001. The result is similar to disk drive manufacturers in that capital spending has declined significantly and
consequently so has demand for and sales of the Company's wafer products.

Management
will continue to market these products to these historic markets as it appears no other technology has been introduced that would make the TMS products technologically
obsolete. There is the belief that once market conditions improve in the disk drive and silicon wafer markets, demand for the Company's products and technology will increase. Also, there are other
uses for the Company's laser light scatter technology and efforts will be directed toward the R&D efforts to develop those products and introduce them to the marketplace.

New products may not be developed to satisfy changes in consumer demands:

The failure to develop new technologies, or react to changes in existing technologies, could materially delay development of new products, which could result
in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design, develop, manufacture, assemble, test, market and support new products and
enhancements on a timely and cost-effective basis. New product opportunities may not be identified and developed and brought to market in a timely and cost-effective manner.
Products or technologies developed by other companies may render products or technologies obsolete or noncompetitive or fundamental shift in technologies in the product markets could have a material
adverse effect on the Company's competitive position within historic industries.

Failure to protect intellectual property rights could adversely affect future performance and growth:

Failure
to protect existing intellectual property rights may result in the loss of valuable technologies or having to pay other companies for infringing on their intellectual property
rights. The

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Company relies on patent, trade secret, trademark and copyright law to protect such technologies. There can be no assurance that any of the Company's U.S. patents will not be invalidated,
circumvented, challenged or licensed to other companies.

Production time and the overall cost of products could increase if any of the primary suppliers are lost or if a primary supplier increased the prices of raw materials:

Manufacturing operations depend upon obtaining adequate supplies of raw materials on a timely basis. The results of operations could be adversely affected if
an adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increased significantly.

Failure to effectively and efficiently transfer German Manufacturing Operations to Portland:

In the fourth fiscal quarter of 2001, management initiated a plan to consolidate all manufacturing operations of the German subsidiary into its operations in
Portland. The reasons for this consolidation were to decrease manufacturing costs, increase operating efficiencies and to eventually manufacture the products of SEG under the Company's ISO quality
system. There can be no assurances the expected operating efficiencies can be achieved or that the engineering and manufacturing techniques can be successfully transferred to Portland.

International Sales

The Company's sales in the last three fiscal years by geographic areas are:

North America

Europe

Asia and OthersFiscal 2001

$
5,041,830

$
1,950,395

$
587,929Fiscal 2000

$
6,063,283

$
2,238,085

$
552,888Fiscal 1999

$
4,901,460

$
2,798,471

$
257,792


Backlog

The Company does not generally track backlog. Normally, orders are shipped within several weeks after receipt unless the customer requests otherwise.

Employees

As of July 6, 2001, the Company employed 45 individuals worldwide on a full-time basis. There were no regular part-time
employees. None of the Company's employees is covered by a collective bargaining agreement.

Item 2.  Properties

The Company's design and assembly facilities and executive offices are located in a 7,500-square foot company owned building in Portland, Oregon
and SMS operations are in a 33,000-square foot company owned facility located across the street from the executive offices. SEL occupies a 1,893-square foot facility in
Coventry, England pursuant to a five-year lease beginning February 1, 1997 with a basic monthly rent of £1,708 (approximately $2,423 as of July 6, 2001). SEG
occupies a 5,194-square foot facility in Alsbach, Germany pursuant to a five-year lease beginning February 1, 1997 with a basic monthly rent of DM 5,442 (approximately
$2,353 as of July 6, 2001). ARI occupies a 3,670 square foot facility in Menlo Park, California pursuant to a one-year lease beginning November 1, 2000 with a basic monthly
rent of $7,487 as of July 5, 2001. Management believes its facilities are adequate to meet its currently foreseeable needs.

12

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Item 3.  Legal Proceedings

There are no material legal proceedings currently pending against the Company.

Item 4.  Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of the security holders of the Company during the fourth quarter ended May 31, 2001.

13

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PART II

Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters

The Company's Common Stock is traded on the Nasdaq National Market under the symbol "SMIT."

The
following tables set forth the high and low sales prices of the Company's Common Stock as reported on the Nasdaq National Market for the periods indicated.

Year Ended May 31, 2000

High

LowFirst Quarter

$
3.56

$
2.50Second Quarter

$
3.38

$
2.38Third Quarter

$
3.75

$
2.06Fourth Quarter

$
3.69

$
2.44


Year Ended May 31, 2001

High

LowFirst Quarter

$
3.47

$
2.13Second Quarter

$
3.00

$
2.00Third Quarter

$
2.38

$
0.88Fourth Quarter

$
1.24

$
0.63


As
of July 6, 2001, there were 7,495,974 shares of Common Stock outstanding held by approximately 130 holders of record. The number of holders does not include individual
participants in security position listings; the Company believes that there are more than 2,500 individual holders of shares of Common Stock.

The
Company has not paid any dividends on its Common Stock since 1994. The Company's current policy is to retain earnings to finance the Company's business. Future dividends will be
dependent upon the Company's financial condition, results of operations, current and anticipated cash requirements, acquisition plans and plans for expansion and any other factors that the Company's
Board of Directors deems relevant. The Company has no present intention of paying dividends on its Common Stock in the foreseeable future.

Item 6.  Selected Financial Data

In thousands, except per share information

|Year Ended                           |  | 5/31/01 |        | 5/31/00 |   | 5/31/99 |  | 5/31/98 |        | 5/31/97
|------------------------------------ |  | ------- | ------ | ------- | - | ------- |  | ------- | ------ | -------
|Sales                                |  | $       | 7,580  |         | $ | 8,854   |  | $       | 7,958  |        
|Net (Loss) income                    |  | $       | (2,367 | )       | $ | 561     |  | $       | (259   | )      
|Net (Loss) income Per Share, Basic   |  | $       | (.30   | )       | $ | 0.07    |  | $       | (0.03  | )      
|Weighted Average. No. Shares, Basic  |  |         | 7,905  |         |   | 8,104   |  |         | 7,592  |        
|Net (Loss) income Per Share, Diluted |  | $       | (.30   | )       | $ | 0.07    |  | $       | (0.03  | )      
|Weighted Average No. Shares, Diluted |  |         | 7,905  |         |   | 8,607   |  |         | 7,592  |        
|Stockholders' Equity                 |  | $       | 8,930  |         | $ | 10,128  |  | $       | 10,587 |        
|Total Assets                         |  | $       | 10,291 |         | $ | 10,953  |  | $       | 11,282 |        
|Long-term debt                       |  | $       | 353    |         | $ |        |  | $       |       |        

Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

The following information contains certain forward-looking statements that anticipate future trends or events. These statements are based on certain
assumptions that may prove to be erroneous and are

14

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subject to certain risks including but not limited to the uncertainties of the Company's new product introductions, the risks of increased competition and technological change in the Company's
industries and other factors detailed in the Company's SEC filings. Accordingly, actual results may differ, possibly materially, from the predictions contained herein.

During
fiscal 2001, the Company experienced sales and profits that were lower than those experienced in the two prior fiscal years. These declines were primarily due to the following
reasons:



| |  |  |  | Disk drive demand is largely tied to demand for personal computers. Therefore the economic condition of that industry is dependent upon the success of the personal computer market. Personal computer demand has always been
seasonal and cyclical and during the fiscal 2001, personal computer manufacturers warned of lower sales expectations with many taking steps to significantly reduce costs. As a result of these market conditions, demand for drives have fallen and the
market is faced with excess manufacturing capacity. Consequently, operations of those companies have suffered and one of the results has been reduced capital spending. This has resulted in minimal demand for the Company's TMS products and sales are
at historic low levels. Industry forecasts are for these conditions to continue in the foreseeable future.                     
| |  | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |  |  | The semiconductor industry is also highly cyclical and is currently facing a down cycle. Beginning in Fiscal 1998 and through Fiscal 2000 the industry experienced significant declines in the product pricing, customers reduced demand forecasts and
manufacturers reduced prices to maintain high capacity utilization. These trends appear to have been due primarily to the Asian financial crisis during that period and excess personal computer inventories. Beginning in fiscal 2001 the semiconductor
industry experienced backlog cancellations, resulting in slower revenue growth. Industry forecasts are for these conditions to continue for the remainder of calendar 2001. The result is similar to disk drive manufacturers in that capital spending has
declined significantly and consequently so has demand for and sales of the Company's wafer products.



15

---



16

---



The result of these latter two actions are expected to resulting in increasing sales and lower operating expenses in fiscal 2002 and beyond.

Net
sales outside the United States accounted for approximately 24% of the Company's revenues in fiscal 2001, 24% in fiscal 2000 and 48% in fiscal 1999. Some foreign customers
purchase in their own country's currencies, thereby imposing on the Company a currency risk. All U.S. sales (76% of total sales in fiscal 2001) were in U.S. dollars and the remaining fiscal 2001 sales
were in currencies other than U.S. dollars. To date, currency fluctuations have had little impact on revenue realization. However, significant variations in the value of the U.S. dollar, relative to
currencies of countries in which the Company has significant competitors, can impact future sales. The Company does not engage in currency hedging. In addition, the longer payment cycles of
international sales can have a negative impact on liquidity. The Company believes international sales will continue to grow in future periods.

A
substantial portion of the Company's revenues is derived from sales to end users through selling agents and directly to builders of machine tools. The Company is dependent on the
sales activities of its selling agents, and there can be no assurance these agents will continue to be successful in their efforts to market the Company's products. The Company enjoys substantial
repeat business from a broad base of customers, but there is no assurance these customers will continue to buy the Company's products.

For
fiscal years 2001, 2000 and 1999, sales to a single customer did not exceed 10% of total revenues.

Fiscal
2001 sales decreased primarily in the Balancer segment, with the general economic slowdown in the United States believed to be the biggest cause. Consolidated revenues were
higher in fiscal 2000 principally from increased sales to the technology industry over those experienced in fiscal 1999. Product improvements and available features have resulted in modestly increased
average product costs.

The
Company operates in highly competitive industries characterized by increasingly rapid technological changes. The Company's competitive advantage and future success are therefore
dependent on its ability to develop new products, qualify these new products with its customers, successfully introduce these products to the marketplace on a timely basis, commence production to meet
customer demands and develop new markets in the industries for its products and services. The successful introduction of new technology and products is increasingly complex. If the Company is unable,
for whatever reason, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, its results of operations could be adversely impacted.

RESULTS OF OPERATIONS

Sales in fiscal 2001 decreased to $7,580,154 from $8,854,256 and $7,957,723 in fiscal 2000 and 1999 respectively. Worldwide sales of Schmitt Balancing products
in fiscal 2001 decreased to $6,030,030 from $7,244,969 and $7,377,879 in fiscal 2000 and 1999 respectively. Measurement sales decreased to $1,550,124 from $1,609,287 in fiscal 2000 but increased from
$579,844 in fiscal 1999. The net (loss) for fiscal 2001 of $(2,366,953) compares to net earnings of $561,459 in fiscal 2000 and a net loss for fiscal 1999 of $259,307. The loss in fiscal 2001 was
primarily attributable to a write-off of excess inventory in the subsidiary which designs and assembles laser light scatter products. However, economic conditions in the United States
contributed to lower sales of balancer products in North American, further dampening earnings. Also, late in the fiscal year Management restructured operations in Europe and recognized expenses of
$226,525 in association with that restructure.

Historically
the Company has enjoyed low cost of sales percentages, with those on its Balancing products less than 50% and those on its Measurement products less than 40%. Fiscal year
2001

16

---

consolidated cost of sales as a percentage of sales totaled 68% compared to those in fiscal 2000 and 1999 of 44% and 52% respectively. Fiscal 2001 cost of sales increased significantly from fiscal
2000 and 1999 due to the large write-downs of inventory in the measurement segment and the write-off of obsolete inventories in the German subsidiary. Cost of sales in the balancer segment
increased slightly to 51% from 47% in fiscal 2000 but decreased from 52% in fiscal 1999. The cost of sales percentage in fiscal 2001 includes a write-off of obsolete inventory in the
German subsidiary of $110,250 which, when excluded from cost of sales, would decrease the percentage to 49%. Cost of sales for Measurement products increased to 136% from 30% and 55% in fiscal 2000
and 1999 respectively. However, when the $1,536,267 inventory write-down is excluded, the cost of sales percentage is 37%. The variation from the percentage in the prior years is due to
the sales mix. Management expects the trends in sales and profits during fiscal 2002 for the Balancer segment to improve slightly while those of the Measurement segment will approximate results for
fiscal 2001. However, no assurances can be made that the Company will be profitable or will generate increased sales in future time periods.

General,
administrative and sales expenses as a percentage of net sales were 57% in fiscal 2001 compared to 43% in fiscal 2000 and 48% in fiscal 1999. In terms of dollars, these
expenses were $4,297,130, $3,809,976 and $3,841,155 in fiscal 2001, 2000 and 1999 respectively. The increase in expenses in fiscal 2001, despite decreasing sales, resulted from the acquisition of
Acuity Research effective June 1, 2001. When the Acuity expenses are excluded, these expenses in 2001 would have been $3,707,754, lower than those reported in fiscal year 2000 and 1999. In
future fiscal periods, Management believes the Company's costs will not increase at the same rate that sales are anticipated to increase, although there can be no such assurance.

Research
and development expenses as a percentage of net sales were 4.3% in fiscal 2001 compared to 4.3% in fiscal 2000 and 5.8% in fiscal 1999. In terms of dollars, these expenses
were $327,474, $380,601 and $462,136 in fiscal 2001, 2000 and 1999 respectively. The Company's future operating results depend, to a considerable extent, on its ability to maintain a competitive
advantage in both the products and services it provides. For this reason, Management believes future investments in research and development are critical to ensure the flow of innovative, productive,
high-quality products and support services. Accordingly, Management expects to continue to place a high priority on research and development projects in the future.

The
company realized a net loss of $(2,366,953) ($0.30 per diluted share) compared to net income of $561,459 in fiscal 2000 ($0.07 per diluted share) and a net loss of ($259,307)
($0.03 per diluted share) in fiscal 1999. Of this net loss in fiscal 2001, $1,646,517 ($0.21 per fully diluted share) related to the write-off of excess inventories in the measurement
segment and obsolete inventories of the German subsidiary and $116,275 ($0.01 per diluted share) related to the expenses incurred in relation to the restructure of the German subsidiary.

LIQUIDITY AND CAPITAL RESOURCES

The Company's ratio of current assets to current liabilities decreased to 4.8 to 1 at May 31, 2001 compared to 8.9 to 1 at May 31, 2000 and 9.4
to 1 at May 31, 1999. As of May 31, the Company had $291,083 in cash compared to $1,264,475 at May 31, 2000.

The
accounts receivable balance at May 31, 2001 was $1,227,157 compared to $1,377,422 at May 31, 2000. This change from prior years is not significant as accounts
receivable in fiscal 2001 turned at 5.8 times per year compared to 6.3 times in fiscal 2000. At May 31, 2001, no significant accounts receivable were considered a doubtful collection. The
Company generally experiences a payment cycle of 30-80 days on invoices. Management believes its credit and collection policies are effective and appropriate for the marketplace and
the Company has had no significant bad debt write-offs since its inception in 1986. There can be no assurance that the Company's collection procedures will continue to be successful.

17

---

Inventories declined in fiscal 2001 primarily due to the write-off of $1.5 million in excess quantities in the measurement segment. This was partially offset by a
$324,901 increase in balancing segment inventories. This increase was carefully evaluated, and, while all inventories in that segment are believed to be usable, these items are under an inventory
reduction program that is projected to produce a significant decrease in the level of inventories in fiscal 2002. The reduction will come about both through sales in the ordinary course of business
and more strict purchasing procedures. The Company maintains levels of inventory sufficient to satisfy normal customer demands plus an increasing short-term delivery requirement for a
majority of its Balancer products. Management believes its ability to provide prompt delivery gives it a competitive advantage for certain sales.

Working
capital decreased to $4,189,525 at May 31, 2001 from $6,542,983 at May 31, 2000. During fiscal 2001 and 2000, the Company spent $147,616 and $190,086
respectively to acquire certain worldwide corporate assets of property and equipment to assist in production and product development. Although the Company has no current material commitments for
capital expenditures, product development to extend Balancer and Measurement products to new markets is expected to result in increased capital expenditures for equipment in fiscal 2002.

In
fiscal 1999, officers/employees exercised stock options for 485,750 shares at an average exercise price of $1.79 per share. The officers/employees issued notes to the Company for
the exercise price. During the years ended May 31, 2001 and 2000, the Company and the officers/employees mutually agreed to terminate these notes. The notes were secured by outstanding common
stock of the Company issued upon exercise of the stock options. In return for cancellation of the notes, the officers/employees surrendered the shares that secured the notes, with those shares
subsequently cancelled.

Also
in fiscal 1999, the Company issued 610,000 shares of its common stock to acquire 1,375,716 outstanding shares of Air Packaging Technologies, Inc. (APTI). That company is
engaged in the design, manufacture, marketing and sales of "Air Box" patented packaging systems used in retail, industrial protective and promotional packaging markets worldwide. The Company made this
investment as the philosophy of APTI is similar to its ownto provide products that make its customers more profitable either through increased productivity or reduced operating costs.

The
acquisition of SMS in fiscal 1995 resulted in a tax loss carryforward in excess $5 million, which is available to offset domestic earnings through the year 2009. As of
May 31, 2000, approximately $2.4 million of these losses remain. In addition, the loss in 2001 generated a net operating loss carryforward of $1.8 million that will be available
to offset earnings through the year 2021.

Management
believes its cash flows from operations, available credit resources and its cash position will provide adequate funds on both a short-term and
long-term basis to cover currently foreseeable debt payments, lease commitments and payments under existing and anticipated supplier agreements. Management believes that such cash flow
(without the raising of external funds) is sufficient to finance current operations, projected capital expenditures, anticipated long-term sales agreements and other expansion-related
contingencies during fiscal 2002.

Item 7A.  Qualitative and Quantitative Disclosures about Market Risk

Interest Rate Risk

The Company does not have any derivative financial instruments as of May 31, 2001. However, the Company is exposed to interest rate risk. The Company
employs established policies and procedures to manage its exposure to changes in the market risk of its marketable securities.

The
Company's interest income and expense are most sensitive to changes in the general level of U.S. and European interest rates. Therefore, changes in U.S. and European interest
rates affect the interest earned on the Company's cash equivalents and marketable securities as well as interest paid on debt.

18

---

The Company has lines of credit and other debt whose interest rates are based on various published prime rates that may fluctuate over time based on economic changes in the
environment. The Company is subject to interest rate risk and could be subject to increased interest payments if market interest rates fluctuate. The Company does not expect any change in the interest
rates to have a material adverse effect on the Company's results from operations.

Foreign Currency Risk

The Company operates subsidiaries in the United Kingdom and Germany. The Company's business and financial condition is, therefore, sensitive to currency
exchange rates or any other restrictions imposed on their currencies. To date, the foreign currency exchange rates have not significantly impacted the Company's profitability.

19

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Item 8. Financial Statements and Supplementary Data

SCHMITT INDUSTRIES, INC.  CONSOLIDATED BALANCE SHEETS  MAY 31, 2001 AND 2000

|                                           |                                                                                                                                                        | 2001 |            | 2000      |  
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------ | ---- | ---------- | --------- | -
|ASSETS                                     |                                                                                                                                                       
|Current Assets                             |                                                                                                                                                        |      |            |           |  
|                                           | Cash                                                                                                                                                   |      | $          | 291,083   |  
|                                           | Accounts receivable                                                                                                                                    |      |            | 1,227,157 |  
|                                           | Inventories                                                                                                                                            |      |            | 3,559,038 |  
|                                           | Prepaid expenses                                                                                                                                       |      |            | 186,570   |  
|                                           | Income taxes receivable                                                                                                                                |      |            | 33,661    |  
|                                           |                                                                                                                                                        |      |            |           |  
|                                           |                                                                                                                                                        |      | 5,297,509  |           |  
|                                           |                                                                                                                                                        |      |            |           |  
|Property and Equipment                     |                                                                                                                                                        |      |            |           |  
|                                           | Land                                                                                                                                                   |      |            | 299,000   |  
|                                           | Buildings and improvements                                                                                                                             |      |            | 1,216,140 |  
|                                           | Furniture, fixtures, and equipment                                                                                                                     |      |            | 948,901   |  
|                                           | Vehicles                                                                                                                                               |      |            | 155,010   |  
|                                           |                                                                                                                                                        |      |            |           |  
|                                           |                                                                                                                                                        |      | 2,619,051  |           |  
|                                           | Less accumulated depreciation and amortization                                                                                                         |      |            | 1,081,854 |  
|                                           |                                                                                                                                                        |      |            |           |  
|                                           |                                                                                                                                                        |      | 1,537,197  |           |  
|                                           |                                                                                                                                                        |      |            |           |  
|Other Assets                               |                                                                                                                                                        |      |            |           |  
|                                           | Long-term investments                                                                                                                                  |      |            | 2,408,000 |  
|                                           | Long-term deferred tax asset                                                                                                                           |      |            | 613,871   |  
|                                           | Other assets                                                                                                                                           |      |            | 433,931   |  
|                                           |                                                                                                                                                        |      |            |           |  
|                                           |                                                                                                                                                        |      | 3,455,802  |           |  
|                                           |                                                                                                                                                        |      |            |           |  
|TOTAL ASSETS                               |                                                                                                                                                        | $    | 10,290,508 |           | $
|                                           |                                                                                                                                                        |      |            |           |  
|LIABILITIES AND STOCKHOLDERS' EQUITY       |                                                                                                                                                       
|Current Liabilities                        |                                                                                                                                                        |      |            |           |  
|                                           | Line of credit                                                                                                                                         |      | $          | 200,000   |  
|                                           | Accounts payable                                                                                                                                       |      |            | 418,087   |  
|                                           | Accrued commissions                                                                                                                                    |      |            | 129,154   |  
|                                           | Other accrued liabilities                                                                                                                              |      |            | 260,743   |  
|                                           | Current portion of long-term debt                                                                                                                      |      |            | 100,000   |  
|                                           |                                                                                                                                                        |      |            |           |  
|                                           |                                                                                                                                                        |      | 1,107,984  |           |  
|                                           |                                                                                                                                                        |      |            |           |  
|Long-term Debt                             |                                                                                                                                                        |      | 252,600    |           |  
|Commitments and Contingencies (Note 8)     |                                                                                                                                                        |      |            |           |  
|Stockholders' Equity                       |                                                                                                                                                        |      |            |           |  
|                                           | Common stock, no par value, 20,000,000 shares authorized, 7,505,774 and 7,980,389 shares issued and outstanding at May 31, 2001 and 2000, respectively |      |            | 7,407,476 |  
|                                           | Accumulated other comprehensive loss                                                                                                                   |      |            | (175,954  | )
|                                           | Retained earnings                                                                                                                                      |      |            | 1,698,402 |  
|                                           |                                                                                                                                                        |      |            |           |  
|                                           |                                                                                                                                                        |      | 8,929,924  |           |  
|                                           |                                                                                                                                                        |      |            |           |  
|TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY |                                                                                                                                                        | $    | 10,290,508 |           | $
|                                           |                                                                                                                                                        |      |            |           |  

The accompanying notes are an integral part of these consolidated statements

20

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SCHMITT INDUSTRIES, INC.  CONSOLIDATED STATEMENTS OF OPERATIONS  FOR THE YEARS ENDED MAY 31, 2001, 2000 AND 1999

|                                                               |                                                | 2001                     |            | 2000      |           | 1999      |          
|-------------------------------------------------------------- | ---------------------------------------------- | ------------------------ | ---------- | --------- | --------- | --------- | ---------
|Net Sales                                                      |                                                | $                        | 7,580,154  |           | $         | 8,854,256 |          
|Cost of Sales                                                  |                                                |                          |            |           |           |           |          
|                                                               | Operations, exclusive of inventory write-downs |                          |            | 3,529,991 |           |           | 3,895,345
|                                                               | Inventory write-downs                          |                          |            | 1,646,517 |           |           |         
|                                                               |                                                |                          |            |           |           |           |          
|                                                               |                                                | Total cost of sales      |            |           | 5,176,508 |           |          
|                                                               |                                                |                          |            |           |           |           |          
|                                                               |                                                | Gross profit             |            |           | 2,403,646 |           |          
|                                                               |                                                |                          |            |           |           |           |          
|Operating expenses:                                            |                                                |                          |            |           |           |           |          
|                                                               | General, administrative, and sales             |                          |            | 4,297,130 |           |           | 3,809,976
|                                                               | Research and development                       |                          |            | 327,474   |           |           | 380,601  
|                                                               | Restructure expenses                           |                          |            | 116,275   |           |           |         
|                                                               |                                                |                          |            |           |           |           |          
|                                                               |                                                | Total operating expenses |            |           | 4,740,879 |           |          
|                                                               |                                                |                          |            |           |           |           |          
|Operating (loss) income                                        |                                                |                          | (2,337,233 | )         |           | 768,334   |          
|                                                               |                                                |                          |            |           |           |           |          
|Other income and expense:                                      |                                                |                          |            |           |           |           |          
|                                                               | Interest expense                               |                          |            | (15,016   | )         |           | (628     
|                                                               | Interest income                                |                          |            | 36,513    |           |           | 30,462   
|                                                               | Miscellaneous (expense) income                 |                          |            | (51,217   | )         |           | (34,505  
|                                                               |                                                |                          |            |           |           |           |          
|                                                               |                                                | Other income and expense |            |           | (29,720   | )         |          
|                                                               |                                                |                          |            |           |           |           |          
|(Loss) income before (benefit from) provision for income taxes |                                                |                          | (2,366,953 | )         |           | 763,663   |          
|Provision for (benefit from) income taxes                      |                                                |                          |           |           |           | 202,204   |          
|                                                               |                                                |                          |            |           |           |           |          
|Net (loss) income                                              |                                                | $                        | (2,366,953 | )         | $         | 561,459   |          
|                                                               |                                                |                          |            |           |           |           |          
|Net (loss) income per common share, basic                      |                                                | $                        | (0.30      | )         | $         | 0.07      |          
|                                                               |                                                |                          |            |           |           |           |          
|Weighted average number of common shares, basic                |                                                |                          | 7,904,793  |           |           | 8,103,563 |          
|                                                               |                                                |                          |            |           |           |           |          
|Net (loss) income per common share, diluted                    |                                                | $                        | (0.30      | )         | $         | 0.07      |          
|                                                               |                                                |                          |            |           |           |           |          
|Weighted average number of common shares, diluted              |                                                |                          | 7,904,793  |           |           | 8,606,835 |          
|                                                               |                                                |                          |            |           |           |           |          

The accompanying notes are an integral part of these consolidated financial statements

21

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SCHMITT INDUSTRIES, INC.  CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY  FOR THE YEARS ENDED MAY 31, 2001, 2000 AND 1999

|                                                  |  | Shares    |   | Amount |           | Retained
Earnings |   | Accumulated
Other
Comprehensive
Loss |   | Total |            | Total
Comprehensive
(Loss) income |  
|------------------------------------------------- |  | --------- | - | ------ | --------- | ----------------- | - | ------------------------------------ | - | ----- | ---------- | --------------------------------- | -
|Balance, May 31, 1998                             |  | 7,099,139 |   | $      | 5,072,634 |                   | $ | 3,763,203                            |   | $     | (147,708   | )                                 | $
|Stock options exercised                           |  | 485,750   |   |        | 869,475   |                   |   |                                     |   |       |           |                                   |  
|Income tax benefit from exercise of stock options |  |          |   |        | 124,072   |                   |   |                                     |   |       |           |                                   |  
|Notes received for stock options                  |  |          |   |        | (869,475  | )                 |   |                                     |   |       |           |                                   |  
|Stock issued for long-term investment             |  | 610,000   |   |        | 2,135,000 |                   |   |                                     |   |       |           |                                   |  
|Common shares repurchased                         |  | (10,000   | ) |        | (47,261   | )                 |   |                                     |   |       |           |                                   |  
|Net loss                                          |  |          |   |        |          |                   |   | (259,307                             | ) |       |           |                                   |  
|Other comprehensive loss                          |  |          |   |        |          |                   |   |                                     |   |       | (54,073    | )                                 |  
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|Balance, May 31, 1999                             |  | 8,184,889 |   |        | 7,284,445 |                   |   | 3,503,896                            |   |       | (201,781   | )                                 |  
|Comprehensive loss, year ended May 31, 1999       |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|Stock options exercised                           |  | 10,000    |   |        | 30,000    |                   |   |                                     |   |       |           |                                   |  
|Common shares retired                             |  | (192,500  | ) |        | (282,975  | )                 |   |                                     |   |       |           |                                   |  
|Note cancelled in return for stock                |  |           |   |        | 282,975   |                   |   |                                     |   |       |           |                                   |  
|Common shares repurchased                         |  | (22,000   | ) |        | (55,046   | )                 |   |                                     |   |       |           |                                   |  
|Net income                                        |  |          |   |        |          |                   |   | 561,459                              |   |       |           |                                   |  
|Other comprehensive loss                          |  |          |   |        |          |                   |   |                                     |   |       | (994,902   | )                                 |  
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|Balance, May 31, 2000                             |  | 7,980,389 |   | $      | 7,259,399 |                   | $ | 4,065,355                            |   | $     | (1,196,683 | )                                 | $
|Comprehensive loss, year ended May 31, 2000       |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|Common shares issued to purchase Acuity Research  |  | 275,000   |   |        | 747,725   |                   |   |                                     |   |       |           |                                   |  
|Common shares retired                             |  | (293,250  | ) |        | (586,500  | )                 |   |                                     |   |       |           |                                   |  
|Note cancelled in return for stock                |  |           |   |        | 586,500   |                   |   |                                     |   |       |           |                                   |  
|Common shares repurchased                         |  | (456,365  | ) |        | (599,648  | )                 |   |                                      |   |       |            |                                   |  
|Net (loss)                                        |  |          |   |        |          |                   |   | (2,366,953                           | ) |       |           |                                   |  
|Other comprehensive income                        |  |          |   |        |          |                   |   |                                     |   |       | 1,020,729  |                                   |  
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|Balance, May 31, 2001                             |  | 7,505,774 |   | $      | 7,407,476 |                   | $ | 1,698,402                            |   | $     | (175,954   | )                                 | $
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|Comprehensive loss, year ended May 31, 2001       |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  
|                                                  |  |           |   |        |           |                   |   |                                      |   |       |            |                                   |  

The accompanying notes are an integral part of these consolidated financial statements

22

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SCHMITT INDUSTRIES, INC.  CONSOLIDATED STATEMENTS OF CASH FLOWS  FOR THE YEARS ENDED MAY 31, 2001, 2000 AND 1999

|                                                                    |                                                   | 2001                                                |                                                 | 2000      |          | 1999       |         
|------------------------------------------------------------------- | ------------------------------------------------- | --------------------------------------------------- | ----------------------------------------------- | --------- | -------- | ---------- | --------
|Cash Flows Relating to Operating Activities                         |                                                   |                                                     |                                                 |           |          |            |         
|Net (Loss) income                                                   |                                                   | $                                                   | (2,366,953                                      | )         | $        | 561,459    |         
|Adjustments to reconcile net (Loss) income to net                   |                                                   |                                                     |                                                 |           |          |            |         
|                                                                    |                                                   |                                                     | Cash provided by (used in) operating activities |           |          |            |         
|                                                                    | Write-down of excess inventory quantities         |                                                     |                                                 | 1,646,517 |          |            |        
|                                                                    | Depreciation and amortization                     |                                                     |                                                 | 269,631   |          |            | 267,580 
|                                                                    | Deferred taxes                                    |                                                     |                                                 |          |          |            | 139,757 
|(Increase) decrease in:                                             |                                                   |                                                     |                                                 |           |          |            |         
|                                                                    | Accounts receivable                               |                                                     |                                                 | 215,525   |          |            | 46,189  
|                                                                    | Inventories                                       |                                                     |                                                 | (495,524  | )        |            | (191,780
|                                                                    | Prepaid expenses                                  |                                                     |                                                 | (115,202  | )        |            | 10,432  
|                                                                    | Income taxes receivable                           |                                                     |                                                 | (8,743    | )        |            | 271,046 
|Increase (decrease) in:                                             |                                                   |                                                     |                                                 |           |          |            |         
|                                                                    | Accounts payable                                  |                                                     |                                                 | (59,226   | )        |            | 79,309  
|                                                                    | Accrued commissions and other accrued liabilities |                                                     |                                                 | 36,847    |          |            | 62,302  
|                                                                    | Income taxes payable                              |                                                     |                                                 |          |          |            | (12,819 
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|                                                                    |                                                   | Net cash provided by (used in) operating activities |                                                 |           | (877,128 | )          |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|Cash Flows Relating to Investing Activities                         |                                                   |                                                     |                                                 |           |          |            |         
|Purchase of property and equipment                                  |                                                   |                                                     | (147,616                                        | )         |          | (190,086   | )       
|Disposal of property and equipment                                  |                                                   |                                                     | 17,067                                          |           |          | 47,145     |         
|Cash acquired in purchase of wholly-owned subsidiary                |                                                   |                                                     | 113,604                                         |           |          |            |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|                                                                    |                                                   | Net cash used in investing activities               |                                                 |           | (16,945  | )          |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|Cash Flows Relating to Financing Activities                         |                                                   |                                                     |                                                 |           |          |            |         
|Proceeds from line of credit borrowings                             |                                                   |                                                     | 200,000                                         |           |          |            |         
|Repayment of long-term debt                                         |                                                   |                                                     | (119,400                                        | )         |          |           |         
|Common stock repurchased                                            |                                                   |                                                     | (127,648                                        | )         |          | (55,049    | )       
|Exercise of stock options                                           |                                                   |                                                     |                                                |           |          | 30,000     |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|                                                                    |                                                   | Net cash used in financing activities               |                                                 |           | (47,048  | )          |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|Effect of foreign exchange translation on cash                      |                                                   |                                                     | (32,271                                         | )         |          | (69,898    | )       
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|Decrease (increase) in cash                                         |                                                   |                                                     | (973,392                                        | )         |          | 995,587    |         
|Cash, beginning of year                                             |                                                   |                                                     | 1,264,475                                       |           |          | 268,888    |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|Cash, end of year                                                   |                                                   | $                                                   | 291,083                                         |           | $        | 1,264,475  |         
|                                                                    |                                                   |                                                     |                                                 |           |          |            |         
|Supplemental Disclosure of Cash Flow Information                    |                                                   |                                                     |                                                 |           |          |            |         
|Cash paid during the period for interest                            |                                                   | $                                                   | 15,016                                          |           | $        | 628        |         
|Cash paid during the period for income taxes                        |                                                   | $                                                   | 20,132                                          |           | $        | 16,110     |         
|Supplemental Schedule of Noncash Investing and Financing Activities |                                                   |                                                     |                                                 |           |          |            |         
|Increase (decrease) in market value of long-term investment         |                                                   | $                                                   | 1,596,000                                       |           | $        | (1,323,000 | )       
|Increase (decrease) in long-term deferred tax asset                 |                                                   | $                                                   | (543,000                                        | )         | $        | 398,000    |         
|Acquisition of long-term investment                                 |                                                   | $                                                   |                                                |           | $        |           |         
|Common stock issued for purchase of wholly-owned subsidiary         |                                                   | $                                                   | 747,725                                         |           | $        |           |         
|Wholly-owned subsidiary  net tangible assets acquired              |                                                   | $                                                   | (325,901                                        | )         | $        |           |         
|Wholly owned subsidiary  intangible assets acquired                |                                                   | $                                                   | (421,824                                        | )         | $        |           |         
|Long-term debt incurred to repurchase stock                         |                                                   | $                                                   | 472,000                                         |           | $        |           |         
|Income tax benefit of stock options exercised                       |                                                   | $                                                   |                                                |           | $        |           |         

The accompanying notes are an integral part of these consolidated statements

23

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SCHMITT INDUSTRIES, INC.        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        FOR THE YEARS ENDED MAY 31, 2001, 2000 AND 1999

NOTE 1  ORGANIZATION AND NATURE OF OPERATIONS

Schmitt Industries, Inc. (the Company) designs, assembles, markets, and distributes electronic and mechanical components for machine tool products and
laser measurement systems worldwide.

NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include those of the Company and its wholly owned subsidiaries: Schmitt Measurement Systems, Inc. (SMS), Schmitt
Europe, Ltd. (SEL), Schmitt Europa GmbH (SEG) and Acuity Research Incorporated (ARI). All significant intercompany accounts and transactions have been eliminated in the preparation of the
consolidated financial statements.

Foreign Currency Translation

Financial statements for the Company's subsidiaries outside the United States are translated into U.S. dollars at year-end exchange rates for
assets and liabilities and weighted average exchange rates for income and expenses. The resulting translation adjustments are recorded as a separate component of stockholders' equity titled
"Accumulated Other Comprehensive Loss."

Revenue Recognition

Revenue from product sales is recognized upon shipment. Sales are reported net of applicable cash discounts and allowances for returns. Revenue from
long-term contracts is recognized based on the effort incurred relative to the total effort expected over the course of the contract. Revenue in excess of billings was approximately
$53,000 and $97,000 at May 31, 2001 and 2000, respectively and is reflected in accounts receivable on the balance sheet.

Research and Development Costs

Research and development costs are charged to expense when incurred.

Stock-Based Compensation

Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (FAS 123) encourages, but does not require,
companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," (APB 25). Accordingly, compensation cost for stock options is measured as the
excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carrying amounts of existing
assets and liabilities and their respective tax bases.

24

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Earnings Per Share

Basic earnings per share are computed using the weighted average number of shares outstanding. Diluted earnings per share are computed using the weighted
average number of shares outstanding, adjusted for the incremental shares attributed to outstanding options to purchase common stock. Incremental shares of 503,272 in 2000 were used in the calculation
of diluted earnings per share. In fiscal 2001 and 1999, 384,442 and 130,245 incremental shares were excluded from the diluted loss per share calculation, as their effect was anti-dilutive.

Cash and Cash Equivalents

The Company considers short-term investments that are highly liquid, readily convertible into cash and have original maturities of less than three
months to be cash equivalents.

Inventory

Inventory is valued at the lower of cost or market with cost determined on the average cost basis. As of May 31, 2001 and 2000, inventories consisted of
raw materials ($1,962,312 and $2,456,522, respectively), work-in-process ($16,838 and $12,232, respectively), and finished goods ($1,579,888 and $2,167,038, respectively).

Property and Equipment

Property and equipment are stated at cost. Depreciation is computed using the straight-line method over estimated useful lives of three to seven
years for furniture, fixtures, and equipment; three years for vehicles; and twenty-five years for buildings and improvements.

Concentration of Credit Risk

Financial instruments that potentially expose the Company to concentration of credit risk are trade accounts receivable. Credit terms generally include a
discount of 11/2% if the invoice is paid within ten days, with the net amount payable in 30 days. No allowance for doubtful accounts is considered necessary.

Financial Instruments

The carrying amounts of financial instruments approximate their fair values at May 31, 2001.

Use of Estimates

The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

25

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New Accounting Pronouncements

In June 2000, the FASB issued SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," amending some
accounting and reporting standards of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 was issued in June 1998. In July 1999, the
FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities: Deferral of the Effective Date of FASB Statement No. 133." SFAS No. 137 delayed for one
year the effective date of SFAS No. 133, meaning adoption of SFAS No. 133 is required on June 1, 2001. SFAS No. 133 expands the definition of a derivative and requires that
all derivative instruments be recorded on an entity's balance sheet at fair value. These pronouncements are not expected to have a material impact on the financial statements.

NOTE 3  LONG-TERM INVESTMENTS

The Company owns 1,375,716 shares or approximately 12% of the outstanding shares of Air Packaging Technologies, Inc. That company is engaged in the
design, manufacture, marketing and sales of "Air Box" patented packaging systems used in the retail, industrial protective and promotional packaging markets worldwide. This investment is classified as
"Available-for-sale securities" under Statement of Financial Accounting Standards No. 115. As required under that statement, all unrealized gains and losses are included
in Accumulated Other Comprehensive Loss and reported as a separate component in Other Comprehensive Loss in Stockholders' Equity until realized. At May 31, 2001 the market value exceeded the
acquisition cost by $273,000.

NOTE 4  LINE OF CREDIT

The Company has a $1.5 million unsecured short-term line of credit agreement with a commercial bank. The line is guaranteed by the Company's
wholly owned subsidiary, Schmitt Measurement Systems, Inc. Interest is payable at the bank's prime rate minus 0.25%, or LIBOR +2.00%. The line of credit is renewable annually. As of
May 31, 2001, $200,000 was outstanding under this line while no balance was outstanding at May 31, 2000.

NOTE 5  INCOME TAXES

The provision (benefit) for income taxes was as follows

|                                           |  | Years ended May 31, |         
|------------------------------------------ |  | ------------------- | --------
|
|Current                                    |  | $                   |        
|Deferred                                   |  |                     | (718,431
|Increase (decrease) in valuation allowance |  |                     | 718,431 
|                                           |  |                     |         
|Total provision (benefit) for income taxes |  | $                   |        
|                                           |  |                     |         

26

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Deferred
tax assets (liabilities) are comprised of the following components:

|                                                                                              |  | 2001 |           | 2000 |  
|--------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- | -
|Depreciation                                                                                  |  | $    | 3,311     |      | $
|Net operating loss carryforwards                                                              |  |      | 1,527,545 |      |  
|Deferred taxes related to the (increase) decline in fair market value of long-term investment |  |      | (145,000  | )    |  
|Other asset capitalization                                                                    |  |      | 10,489    |      |  
|Other deferred assets                                                                         |  |      | 60,188    |      |  
|                                                                                              |  |      |           |      |  
|Gross deferred tax assets                                                                     |  |      | 1,456,533 |      |  
|Deferred tax asset valuation allowance                                                        |  |      | (842,662  | )    |  
|                                                                                              |  |      |           |      |  
|Net deferred tax asset                                                                        |  | $    | 613,871   |      | $
|                                                                                              |  |      |           |      |  

Through
the acquisition of Schmitt Measurement Systems, Inc., the Company acquired approximately $5.5 million of U.S. federal net operating loss carryforwards. As of
May 31, 2001, approximately $2.4 million of these net-operating losses remain and will expire in the years 2007 through 2009. The NOL carryforwards aggregate approximately
$4.2 million at May 31, 2001 and will expire in the years 2007 to 2021. The deferred tax asset valuation allowance in fiscal years 2001 and 2000 has been
established based on management's determination of the portion of the deferred tax asset that will more likely than not be utilized.

The
provision for income taxes differs from the amount of income taxes determined by applying the U.S. statutory federal tax rate to pre-tax (loss) income due to the
following:

|                                           |  | 2001  |   | 2000  |   | 1999  |   
|------------------------------------------ |  | ----- | - | ----- | - | ----- | --
|Statutory federal tax rate                 |  | 34.0  | % | 34.0  | % | (34.0 | )%
|State taxes, net of federal benefit        |  |      |   | 4.4   |   | (4.3  | ) 
|Change in deferred tax valuation allowance |  | (30.3 | ) | (13.2 | ) |      |   
|Permanent and other differences            |  | (3.7  | ) | 1.3   |   | 3.9   |   
|                                           |  |       |   |       |   |       |   
|Effective tax rate                         |  |      | % | 26.5  | % | (34.4 | )%
|                                           |  |       |   |       |   |       |   

NOTE 6  EMPLOYEE BENEFIT PLANS

The Company adopted the Schmitt Industries, Inc. 401(k) Profit Sharing Plan & Trust effective June 1, 1996. Employees must meet certain
age and service requirements to be eligible. Participants may contribute up to 15% of their eligible compensation that is partially matched by the Company. The Company may further make either a profit
sharing contribution or a discretionary contribution. Contributions made by the Company to this Plan during the year ended May 31, 2001 and May 31, 2000 were $128,543 and $88,759,
respectively.

NOTE 7  LONG-TERM DEBT

During fiscal 2001, the Company purchased 400,000 shares of its common stock from a private investor for $472,000. Under the terms of the stock purchase
agreement, the Company paid $94,400 in

27

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cash at closing with the remainder due under a note agreement. The agreement calls for quarterly principal payments of $25,000, plus interest at 9.00%, with the remaining balance due on
December 31, 2002.

NOTE 8  COMMITMENTS AND CONTINGENCIES

In a transaction related to the acquisition of Schmitt Measurement Systems, Inc. the Company established a royalty pool and vested in each shareholder
and debt holder of the acquired company an interest in the royalty pool equal to the amount invested or loaned including interest payable through March 1995. The royalty pool will be funded at
5% of net sales (defined as gross sales less returns, allowances, and sales commissions) of Schmitt Measurement Systems, Inc.'s products and future
derivative products developed by Schmitt Industries, Inc., which utilize these technologies. As part of the royalty pool agreement, each former shareholder and debt holder released TMA
Technologies, Inc., from any claims with regard to the acquisition except their rights to future royalties. Royalty payment applicable to the years ended May 31, 2001, 2000 and 1999
amounted to $36,964, $78,977 and $28,992, respectively.

NOTE 9  SEGMENTS OF BUSINESS

The Company operates principally in two segments of business: the manufacturing of mechanical components for the machine tool industry, and the manufacturing
of laser measurement systems. The Company also operates in two principal geographic markets, US and foreign.

The
segment that manufactures mechanical components reported gross sales of $7,112,415 for the year ended May 31, 2001, including inter-company sales of $1,082,385. This
segment reported gross sales of $8,173,275 for the year ended May 31, 2000, including inter-company sales of $928,306 and gross sales of $8,223,308 for the year ended May 31, 1999
including intercompany sales of $845,429. The segment that manufactures laser measurement systems reported gross sales of $1,644,309 for the year ended May 31, 2001 including intercompany sales
of $94,185. This segment reported gross sales of $1,625,717 for the year ended May 31, 2000 including intercompany sales of $16,430 and gross sales of $579,844 with no inter-company sales for
the fiscal year ended May 31, 1999. Geographically, US sales were $4,801,558, $5,822,941 and $4,756,079 for fiscal years ended May 31, 2001, 2000 and 1999 respectively. Foreign sales
were $3,955,066, $3,976,051 and $4,047,073 for the same years, respectively. This includes inter-company sales of $1,176,570 for the year ended May 31, 2001, $944,736 for the year ended
May 31, 2000 and $845,429 for the year ended May 31, 1998. For the years ended May 31, 2001, 2000 and 1999, respectively, export sales by the US segment totaled $982,145, $878,303
and $615,212.

(Loss)
income from operations for the years ended May 31, 2001, 2000 and 1999 for the mechanical components segment was $(353,064), $119,015 and $(263,965), respectively.
(Loss) income from operations for the years ended May 31, 2001, 2000 and 1999 of the laser measurement segment was $(1,984,169), $649,319 and $(226,883), respectively. Consolidated (Loss)
income from operations includes an adjustment of $30,000 for the elimination of inter-company rent for the years ended May 31, 2001, 2000 and 1999. (Loss) income from operations for the US
segment was $(2,032,282), $823,904
and $(305,390), respectively, for the years ended May 31, 2001, 2000 and 1999 and, for the foreign segment, losses of $(304,951), $(55,570) and $(185,458) respectively, for the same years.

28

---

Long-term assets at May 31, 2001 and 2000 were $4,074,588 and $3,107,721 for the mechanical components segment and $918,411 and $477,367 for the laser measurement
segment. Long-term assets at May 31, 2001 and 2000, were $4,940,040 and $3,489,686 for the US segment and $52,959 and $95,402 for the foreign segment.

Depreciation
expense incurred during the years ended May 31, 2000, 1999 and 1998, by the mechanical components segment was $147,719, $176,367 and $194,541, respectively. The
laser measurement segment incurred depreciation expense of $67,352, $71,213 and $99,972, for the years ended May 31, 2001, 2000 and 1999, respectively. Amortization expense incurred during the
years ended May 31, 2001, 2000 and 1999 by the mechanical components segment was $20,000, $20,000 and $13,333, respectively. The laser measurement segment incurred amortization expense of
$34,560 for 2001 and did not incur amortization expense for years 2000 and 1999. The US segment incurred depreciation expense of $174,593, $194,204 and $221,295 during the years ended May 31,
2001, 2000 and 1999, respectively. The foreign segment incurred depreciation expense of $40,478, $53,376 and $73,218, respectively, for these same years. The US segment incurred amortization expense
of $54,560, $20,000 and $13,333 for the fiscal years ended May 31, 2001, 2000 and 1999. The foreign segment has not incurred amortization expense.

Capital
expenditures for the years ended May 31, 2001 and 2000, were $98,014 and $173,071 by the mechanical components segment and $49,602 and $17,015 by the laser measurement
segment, respectively. Capital expenditures for the years ended May 31, 2001 and 2000, were $133,153 and $137,443 by the US segment and $14,463 and $52,643 by the foreign segment, respectively.

Income
from operations represents sales less costs and operating expenses. In computing income from operations, all overhead expenses have been allocated to both industry segments, as
they are an integral part of profit recognition for each segment. Identifiable assets by segment of business are those assets used in the Company's operations in each segment. There are no unallocated
Company assets.

NOTE 10  STOCK OPTIONS

Prior to 1995, the Company granted stock options to officers and employees of the Company. Stock options for up to 10% of the outstanding shares were eligible
for grant provided the stock options for any one individual did not exceed 5% of the issued and outstanding shares of common stock. The purchase price of the optioned shares was equal to not less than
the average closing price of the Company's common stock for the ten trading days immediately preceding the grant date of the stock options. The maximum term of each stock option did not exceed five
years and all options were vested and exercisable upon grant.

The
outstanding options exercised in the fiscal year ended May 31, 1999 were held by officers/employees who issued notes to the Company for the exercise price. During the years
ended May 31, 2001 and 2000, the Company and each of the officers/employees mutually agreed to terminate the notes. The notes were secured by outstanding common stock of the Company that had
been issued upon exercise of the options. In return for cancellation of the note, the officers/employees surrendered the shares that secured the notes, with those shares subsequently cancelled.

The
Board of Directors adopted a 1995 Stock Option Plan on December 19, 1995, which plan was amended in August 1996 and restated in August 1998. An option granted
under the Amended and Restated Stock Option Plan might be either an incentive stock option (ISO), or a nonstatutory stock option (NSO). ISOs may be granted only to employees of the Company and are
subject to certain limitations, in addition to restrictions applicable to all stock options under the Plan. Options not meeting these limitations will be treated as NSOs. The purchase of ISOs is fair
market value on the date of grant; the purchase price of NSOs may vary from fair market value. Vesting is at the discretion of the option committee of the Board of Directors but generally 50% at grant
date and 16.7% on each

29

---

anniversary thereafter. The Company has 800,000 shares reserved for issuance under the stock option plan. The options expire in years 2010 through 2011.

The
following summarizes the options outstanding as of May 31, 2001:

|                                  |  | Options Prior to 1995 |   | 1995 Stock Option Plan |      |  |         
|--------------------------------- |  | --------------------- | - | ---------------------- | ---- |  | --------
|
|Options outstanding, May 31, 1998 |  | 485,750               |   | $                      | 1.79 |  | 289,250 
|Options granted                   |  |                      |   |                        |     |  | 589,250 
|Options exercised                 |  | (485,750              | ) | $                      | 1.79 |  |        
|Options forfeited/cancelled       |  |                      |   |                        |     |  | (426,750
|                                  |  |                       |   |                        |      |  |         
|Options outstanding, May 31, 1999 |  |                      |   |                        |     |  | 451,750 
|Options granted                   |  |                      |   |                        |     |  | 179,000 
|Options exercised                 |  |                      |   |                        |     |  | (10,000 
|Options forfeited/cancelled       |  |                      |   |                        |     |  | (37,500 
|                                  |  |                       |   |                        |      |  |         
|Options outstanding May 31, 2000  |  |                      |   |                        |     |  | 583,250 
|Options granted                   |  |                      |   |                        |     |  | 645,000 
|Options exercised                 |  |                      |   |                        |     |  |        
|                                  |  |                       |   |                        |      |  |         
|Options repurchased               |  |                      |   |                        |     |  | (329,250
|                                  |  |                       |   |                        |      |  |         
|Options forfeited/cancelled       |  |                      |   |                        |     |  | (222,000
|                                  |  |                       |   |                        |      |  |         
|Options outstanding May 31, 2001  |  |                      |   |                        |     |  | 677,000 
|                                  |  |                       |   |                        |      |  |         
|Options vested at May 31, 2001    |  |                      |   |                        |     |  | 347,246 
|                                  |  |                       |   |                        |      |  |         

The
Company has adopted the disclosure only provisions of SFAS 123. Accordingly, no compensation cost has been recognized for the stock option plans. Adjustments are made for
options forfeited prior to vesting. For the years ended May 31, 2001, 2000 and 1999, total value of options granted was computed to be $621,850, $473,460 and $1,275,098, respectively, which
would be amortized on a straight-line basis over the vesting period of the options. Had compensation cost for the Company's stock option plans been determined based on the fair value at
the grant date for the awards in 2001, 2000 and 1999, consistent with the provisions of SFAS 123, the Company's pro forma net (loss) income for the years ended May 31, 2001, 2000 and
1999, would be $(2,758,930), $261,255 and ($467,573), respectively. Pro forma basic (loss) earnings per share for the years ended May 31, 2001, 2000 and 1999 would be $(.35) $03 and ($.06)
respectively. Pro forma diluted (loss) earnings per share for the years ended May 31, 2001, 2000 and 1999 would be $(.35), $03 and ($.06), respectively.

Pursuant
to SFAS 123, the fair value of each option granted is estimated on the date of the grant using the Black-Scholes option and pricing model. The weighted average
assumptions used for fiscal 2001, 2000 and 1999 was a risk-free interest rate of 5.00% for 2001, 7.50% for 2000 and 5.50% for 1999, an expected dividend yield of 0% for all years, an
expected life of 8 years for all periods, and a volatility of 80%, 132% and 65%, respectively.

The
effects of applying SFAS No. 123 in the proforma disclosure are not indicative of future amounts.

30

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NOTE 11  COMPREHENSIVE OTHER LOSS

|                                             |                                                                                | Years ended May 31, |           
|-------------------------------------------- | ------------------------------------------------------------------------------ | ------------------- | ----------
|
|Significant components of net (loss) income: |                                                                                |                     |           
|                                             | Inventory write-downs                                                          |                     | $         
|                                             | Restructure costs                                                              |                     |           
|                                             | Operations exclusive of inventory write-downs and restructure costs            |                     |           
|                                             |                                                                                |                     |           
|Net (loss) income                            |                                                                                |                     | (2,366,953
|Other comprehensive (loss) income:           |                                                                                |                     |           
|                                             | Increase (decrease) in fair market value of long-term Investment, net of taxes |                     |           
|Foreign currency translation adjustment      |                                                                                |                     | (32,271   
|                                             |                                                                                |                     |           
|Total comprehensive loss                     |                                                                                | $                   | (1,346,224
|                                             |                                                                                |                     |           

The
long-term investment is considered an "Available-for-sale security". As required under Statement of Financial Accounting Standards
No. 115, all unrealized gains and losses, net of tax benefits, are included in Accumulated Other Comprehensive (Loss) Income and reported as a separate component of Other Comprehensive (Loss)
Income in Stockholders' Equity until realized. The cumulative translation adjustment consists of unrealized gains/losses from translation adjustments on intercompany foreign currency transactions that
are of a long-term investment nature.

31

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NOTE 12  ACQUISITION OF ACUITY RESEARCH INCORPORATED

On June 1, 2000, in a business combination accounted for as a purchase, the Company acquired Acuity Research Incorporated. Acuity designs manufactures
and markets precision dimensional laser measurement sensors. The results of operations of Acuity are included in the accompanying consolidated financial statements since the date of acquisition. The
Company issued 275,000 of its common shares, valued at $747,725, in exchange for all of the outstanding stock of Acuity. The purchase price was allocated, based upon management estimates, to the
estimated fair value of assets and liabilities acquired, with the allocation as follows:

Current assets net of current liabilities

$
253,732Fair value of equipment acquired

$
72,169Intangible assets, patented technology acquired

$
421,824$
747,725


The
patents acquired are being amortized over useful lives ranging from eleven to seventeen years.

NOTE 13  PRO FORMA RESULTSIMPACT OF PURCHASE OF ACUITY RESEARCH

The following pro forma results (unaudited) of operations are provided for illustrative purposes only and does not purport to be indicative of the consolidated
results of operations for future periods or what actually would have been realized had the Company and Acuity Research been a consolidated entity during the period presented. The pro forma results
combine the results of operations as if Acuity had been acquired as of the beginning of the period presented. The results include the impact of the valuation assigned to the patented technology
acquired.

|                                     |  | Year Ended May 31,
|------------------------------------ |  | ------------------
|
|
|Net sales                            |  | $                 
|Net (loss) income                    |  | $                 
|Net (loss) income per share, basic   |  | $                 
|Net (loss) income per share, diluted |  | $                 

NOTE 14  RESTRUCTURING CHARGES

During the fourth quarter of fiscal 2001, the Company restructured the operations of SEG and, in association with that action, the Company incurred $226,525 in
restructuring charges. These costs include the provision for a $56,840 liability related to the payroll and benefits of five terminated employees. In addition, one-time charges of $110,250
were recognized to write-off inventory related to discontinued product lines and $9,511 in equipment written-off. Finally, a liability of $49,924 was established for certain
costs expected to be incurred in association with the changes in German operations. Of these total costs, $110,250 was included in cost of sales and $116,275 was included in operating expenses.

33

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SUMMARIZED QUARTERLY FINANCIAL DATA  In thousands, except per share information  (unaudited)

|                                     |      | 2001 Quarter Ended |      
|------------------------------------ | ---- | ------------------ | -----
|
|Sales                                |      | $                  | 1,943
|Gross Profit                         |      | $                  | 1,177
|Net (Loss) income                    |      | $                  | 29   
|Net (Loss) income Per Share, Basic   |      | $                  | .00  
|Net (Loss) income Per Share, Diluted |      | $                  | .00  
|Market Price of Common Stock         |      |                    |      
|                                     | Low  |                    | $    
|                                     | High |                    | $    

|                              |      | 2000 Quarter Ended
|----------------------------- | ---- | ------------------
|
|Sales                         |      | $                 
|Gross Profit                  |      | $                 
|Net Income                    |      | $                 
|Net Income Per Share, Basic   |      | $                 
|Net Income Per Share, Diluted |      | $                 
|Market Price of Common Stock  |      |                   
|                              | Low  |                   
|                              | High |                   

34

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Report of Independent Accountants:To the Board of Directors and Shareholders of
Schmitt Industries, Inc.

In
our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in stockholders' equity and of cash flows present
fairly, in all material respects, the financial position of Schmitt Industries, Inc. and its subsidiaries at May 31, 2001 and 2000, and the results of their operations and their cash
flows for each of the three years in the period ended May 31, 2001 in conformity with accounting principles generally accepted in the United States of America. These financial statements are
the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance
with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

PricewaterhouseCoopers
LLP
Portland, Oregon
July 3, 2001

35

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Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None

PART III

Certain information required by Part III is included in the Company's definitive Proxy Statement for its 2001 Annual Meeting of Shareholders ("Proxy
Statement") and is incorporated herein by reference. The Proxy Statement will be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934 not later than 120 days after the
end of the fiscal year covered by this Report.

Items 10 and 11.  Directors and Executive Officers of the Registrant and Executive Compensation

The information required by these items is included in the Proxy Statement under the headings "Election of Directors," "Executive Compensation," "Summary
Compensation Table," "Options Grants in Fiscal 2001," "Aggregated Option Expenses in Fiscal 2001 and Fiscal Year-End Option Values" and "Section 16(a) Beneficial Ownership Reporting
Compliance" and is incorporated herein by reference.

Item 12.  Security Ownership of Certain Beneficial Owners and Management

The information required by this item is included in the Proxy Statement under the heading "Principal Shareholders" and is incorporated herein by reference.

Item 13.  Certain Relationships and Related Transactions

The information required by this item is included in the Proxy Statement under the heading "Certain Transactions" and is incorporated herein by reference.

PART IV

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K

36

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

|                      |  | SCHMITT INDUSTRIES, INC.
|--------------------- |  | ------------------------
|Date: August 24, 2001 |  | By:                     

Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities
indicated on August 24, 2001.

|Signature                               |  | Title                                                                                     
|--------------------------------------- |  | ------------------------------------------------------------------------------------------
|                                        |  |                                                                                           
|/s/WAYNE A. CASEWayne A. Case           |  | Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer)
|/s/ROBERT C. THOMPSONRobert C. Thompson |  | Chief Financial Officer/Treasurer (Principal Financial and Accounting Officer)            
|/s/DAVID M. HUDSONDavid M. Hudson       |  | Director                                                                                  
|/s/TREVOR NELSONTrevor Nelson           |  | Director                                                                                  
|/s/RAY OELTJENRay Oeltjen               |  | Director                                                                                  
|/s/DENNIS T. PIXTONDennis T. Pixton     |  | Director                                                                                  
|/s/JOHN A. RUPPJohn A. Rupp             |  | Director                                                                                  

37

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INDEX TO EXHIBITS

|Exhibits |  | Description                                                                                                                                                                                                                                                                                                    
|-------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3(i)     |  | Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the "Company"). Incorporated by reference to Exhibit 3(i) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31,
1999                                                                                            
|3(ii)    |  | Second Restated Bylaws of the Company Incorporated by reference to Exhibit 3(ii) to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1999                                                                                                                                            
|*10.1    |  | Schmitt Industries, Inc. Amended & Restated Stock Option Plan. Incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1999                                                                                                                    
|10.2     |  | Agreement dated December 31, 1999 between David W. Case and Registrant. Incorporated by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended February 28,
2001.                                                                                             
|10.3     |  | Agreement dated December 1, 2000 between Wayne A. Case and Registrant. Incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended February 28, 2001.                                                                                              
|10.4     |  | Stock Purchase Agreement dated December 31, 2000 between Hortex Anstalt and Registrant and Promissory Note dated December 31, 2000 from Registrant to Hortex Anstalt Incorporated by reference to Exhibit 10.4 to the
Company's Quarterly Report on Form 10-Q for the quarterly period ended February 28, 2001.
|**21.1   |  | Subsidiaries of Schmitt Industries, Inc.                                                                                                                                                                                                                                                                       
|**23.1   |  | Consent of PricewaterhouseCoopers LLP                                                                                                                                                                                                                                                                          

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