UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-KSB

|[ X ]  | Annual Report under Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the fiscal year ended December 31, 2006      
|------ | -------------------------------------------------------------------------------------------------------------------------------------
|       |                                                                                                                                      
|[    ] | Transition Report under Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the transition period from _____ to _____

Commission file number: 1-31070

DERMA SCIENCES, INC.(Name of small business issuer in its charter)

|Pennsylvania                                                        | 23-2328753                              
|------------------------------------------------------------------- | ----------------------------------------
|(State or other jurisdiction of
     incorporation or organization) | (I.R.S. EmployerIdentification
     No.)
|                                                                    |                                         
|214 Carnegie Center,
     Suite 100, Princeton, New Jersey          | 08540                                   
|(Address of principal executive
     offices)                       | (Zip code)                              

Registrant's telephone number: (609) 514-4744

Securities registered under Section 12(b) of the Exchange Act:

|Title of each class               | Name of each exchange on which
     registered
|--------------------------------- | ----------------------------------------------
|                                  |                                               
|Common Stock, $.01 par
     value | Boston Stock Exchange                         
|Common Stock, $.01 par value      | Pacific Stock Exchange                        

Securities registered under Section 12(g) of the Exchange Act:

Title of Class

Common Stock, $.01 par value

Check whether
the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange
Act.[    ]

Check whether the Registrant:
(1) filed all reports required to be filed by Sections 13 or 15(d) of the Exchange Act during the past 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
past 90 days.

         YesX
     No

Check if there is no
disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will 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-KSB or any amendment to this Form 10-KSB. [    ]

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

         Yes
     NoX

Issuers
revenues for its most recent fiscal year were $27,887,391.

The
aggregate market value of the common equity stock held by non-affiliates, computed by
reference to the average bid and asked prices of such stock as of February 28, 2007, was
approximately $13,460,209.

The
number of shares outstanding of the issuers common equity as of February 28, 2007
was 25,258,335.

Documents
incorporated by reference: None

---

Part I

Item 1. Description of
Business

Overview

Derma
Sciences, Inc. (Derma Sciences) was incorporated under the laws of Colorado on
September 10, 1984. On June 3, 1996 Derma Sciences changed its state of domicile to
Pennsylvania.

In
September, 1998 Derma Sciences acquired Genetic Laboratories Wound Care, Inc.
(Genetic Labs) by means of a tax-free reorganization whereby Genetic Labs
became a wholly-owned subsidiary of Derma Sciences. In December, 1999, pursuant to an
Agreement and Plan of Merger dated December 27, 1999, Genetic Labs was merged into Derma
Sciences by means of a tax-free reorganization whereby the separate corporate existence of
Genetic Labs ceased.

In
November, 1998 Derma Sciences purchased the stock of Sunshine Products, Inc.
(Sunshine Products) in a cash transaction. As a result of the stock purchase,
Sunshine Products became a wholly-owned subsidiary of Derma Sciences.

In
August, 2002 Derma Sciences acquired the assets of Dumex Medical Inc., a leading
manufacturer and distributor of wound care and related medical devices to the Canadian
market. The acquisition was effected by Derma Sciences wholly-owned Canadian
subsidiary, Derma Sciences Canada Inc. (Derma Canada) f/k/a Dumex Medical
Canada Inc.

In
January 2004, Derma Sciences purchased substantially all the assets of the Kimberly-Clark
Corporations wound care assets. These assets have been integrated into the
Companys existing wound care and wound closure and specialty securement device
product lines.

In
April 2006, Derma Sciences purchased certain assets and the business of Western Medical,
Inc. (Western Medical), a manufacturer and marketer of a line of specialty
medical textile compression, support and protective dressing products. These assets have
been integrated into the Companys existing wound care product line.

Derma
Sciences and its subsidiaries Sunshine Products and Derma Canada are referred to
collectively as the Company. The Companys executive offices are located
at 214 Carnegie Center, Suite 100, Princeton, New Jersey.

The
Company engages in the manufacture, marketing and sale of three dermatological related
product lines: wound care, wound closure and specialty securement devices and skin care.
In addition, the Company has leveraged its expanding manufacturing capabilities by
building a growing private label / original equipment manufacture (OEM)
business. The Companys customers consist of various health care agencies and
institutions such as nursing homes, hospitals, home healthcare agencies, physicians
offices and retail and closed door pharmacies. The Company sells its products principally
through distributors servicing these markets in the United States, Canada and select
international markets. The Companys principal distribution facilities are located in
St. Louis, Missouri and Toronto, Canada. The Companys principal manufacturing
facility is located in Toronto, Canada. The Company, through Derma Canada, also maintains
a light manufacturing facility in Nantong, China producing labor intensive wound care
products.

Company Products and
Markets

Wound Care

The
Company markets a line of wound care products to doctors, clinics, nursing homes,
hospitals and other institutions. The Wound Care line consists of basic and advanced
dressings, ointments and sprays designed to manage and treat a wide range of skin
conditions from basic burns, skin tears, abrasions and incontinence related skin
impairment to chronic non-healing skin ulcerations such as pressure, diabetic and venous
ulcers, surgical incisions and serious burns.

1

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Wound Closure and
Specialty Securement Devices

The
Company markets a line of wound closure strips, nasal tube fasteners and a variety of
catheter fasteners to doctors, clinics, nursing homes, hospitals and other institutions.

Private Label / OEM

The
Company manufactures private label wound care and wound closure and specialty securement
devices for a number of U.S. and international customers.

Skin Care

The
Company markets general purpose and specialized skin care products to nursing homes,
hospitals, home healthcare agencies and other institutions. These products include bath
sponges, antibacterial skin cleansers, soaps, hair and body washes, lotions, body oil and
moisturizers.

The
Company has successfully built a base business through sales of its own brand and private
label brand commodity products. Prospectively, the Company is focusing its resources on
the marketing, sale and distribution of novel higher margined advanced wound care
products.

Sales Resources

United States

In
the United States, the Company employs a direct sales force and a number of national,
regional and local distributors (with their own sales forces) to sell the Companys
products. The majority of the Companys sales are made to national, regional and
local distributors and large institutional customers who sell the products to end users.
Direct sales to end users are not a significant part of the Companys business.

The
Companys direct sales force consists of an Executive Vice President  Sales, a
Vice President  Corporate Accounts and three Regional Sales Managers. Company sales
employees receive a base salary together with commissions based upon sales and gross
profit achievement within their area of responsibility.

Canada

In
Canada, the Company employs a Sales Manager, one direct sales representative in Ontario,
the most densely populated province, and a manufacturers representative located in British
Colombia. Company sales employees receive a base salary together with commissions based
upon sales and gross profit achievement within their areas of responsibility. The majority
of the Companys Canadian sales are to hospitals pursuant to tender contracts with
national, provincial and local buying groups. These institutional contracts are generally
exclusive in nature and are awarded for a term of 1 to 5 years. Nursing home, home
healthcare, physician office and retail sales are for the most part made through local
dealers and government sponsored Community Care Access Centres (CCAC) agencies.

In
May 2005, the Company entered into a five year agreement with a Canadian company to serve
as the exclusive distributor of its products in Canada. The distributor maintains
strategically located distribution centers and over 40 sales representatives throughout
Canada. The Company believes the agreement will provide better service to its customers
throughout Canada and greater opportunity for sales growth.

Other Foreign Markets

The
Companys products are sold throughout the rest of the world through various
licensing and distribution agreements. Foreign sales are made principally to Europe and
Latin America. Sales made to other foreign markets totaled approximately $1,226,000 in
2006 and $952,000 in 2005.

2

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Competition

The
wound and skin care sectors of the medical products industry are characterized by rapidly
evolving technology and intense competition. Many suppliers of competing products are
considerably larger and have much greater resources than the Company. In addition, many
specialized products companies have formed collaborations with large, established
companies to support research, development and commercialization of wound and skin care
products which may be competitive with those of the Company. Academic institutions,
government agencies and other public and private research organizations are also
conducting research activities and may commercialize wound and skin care products on their
own or through joint ventures.

In
the United States, the Companys basic wound care products compete in a very
competitive commodity oriented marketplace with Kendall Tyco, Medical Action and a number
of others. In the advanced wound care products marketplace, the Company competes
principally with Bristol-Myers Squibb  Convatec, Smith & Nephew and Johnson
& Johnson. The market for wound closure strips and catheter fasteners is characterized
by a wide range of generic competition. The most dominant competitor in the suture strip
market is 3M. The Companys skin care products compete in a commodity oriented
marketplace with Provon, Chester Laboratories, Calgon Vestal  Steris and a number of
others.

In
Canada, the Companys basic wound care products compete in a very competitive
commodity-oriented marketplace with Kendall Tyco, Medicom, Medical Mart, Johnson &
Johnson and a number of others. In the advanced wound care products marketplace, the
Company competes principally with the same competitors as it competes with in the United
States together with a number of domestic generic companies.

The
ability of the Company to remain competitive is based on its ability to provide its
customers with a broad range of quality products, at a competitive price with superior
customer service. The prospective ability to cost effectively develop and or acquire and
commercialize new products that provide superior value is an integral component of the
Companys ability to stay competitive. The Company believes that the breadth and
quality of its existing product lines, the infrastructure in place to cost effectively
source and market its products and the skill and dedication of its employees will allow
the Company to successfully compete.

Product Sourcing

The
Company maintains manufacturing facilities in Toronto, Canada, and Nantong, China. The
Toronto and Nantong facilities manufacture the Companys line of basic and advanced
wound care and its wound closure-specialty securement device products. The Derma line of
wound care, skin care products and the patient bathing sponge are outsourced. A number of
basic and advanced wound care products are sourced in semi-finished and finished form
directly from suppliers. Derma Canada also serves in a distributor capacity (sourcing
finished product directly from suppliers) for a number of medical device products in
Canada.

The
Company maintains a long-standing network of suppliers for its outsourced products. The
majority of the Companys outsourced products utilize readily available components.
Accordingly, there are numerous companies capable of manufacturing these products to
applicable regulatory standards. Given the availability of other suppliers, as well as the
Companys policy regarding maintenance of adequate safety stock levels, the Company
does not believe that a temporary interruption in supply or loss of one or more of its
suppliers would have a long-term detrimental impact on its operations.

The
Nantong facility is ISO 9002 certified. The Toronto facility is ISO 9001 2000/ISO 13485/EN
46001 certified. The Company requires that all of its suppliers conform to the standards
set forth in the Good Manufacturing Practice (GMP) regulations promulgated by
the United States FDA and local health agencies.

Patents, Proprietary and
Non-Proprietary Technology

The
Company has a trademark on the name Derma Sciences in the United States and
Dumex in the United States and Canada. A significant number of the
Companys products in the United States are trademarked. The Company possesses a
number of patented and non-patented formulations and process technologies that provide competitive
advantages in the marketplace.

3

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The
Company believes the aforementioned patents, proprietary and non-proprietary technology
affords reasonable protection to the Company against the unauthorized copying of the
technology embodied in the subject products. However, the specific means whereby these
products promote wound healing and skin care are unknown and the chemical and biological
processes bearing upon wound healing and skin care are highly complex and subject to a
wide variety of influences and stimuli. As such, it is possible that competitors will
develop products equal to or superior to those of the Company without infringing upon the
Companys intellectual property.

Patent
law relating to the scope of claims with respect to wound care products is still evolving
and the Companys patent rights are subject to uncertainty. Furthermore, the
existence of patent rights does not provide absolute assurance against infringement of
these rights. The prosecution and defense of patent claims is both costly and time
consuming, regardless of the outcome.

An
important component of the Companys growth strategy is to acquire, by purchase or
license, both proprietary and non-proprietary wound and skin care technology. There can be
no assurance that the Company will be able to obtain such technology on acceptable terms,
if at all. Future inability to acquire or license wound and skin care technology could
have a material adverse effect on the Companys business.

Government Regulation

United States 
Scope of Regulation

Agencies

The
manufacture, distribution and advertising of the Company and its products are subject to
regulation by numerous federal and state governmental agencies in the United States. The
United States Food and Drug Administration (FDA) is responsible for
enforcement of the Federal Food, Drug and Cosmetic Act, as amended, (FDC Act)
which regulates drugs and devices manufactured and distributed in interstate commerce.
Many of the Companys products are classified either as over-the-counter drugs or
medical devices pursuant to the FDC Act. The Federal Trade Commission (FTC)
administers the Federal Trade Commission Act (FTC Act) which regulates the
advertising of products including over-the-counter drugs and devices. All states have
individual laws that resemble the FDC Act and the FTC Act.

Medical
Devices

The
FDC Act requires that all devices for human use marketed in the United States prior to May
28, 1976 (Pre-amendment Devices) be classified by the FDA, based on
recommendations of expert panels, into one of three regulatory classes. Class I products
are subject only to the general controls which apply to all devices, irrespective of
class. General controls include the registration of manufacturers, record-keeping
requirements, labeling requirements, and Good Manufacturing Practice (GMP)
regulations.

Class
II devices are those for which general controls are not sufficient to ensure safety and
effectiveness, and for which enough information exists to develop a standard. These
devices are required to meet performance standards established by the FDA. Performance
standards may specify materials, construction components, ingredients, labeling and other
properties of the device. A standard may also provide for the testing of devices to ensure
that different lots of individual products conform to the requirements.

The
most restrictive controls are applied to devices placed in Class III. Class III devices
are required to have FDA approval for safety and effectiveness before they can be marketed
unless the FDA determines that pre-market approval is not necessary. Pre-market approval
necessitates the compilation of extensive safety and effectiveness data which is extremely
expensive to compile. Approval of Class III devices may require several years.

Devices
marketed after May 28, 1976 are considered to be one of two kinds: those that are and
those that are not substantially the same as a Pre-amendment Device. Those that are
substantially equivalent to a Pre-amendment Device are given the same classification as
the equivalent Pre-amendment Device. New devices which are not substantially equivalent to
Pre-amendment Devices are automatically placed in Class III thereby requiring pre-market
approval.

4

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All
manufacturers are required to give the FDA ninety days notice before they can introduce a
device on the market. During the ninety-day period, the FDA will determine whether the
device is or is not substantially equivalent to a Pre-amendment Device. If the FDA
determines that the device is not substantially equivalent to a Pre-amendment Device, it
is automatically placed in Class III and the manufacturer will have to provide the FDA
with a Premarket Approval Application (PMA) containing evidence that the
device is safe and effective before the device may be commercially distributed to the
public. However, the manufacturer may request that the FDA reclassify the device by filing
a reclassification petition.

All
of the devices currently marketed by the Company, with the exceptions of Sterile Water and
Sterile Saline, have been found by the FDA to be substantially equivalent to a
Pre-amendment Device and are, therefore, classified in Class I. Sterile Water and Sterile
Saline are classified in Class II. Calcium Alginate dressings with antimicrobial silver,
which was recently approved by the FDA, is currently unclassified.

Over-the-Counter
Drugs

Prescription
drugs may be dispensed only on the prescription of a licensed practitioner and must be
labeled: Caution: Federal law prohibits dispensing without prescription. In
general, a drug is restricted to the prescription class if it is not safe for use except
under professional supervision. All drugs having characteristics that do not require
prescription dispensing are considered to be over-the-counter (OTC) drugs.

In
1972, the FDA began a comprehensive review of the safety, efficacy, and labeling of all
OTC drugs for the purpose of establishing the conditions under which such drugs could be
generally recognized as safe, effective, and not misbranded. To facilitate the review,
these drug products were grouped into therapeutic classes, and advisory panels were
established to review each class. The panels completed their review in 1983, and it
remains for the FDA to complete the rulemaking process.

On
the basis of the recommendations submitted by the panels, the FDA issues monographs
setting forth the conditions under which OTC drugs in each class are deemed to be
generally recognized as safe, effective, and not misbranded. Generally, the administrative
process includes the publication of a Preliminary, Tentative
Final, and Final Monograph. During the rulemaking process, products are
placed into one of three categories describing whether a drug is deemed to be generally
recognized as safe and effective and not misbranded (Category I), to be not generally
recognized as safe and effective or misbranded (Category II), or to lack sufficient data
for categorization (Category III). Products that do not comply with general OTC
regulations or an applicable Final Monograph are subject to regulatory action. Any OTC
drug not in compliance with the content and labeling requirements of a Final Monograph is
subject to regulatory action unless it is the subject of an approved new drug application.
The FDA has issued a Compliance Policy Guide in which it determined that it would not
pursue regulatory action against OTC drugs prior to the adoption of a final regulation
unless failure to do so presents a potential public health hazard. Management believes all
of the OTC products currently marketed by the Company have been deemed to be generally
recognized as safe and effective and not misbranded.

Canada  Scope of
Regulation

Medical
Devices

The
Medical Devices Regulations have been established under the authority of the Food and
Drugs Act and apply to all medical devices imported and sold in Canada. The Medical
Devices Bureau of the Therapeutic Products Directorate is the national authority that
monitors and evaluates the safety, effectiveness and quality of diagnostic and therapeutic
medical devices in Canada.

On
July 1, 1998 the Medical Devices Regulations set forth the requirements governing the
sale, importation and advertisement of medical devices in Canada. Regulatory scrutiny is
applied in these areas based on risk management principles that classify medical devices
into four classes, with Class I representing the lowest risk and Class IV the highest.

5

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Every
medical device imported or sold in Canada, with the exception of Class I medical devices,
is required to be licensed prior to being imported or sold. A device license will be
issued to the manufacturer of a device if it is determined that the device meets
applicable safety and effectiveness requirements. Although Class I devices do not require
a license, they are monitored through Establishment Licenses. An Establishment License
permits importers, distributors and manufacturers of Class I devices to operate in Canada
without using a licensed importer.

As
of January 1, 2003, manufacturers of Class II, III and IV devices are required to have a
quality system registered to ISO 13485 or ISO 13488 by a registrar recognized by Health
Canada. Proof of registration must be submitted with any new license application after
January 1, 2003 and with the renewal of existing licenses after November 1, 2003.

Drugs

The
Health Products and Food Branch Inspectorate of Health Canada is mandated to regulate
drugs and the processes used to manufacture drugs. A Drug Establishment License is
required for activities such as fabrication, packaging/labeling, importation,
distribution, wholesale and testing. Derma Canada last underwent an inspection by the
Health Products and Food Branch Inspectorate in September, 2004 which occasioned the
renewal and subsequent annual renewal of its Drug Establishment License.

Once
a drug has been approved, the Therapeutic Products Directorate issues a DIN (Drug
Identification Number) which permits the manufacturer to market the drug in Canada. A DIN
lets the user know that the product has undergone and passed a review of its formulation,
labeling and instructions for use. A drug product sold in Canada without a DIN is not in
compliance with Canadian Law.

Registration and Status
of Derma Canada Products Sold in United States

Derma
Canada has passed inspection by the United States Food and Drug Administration.

Other Foreign Regulatory
Authorities

Whether
or not FDA approval has been obtained, approval of medical drugs and devices by regulatory
authorities in foreign countries must be obtained prior to marketing drugs and devices in
such countries. The requirements governing the conduct of clinical trials and product
approval vary widely from country to country and the time required for approval may be
longer or shorter than that required for FDA approval. Although there are procedures for
unified filings for certain European countries, most countries currently maintain their
own product approval procedures and requirements.

Other Regulatory
Requirements

In
addition to the regulatory framework for product approvals, the Company is subject to
regulation under state and federal law, including requirements regarding occupational
safety, laboratory practices, environmental protection and hazardous substance control,
and may be subject to other present and future local, state, federal and foreign
regulation.

The
Company is also subject to federal, state and foreign laws and regulations adopted for the
protection of the environment and the health and safety of employees. Management believes
that the Company is in compliance with all such laws, regulations and standards currently
in effect and that the cost of compliance with such laws, regulations and standards will
not have a material adverse effect on the Company.

U.S. Third Party
Reimbursement

In
the United States, the Company sells its wound care products to nursing homes, hospitals,
home healthcare agencies, retail and closed door pharmacies and similar
institutions. The patients at these institutions for whose care the Companys
products are purchased often are covered by medical insurance. Accordingly, the
Companys customers routinely seek reimbursement for the cost of the Companys
wound care products from third party payors such as Medicare, Medicaid, health maintenance
organizations and private insurers. The availability of reimbursement from such third
party payors is a factor in the Companys sales of wound care products.

6

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Medicaid
is a federally funded program administered by the states. Medicaid insurance is available
to individuals who have no Medicare or private health insurance or to individuals who have
exhausted their Medicare benefits. Included in the Medicaid insurance coverage are
in-patient stays in long term care facilities, hospitalization and drugs.

Medicare
is a federally funded program administered by private insurance companies. Medicare
insurance generally is available to individuals who have paid social security taxes and
are over the age of 65 years. Several of the Companys wound care and fixation
products are eligible for Medicare reimbursement.

Federal
and state governments, as well as private insurers, will continue their pursuit of
programs designed to control or reduce the cost of health care. These cost cutting
measures may include reductions in reimbursements and/or increases in mandatory rebates
for wound care products. As such, there is uncertainty as to whether, and to what extent,
reimbursements for the Companys products will continue to be available.

Employees

The
Company maintained 137 full-time and 2 part-time employees at December 31, 2006. Of these
employees, 25 are located in the United States, 68 in Canada and 44 in China. The Company
considers its employee relations to be satisfactory.

Item 2. Description of
Property

The
Companys headquarter offices are located in Princeton, New Jersey. The Company
leases its headquarters office space, at a rate of $11,857 per month, under a lease that
expires in August, 2007. In December 2006, the Company amended and extended the Princeton
headquarters lease. As soon as renovations are completed (estimated by mid-2007), the
Company will relocate its headquarters to 5,328 square feet of space in the same building
(versus the 3,970 presently occupied) at a rate of $15,092 per month under a lease that
expires in August 2012. The Company leases 24,000 square feet of office, light
manufacturing and warehouse space in St. Louis, Missouri, at a rate of $7,663 per month
under a lease that expired in January 2007. This lease was not renewed. This facility had
been unoccupied since September 2005. It was previously used to manufacture the
Companys skin care product line which is now outsourced. In March 2004, the Company
leased a 42,400 square foot warehouse in Fenton, Missouri, at a rate of $17,988 per month,
under a lease that expires in March 2009. The Fenton, Missouri, facility serves as the
United States distribution center for the Companys products.

Derma
Canada leases 45,640 feet of office and manufacturing space, at a rate of $31,885 per
month, under a lease that expires in August, 2012 and leases a 20,400 square foot
distribution facility, at a rate of $11,300 per month, under a lease that expires in
August, 2009. The 20,400 square foot facility formerly served as Derma Canadas
distribution facility, a function outsourced commencing in June 2005. This facility is
being sublet under a lease that expires in June 2008. In December 2006, the Company leased
an additional 15,499 square feet of space adjacent to its Toronto office and manufacturing
space, at a rate of $10,600 per month, for additional manufacturing and warehouse space.
Simultaneously, the Company, in agreement with the landlord, was released from its lease
on 6,068 square feet of non-adjacent property. A subsidiary of Derma Canada also leases
11,400 square feet of office and manufacturing space in Nantong, China, at a rate of
$1,040 per month, under a lease that expires in June, 2008.

Management
believes that the Companys facilities are adequate to meet its office, manufacturing
and distribution requirements for the foreseeable future.

Item 3. Legal Proceedings

The
Company is not a party to any material litigation.

7

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

The Company
did not submit any matter to a vote of shareholders during the fourth quarter, 2006.

Part II

Item 5. Market for Common Equity,
Related Shareholder Matters and Small Business Issuer Purchases of Equity Securities

The
Common Stock of the Company is traded on the OTC Bulletin Board under the symbol
DSCI.OB. The Common Stock is also traded on the Boston Stock Exchange under
the symbol DMS. The Companys Common Stock commenced trading on May 13,
1994. The following table sets forth the high and low bid prices for the Companys
Common Stock at the end of the indicated calendar quarters:



| |                    |  |       |  |       | 
| | ------------------ |  | ----- |  | ----- | 
| | Quarter Ended      |  | High  |  | Low   | 
|
| | 2006               |  |       |  |       | 
| | March 31, 2006     |  | $0.84 |  | $0.45 | 
| | June 30, 2006      |  | $0.90 |  | $0.75 | 
| | September 30, 2006 |  | $0.87 |  | $0.59 | 
| | December 31, 2006  |  | $0.90 |  | $0.66 | 
|
| | 2005               |  |       |  |       | 
| | March 31, 2005     |  | $0.70 |  | $0.50 | 
| | June 30, 2005      |  | $0.59 |  | $0.42 | 
| | September 30, 2005 |  | $0.78 |  | $0.52 | 
| | December 31, 2005  |  | $0.65 |  | $0.43 | 

The
stock prices reflect inter-dealer prices without retail mark-up, mark-down or commission
and may not necessarily represent actual transactions. There is no public market for the
Companys preferred stock. As of the close of business on February 28, 2007 there
were 1,303 holders of record of the Common Stock. The Company has paid no cash dividends
in respect of its Common Stock and does not intend to pay cash dividends in the near
future.

Item 6.  Management's Discussion and
Analysis of Financial Condition or Plan of Operations

Reference to Consolidated
Financial Statements

Managements
Discussion and Analysis or Plan of Operations should be read in conjunction with the
Companys consolidated financial statements and notes to consolidated financial
statements set forth in Item 7.

Restatement of Financial
Statements

In
May 2005, the Company entered into a five-year distribution agreement with a Canadian
company to serve as the Companys exclusive distributor in Canada. The Company
records revenues at the time product is shipped to the distributor. The distribution
agreement requires the Company to pay a distribution fee to the distributor. Prior to
October 1, 2006, the Company classified this distribution fee in operating expenses. The
Company has since concluded that this fee should be classified as an adjustment to gross
sales in arriving at net sales, similar to trade rebates and other adjustments to gross
sales. Further, the Company has concluded that the distribution fee should be accrued and
expensed at the time of sale. Previously the Company expensed the fee when billed by the
distributor to the Company. Accrued distribution fees are recorded as a credit to
accounts receivable on the consolidated balance sheet. Previously, accrued distribution
fees were recorded in accounts payable on the consolidated balance sheet. As a result of
the foregoing errors, the Company has restated its financial statements and accompanying
notes for the correction of these errors in the application of U.S. generally accepted
accounting principles. A summary of the restatement impact on the consolidated balance
sheet at December 31, 2005 and on the consolidated statement of operations for the year
ended December 31, 2005 is outlined below:

8

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|                                          |                       |  |             |            |        |   |            |  |   |          |  
|----------------------------------------- | --------------------- |  | ----------- | ---------- | ------ | - | ---------- |  | - | -------- | -
|                                          | December 31, 2005     | 
|                                          | As PreviouslyReported |  | As Restated |            | Change |  
|Selected consolidated balance sheet data: |                       | 
|                                         
|Total current assets                      |                       |  | $           | 6,409,920  |        | $ | 6,112,860  |  | $ | (297,060 | )
|Total assets                              |                       |  | $           | 10,595,246 |        | $ | 10,298,186 |  | $ | (297,060 | )
|Total current liabilities                 |                       |  | $           | 3,055,127  |        | $ | 2,960,931  |  | $ | (94,196  | )
|Total liabilities                         |                       |  | $           | 3,543,582  |        | $ | 3,449,386  |  | $ | (94,196  | )
|Total shareholders equity                |                       |  | $           | 7,051,664  |        | $ | 6,848,800  |  | $ | (202,864 | )

The
$297,060 adjustment to total current assets and total assets represents incremental
accrued distribution fees of $202,864 and a reclassification of $94,196 previously accrued
distribution fees. The $94,196 adjustment to total current liabilities and total
liabilities represents a reclassification of previously accrued distribution fees from
accounts payable to a credit to accounts receivable. The $202,864 restatement to total
shareholders equity represents the incremental accrued distribution fee expense of
$190,886 together with $11,978 of cumulative translation adjustment associated with the
restatement.

|                                                    |                              |  |             |            |        |   |            |   |   |          |  
|--------------------------------------------------- | ---------------------------- |  | ----------- | ---------- | ------ | - | ---------- | - | - | -------- | -
|                                                    | Year Ended December 31, 2005 | 
|                                                    | As PreviouslyReported        |  | As Restated |            | Change |  
|                                                   
|Selected consolidated statement of operations data: |                              | 
|                                                   
|Net sales                                           |                              |  | $           | 23,545,475 |        | $ | 22,799,640 |   | $ | (745,835 | )
|Gross profit                                        |                              |  |             | 7,789,422  |        |   | 7,043,587  |   |   | (745,835 | )
|Gross profit percentage                             |                              |  |             | 33.1%      |        |   | 30.9%      |   |   | (2.2%    | )
|Total expenses                                      |                              |  |             | 8,698,526  |        |   | 8,143,577  |   |   | 554,949  |  
|Net loss                                            |                              |  | $           | (909,104   | )      | $ | (1,099,990 | ) | $ | (190,886 | )
|Loss per common share  basic and diluted           |                              |  |             | $(0.07     | )      |   | $(0.09     | ) |   | $(0.02   | )

The
$745,835 credit to net sales represents the total of the incremental accrued distribution
fees of $190,886 together with the reclassification of $554,949 of distribution fee
expense that was previously recorded in operating expenses.

All
2005 Management Discussion and Analysis figures have been restated to reflect this
restatement.

9

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Overview of Consolidated
Operating Results

The
following table highlights the year ended December 31, 2006 versus 2005 operating results:

|                                  |  |                         |   |                   |   |             |   |       |   
|--------------------------------- |  | ----------------------- | - | ----------------- | - | ----------- | - | ----- | --
|                                  |  | Year Ended December 31, |  
|                                  |  | 2006                    |   | 2005     Restated |   | Variance   
|                                 
|Gross Sales                       |  | $ 33,973,676            |   | $ 27,205,522      |   | $ 6,768,154 |   | 24.9  | % 
|Sales adjustments                 |  | (6,086,285              | ) | (4,405,882        | ) | (1,680,403  | ) | 38.1  | % 
|                                 
|Net sales                         |  | 27,887,391              |   | 22,799,640        |   | 5,087,751   |   | 22.3  | % 
|Cost of sales                     |  | 18,235,003              |   | 15,756,053        |   | 2,478,950   |   | 15.7  | % 
|Gross profit                      |  | 9,652,388               |   | 7,043,587         |   | 2,608,801   |   | 37.0  | % 
|Gross profit percentage           |  | 34.6                    | % | 30.9              | %
|Operating expenses                |  | 8,339,227               |   | 6,966,037         |   | 1,373,190   |   | 19.7  | % 
|Goodwill impairment               |  | 200,000                 |   | 910,967           |   | (710,967    | ) | (78.1 | %)
|                                 
|Interest expense, net             |  | 374,079                 |   | 336,867           |   | 37,212      |   | 11.0  | % 
|Other income, net                 |  | (47,998                 | ) | (70,294           | ) | 22,296      |   | (31.7 | %)
|                                 
|Total expenses                    |  | 8,865,308               |   | 8,143,577         |   | 721,731     |   | 8.9   | % 
|Income (loss) before income taxes |  | 787,080                 |   | (1,099,990        | ) | 1,887,070   |   | -     |   
|                                 
|Provision for income taxes        |  | 118,341                 |   | -                 |   | 118,341     |   | -     |   
|                                 
|Net income (loss)                 |  | $      668,739          |   | $ (1,099,990      | ) | $ 1,768,729 |   | -     |   

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, distribution fees (in Canada), Medicaid rebates,
returns and allowances and cash discounts to derive net sales. Trade rebates are trued-up
monthly based upon an analysis of historical sales subject to rebate and actual rebates
received from distributors. The normal rebate cycle is one month. Non-exclusive
distributors generally carry one months inventory. The Companys exclusive
distributor in Canada normally carries two to three months of inventory. As distributor
inventory is depleted via sales, it is replenished via purchases from the Company. Rebates
are processed and submitted for credit on a timely basis consistent with distributor
sales. If the normal rebate cycle was one-half month less at December 31, 2006, the trade
rebate reserve would be overstated by approximately $235,000. If the normal rebate cycle
was one month higher at December 31, 2006, the trade rebate reserve would be understated
by approximately $470,000. To minimize its cash outflow invested in rebates, distributors
generally strive to optimize the rebate credit submission process.

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

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

Medicaid
rebates are accrued monthly based upon recent historical activity and reconciled quarterly
based upon receipt of rebate reports from participating state agencies. Returns and
allowances and cash discounts are accrued monthly based upon recent historical activity.

10

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Gross
to net sales adjustments comprise the following:

| |                        |                         |                  |   |              |  
| | ---------------------- | ----------------------- | ---------------- | - | ------------ | -
| |                        | Year Ended December 31, |                 
| |                        | 2006                    | 2005    Restated |  
|
| | Gross Sales            |                         | $ 33,973,676     |   | $ 27,205,522 |  
|
| | Trade rebates          |                         | (4,787,791       | ) | (3,462,953   | )
| | Distribution fees      |                         | (979,776         | ) | (693,624     | )
| | Medicaid rebates       |                         | (11,486          | ) | (29,256      | )
| | Returns and allowances |                         | (87,101          | ) | (65,731      | )
| | Cash discounts         |                         | (220,131         | ) | (154,318     | )
|
| | Total adjustments      |                         | (6,086,285       | ) | (4,405,882   | )
|
| | Net sales              |                         | $ 27,887,391     |   | $ 22,799,640 |  

Trade
rebates increased $1,324,838 in 2006 versus 2005 due to the Companys implementing
an exclusive third party distribution agreement in the second quarter 2005 for its
Canadian business, the continuing growth of rebate intensive U.S. private label sales and
the addition of incremental rebates associated with the Western Medical business acquired
in April 2006, partially offset by a decrease in the level of sales subject to rebate (contract
business) in other areas of the Companys U.S. business. Implementing the
third party distribution agreement was responsible for $1,157,710 of the increase as the
majority of the Canadian sales represent contract business subject to rebate. The
$286,152 increase in distribution fees reflects the higher level of Canadian sales
subject to the fee in 2006 versus 2005 (the distribution agreement was implemented in
June 2005) coupled with an increase in the contractual fee to 10% effective December 2005
versus the previous 9% fee. A continuing trend towards lower levels of Medicaid
reimbursed sales is responsible for the lower level of Medicaid rebates in 2006. The
increase in sales returns and allowances in 2006 primarily reflects the increase in
sales. The increase in cash discounts in 2006 reflects the growth of sales. Likewise,
discounts as a percentage of sales increased slightly in 2006 as a larger portion of the
sales growth came from customers that have historically taken advantage of the Companys
discount terms.

Rebate Reserve Roll
Forward

A
roll forward of the trade rebate accruals at December 31, 2006 and 2005 is outlined below:

| |                                 |                         |             |   |              |  
| | ------------------------------- | ----------------------- | ----------- | - | ------------ | -
| |                                 | Year Ended December 31, |            
| |                                 | 2006                    | 2005        |  
|
| | Beginning balance - January 1st |                         | $ 1,600,172 |   | $    253,815 |  
| | Rebates paid                    |                         | (4,475,949  | ) | (2,116,596   | )
| | Rebates accrued                 |                         | 4,787,791   |   | 3,462,953    |  
|
| | Ending balance - December 31st  |                         | $ 1,912,014 |   | $ 1,600,172  |  

The
$311,842 net increase in the 2006 trade rebate reserve reflects a $316,578 increase to the
Canadian reserve to reflect a change in the underlying assumption used to calculate the
rebate amount for certain products and a modest build up of the exclusive
distributors inventory and incremental reserve requirements associated with the
Western Medical business acquired in April 2006. Partially offsetting these increases was
a change from annual to semi-annual payment terms for a large rebate intensive U.S.
private label customer and a decrease in the level of sales subject to rebate in other
areas of the Companys U.S. business. There has been no other discernable change in
the nature of the Companys business as it relates to the accrual and subsequent
payment of rebates.

11

---

The
ending balance consists of accrued rebates and third party deductions accrued by and paid
by the Company that are recorded in accrued liabilities. The ending balance at December
31, 2006 and 2005 consist of the following:

| |                                                                    |              |            |  |            | 
| | ------------------------------------------------------------------ | ------------ | ---------- |  | ---------- | 
| |                                                                    | December 31, |           
| |                                                                    | 2006         | 2005       | 
|
| | Accrued rebates                                                    |              | $1,727,558 |  | $1,404,290 | 
| | Third party deductions recorded
            in accrued liabilities |              | 184,456    |  | 195,882    | 
|
| | Total                                                              |              | $1,912,014 |  | $1,600,172 | 

Net Sales and Gross Margin

The
following table highlights 2006 versus 2005 product line net sales and gross profit:

|                          |  |                         |  |                   |   |             |   |       |    
|------------------------- |  | ----------------------- |  | ----------------- | - | ----------- | - | ----- | ---
|                          |  | Year Ended December 31, | 
|                          |  | 2006                    |  | 2005     Restated |   | Variance   
|                         
|Wound care                |  | $24,367,164             |  | $ 18,621,069      |   | $ 5,746,095 |   | 30.9  | %  
|Wound closure-specialty   | 
|securement devices        |  | 2,403,019               |  | 2,676,979         |   | (273,960    | ) | (10.2 | %) 
|Skin care                 |  | 1,117,208               |  | 1,501,592         |   | (384,384    | ) | (25.6 | %) 
|                         
|Total                     |  | $27,887,391             |  | $ 22,799,640      |   | $ 5,087,751 |   | 22.3  | %  
|                         
|Product Line Gross Profit | 
|                         
|Wound care                |  | $  8,431,092            |  | $   5,786,967     |   | $ 2,644,125 |   | 45    | .7%
|Wound closure-specialty   | 
|securement devices        |  | 1,177,687               |  | 1,358,577         |   | (180,890    | ) | (13.3 | %) 
|Skin care                 |  | 43,609                  |  | (101,957          | ) | 145,566     |   | 142.8 | %  
|                         
|Total                     |  | $  9,652,388            |  | $   7,043,587     |   | $ 2,608,801 |   | 37.0  | %  

Company
net sales increased $5,087,751, or 22.3%, in 2006 versus 2005. Canadian net sales
decreased $1,273,517, or 10.7%, to $10,680,639 in 2006 from $11,954,156 in 2005. This
decrease was driven by the non-recurrence of an estimated $1,685,000 sales benefit related
to the sale of inventory on hand to fill the distribution pipeline in conjunction with the
appointment of an exclusive third party distributor for Canada in the second quarter 2005
coupled with a sales shortfall of $260,736, partially offset by favorable exchange of
$672,219 associated with a 6.5% strengthening of the Canadian dollar. U.S. net sales
increased $6,361,268, or 58.7%, to $17,206,752 in 2006 from $10,845,484 in 2005. The
increase was driven by the addition of incremental Western Medical sales of $4,980,951
coupled with continued growth of the private label and impregnated gauze dressing
businesses, partially offset by the continued decline in skin care sales due to
competitive pressure and softening demand for the Derma line of advanced wound care
products and wound closure-specialty securement devices. Year end backorders were also a
contributing factor to the wound closure-specialty securement device sales shortfall.
Excluding Western Medical sales, U.S. sales were up $1,380,317, or 12.7%.

Company
gross profit increased $2,608,801, or 37.0%, in 2006 versus 2005. Company gross profit
margin percentage increased to 34.6% in 2006 from 30.9% in 2005. Canadian gross profit
increased $152,964, or 4.4%, to $3,607,759 in 2006 from $3,454,795 in 2005. The Canadian
gross profit margin increased to 33.8% in 2006 from 28.9% in 2005. The improvement in
Canadian 2006 gross profit dollars and margin percentage reflects the combined impact of
continuing improvement in manufacturing performance, the benefit of lower negotiated
basic wound care

12

---

costs and favorable foreign
exchange, partially offset by lower sales and the non-recurrence of an estimated $445,000
margin benefit related to the one-time sale of inventory to fill the new Canadian
distributors pipeline in the second quarter 2005. U.S. gross profit increased
$2,455,837, or 68.4%, to $6,044,629 in 2006 from $3,588,792 in 2005. The gross profit
margin percentage increased to 35.1% in 2006 from 33.1% in 2005. The improvement in U.S.
gross margin dollars and margin percentage reflects the combined impact of higher sales,
favorable product mix and the benefit of lower inter company wound care product costs and
third party skin care product costs associated with outsourcing the line in the third
quarter 2005. Excluding Western Medical, gross profit increased $353,467, or 9.8%, and
the gross profit margin percentage would have been 32.3%.

Wound
care sales increased $5,746,095, or 30.9%, in 2006 versus 2005. The increase is
attributable to an advanced wound care increase of $2,098,849, or 43.3%. This increase was
principally driven by continued growth of the Companys private label sales. Basic
wound care sales increased $3,647,246, or 26.5%. This performance reflects incremental
Western Medical sales of $4,980,951, incremental Canadian sales of $411,483, or 4.0%, on
its continuing business comprised of favorable foreign exchange of $672,219, or 6.5%,
coupled with a sales shortfall of $260,736, or 2.5%, partially offset by the
non-recurrence of the one-time estimated benefit of $1,685,000 related to implementation
of the exclusive distribution agreement in Canada in the second quarter 2005 and lower
other (non Western Medical) U.S. sales of $60,187, or 3.3%. The other U.S. sales
performance reflects a softening of demand for these products.

Wound
care gross profit increased $2,644,125, or 45.7%, in 2006 versus 2005. The gross profit
margin percentage increased to 34.6% in 2006 from 31.1% in 2005. The margin dollar
increase and improved gross margin percentage reflect the increase in sales and the flow
through of lower product costs as a result of continued improvement in the Companys
Canadian manufacturing operation and the benefit of lower basic wound care and silver
product purchase prices, partially offset by the non-recurrence of an estimated $445,000
margin benefit related to the one-time sale of inventory to fill the new Canadian
distributors pipeline in the second quarter 2005.

Wound
closure-specialty securement device sales decreased $273,960, or 10.2%, in 2006 versus
2005. The non-recurrence of $64,523 in residual sales of certain catheter fasteners in
2005 associated with the loss of the Companys exclusive distribution agreement for
the sale of these products in August 2004 and a softening of demand for these products is
principally responsible for the decrease. Year-end backorders were also a contributing
factor to the sales shortfall.

Wound
closure-specialty securement device gross profit decreased $180,890, or 13.3%, in 2006
versus 2005. The gross profit margin percentage decreased to 49.0% in 2006 from 50.8% in
2005. The decrease in margin dollars reflects lower sales and margin deterioration. The
gross margin percentage deterioration is due principally to the combined impact of pricing
pressure and higher product costs from the former third party supplier in connection with
the transition to in-house manufacture during 2006.

Skin
care sales decreased $384,384, or 25.6%, in 2006 versus 2005 due to continuing competitive
pressure. Skin care gross profit improved $145,566 to $43,609 in 2006 from a $101,957
gross profit loss in 2005. The main driver for the margin improvement is the
non-recurrence of the one-time manufacturing facility closure costs incurred in 2005. The
elimination of most of the fixed overhead associated with the former skin care
manufacturing facility that closed in August 2005 and outsourcing production to lower cost
third parties have allowed the business to operate at slightly above break even in terms
of gross profit contribution while the sales continue to decline.

13

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Operating Expenses

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

|                       |  |                         |  |                   |  |             |   |       |   
|---------------------- |  | ----------------------- |  | ----------------- |  | ----------- | - | ----- | --
|                       |  | Year Ended December 31, | 
|                       |  | 2006                    |  | 2005     Restated |  | Variance   
|                      
|Distribution           |  | $   706,012             |  | $1,009,563        |  | $  (303,551 | ) | (30.1 | %)
|Marketing              |  | 640,376                 |  | 416,779           |  | 223,597     |   | 53.6  | % 
|Sales                  |  | 2,143,113               |  | 1,912,030         |  | 231,083     |   | 12.1  | % 
|General administrative |  | 4,849,726               |  | 3,627,665         |  | 1,222,061   |   | 33.7  | % 
|                      
|Total                  |  | $8,339,227              |  | $6,966,037        |  | $ 1,373,190 |   | 19.7  | % 

Operating expenses
increased $1,373,190, or 19.7%, to $8,339,227 in 2006 from $6,966,037 in 2005. This
increase is partially attributable to an increase of $153,013, or 2.2%, associated with a
6.5% strengthening of the Canadian dollar.

Distribution
expense decreased $303,551, or 30.1%, in 2006 versus 2005. Expenses in Canada decreased
$340,030 (including $42,789 expense related to exchange) while expenses in the U.S
increased $36,479, or 7.3%. Excluding foreign exchange, distribution expense in Canada
decreased $382,819, or 75.1%, due principally to discontinuation of most of Canadas
distribution functions in connection with implementation of the exclusive distribution
agreement in Canada effective June 1, 2005. Post agreement, Canada has maintained a small
distribution function to handle inbound receipts and coordinate outbound shipments to the
exclusive distributor. The U.S. increase was attributable to incremental ongoing personnel
and supply costs associated with integrating Western Medical into the U.S. distribution
operation and other one-time Western Medical related transition costs, partially offset by
the discontinuation in the third quarter 2005 of compensation related occupancy costs
previously charged to distribution in connection with the closure of the Skin Care
manufacturing facility in August 2005.

Marketing
expense increased $223,597, or 53.6%, in 2006 versus 2005. The increase was principally
attributable to higher promotion and product development expense in support of the
Companys growth initiatives. Higher compensation (associated with an employee
promotion and bonus (there was no bonus in 2005)) and travel, also contributed.

Sales
expense increased $231,083, or 12.1%, in 2006 versus 2005. Expenses in Canada increased
$69,268 (including $33,939 expense related to exchange) while expenses in the U.S.
increased $161,815, or 11.3%. Excluding foreign exchange, sales expense in Canada
increased $35,329, or 7.3%, due principally to higher commission and operating expenses to
expand sales support activities to improve market visibility and contract compliance,
partially offset by cost savings initiatives implemented in 2005 and the non-recurrence of
transition related costs associated with implementation of the new exclusive third party
distribution agreement in the second quarter 2005. The U.S. increase was attributable to
incremental consulting expenses of approximately $104,000 to assist in the integration of
the Western Medical business into the Company, higher compensation relating to 2006 bonus
expense (there were no bonuses in 2005), the annualized impact of hiring two new sales
representatives in the third quarter 2005 and incremental ongoing personnel costs
associated with integrating Western Medical into customer service operations, partially
offset by lower sales commissions, sample expense and recruiting expenses.

General
administrative expense increased $1,222,061, or 33.7%, in 2006 versus 2005. Expenses in
Canada increased $88,379 (including $76,285 expense related to exchange) while expenses
in the U.S. increased $1,133,682, or 45.6%. Excluding foreign exchange, general
administrative expense in Canada increased $12,094, or 1.1%. The increase in Canada
reflects higher compensation, bonus (there were none in 2005) and retirement benefit
costs, higher travel costs principally to China and in support of new private label
opportunities, higher employee stock option expense (recognized beginning in 2006) and
higher accounting fees. Offsetting these increases was the benefit of eliminating the
customer service function mid-way through 2005, the non-recurrence of transition related
expenses associated with implementation of the new exclusive third party distribution
agreement in the second quarter 2005, lower employee health benefit costs due to a
true-up of the allocation amongst the various company cost centers and

14

---

lower capital tax expense and bank
charges associated with reduced borrowing activity in 2006. The U.S. increase of
$1,133,682 principally reflects incremental intangible asset amortization expense of
$318,750 related to the Western Medical acquisition, bonus of $248,000 (none were paid in
2005), bad debt expense of $118,000, equity based employee and board compensation expense
of $91,000, annual compensation and benefit increases of $90,000 and one-time Western
Medical transition costs of $69,000, together with higher accounting, Sarbanes-Oxley
compliance, legal, consulting and investor relations expenses. Partially offsetting these
increases were lower insurance costs.

Goodwill Impairment

The
Sunshine product line has continued to experience competitive pressure leading to
declining sales and gross profit. Despite attempts to improve the financial performance of
the line, the Company has been unable to overcome the sales and marketing breadth and
product cost advantage held by its larger competitors.

The
Company recorded a goodwill impairment charge of $910,967 in 2005, leaving an implied
value of $200,000 for Sunshine goodwill as of December 31, 2005. As a result of the
continued deterioration of the product line in 2006, the remaining balance of the goodwill
of $200,000 was determined to be impaired and was written-off as of December 31, 2006.
Excluding goodwill, management believes the balance of the assets and liabilities related
to the product line are fairly valued and recovery is reasonably assured.

The
goodwill impairment of $200,000 in 2006 and $910,967 in 2005 have been recorded as a
separate line item in the consolidated statement of operations. As the Company purchased
the outstanding stock of Sunshine when it acquired the company, the impairment write-downs
are non-deductible for tax purposes. Accordingly, no tax benefit has been provided
relative to the impairment losses.

Interest Expense

Interest
expense increased $37,212, or 11.0%, to $374,079 in 2006 from $336,867 in 2005. Interest
expense in Canada decreased $38,325 (net of $6,751 expense related to exchange) while
interest expense in the U.S. increased $75,537. The decrease in Canada reflects lower
outstanding line of credit and term loan balances in 2006 versus 2005, partially offset by
higher interest rates. Canadas outstanding line of credit balance was reduced to
zero by the end of June 2005 through use of the one-time positive cash flow generated by
implementation of the new distribution agreement. The U.S. increase is due to incremental
term loan and promissory note interest and fees related to the Western Medical acquisition
in April 2006. These increases were partially offset by lower line of credit interest
(despite higher interest rates) due to lower outstanding average balances which, in turn,
resulted from improved U.S. cash flow in 2006.

Other Income

Other
income decreased $22,296 to $47,998 in 2006 from $70,294 in 2005. The main driver for the
decrease was the non-recurrence of a $164,300 gain recorded in the first quarter 2005
associated with a one-time distribution agreement upset fee, partially offset by the
favorable settlement of a supplier liability of $64,971 in the first quarter 2006. Lower
fixed asset write-offs, higher profit sharing income and other miscellaneous income,
partially offset by higher foreign exchange expense in 2006, also contributed.

Income Taxes

The
Company recorded a $118,341 provision for income taxes in 2006 relating to operating
results for the year ended December 31, 2006 primarily as a result of the continued
profitability of the Companys Canadian subsidiary. No provision for income taxes was
recorded in the year ended December 31, 2005 due to the net operating loss for the year
and available net operating loss carry forwards.

Net Income (Loss)

The
Company generated net income of $668,739, or $0.03 per share basic and $0.03 per share
diluted, in 2006 compared to a net loss of $1,099,990, or $0.09 loss per share
(basic and diluted), in 2005.

15

---

Liquidity and Capital
Resources

Operational Overview

Net
sales increased 22.3%, (18.6% adjusted for foreign exchange), as reported and 28.9%
excluding the 2005 one-time sales benefit for appointment of an exclusive distributor for
Canada in 2006 over 2005. This growth was driven by a sales increase in the U.S. of 58.7%,
partially offset by a decrease in Canadian sales of 10.7% (17.7% adjusted for foreign
exchange). Sales growth in the U.S. was driven by the addition of incremental Western
Medical sales of $4,980,951 (since April 18, 2006) and the continued growth of the private
label business. Skin care sales continue to deteriorate in the face of competitive
pressure and a reduction of resources allocated to support the line. Sales for the balance
of the U.S. product lines were down 3.6% year on year, with softness in the Derma advanced
wound care and wound-closure and specialty securement devices being partially offset by
growth in the impregnated gauze traditional wound care products. Excluding Western Medical
sales, U.S. sales growth was 12.7%. Adjusted for the non-recurrence of an estimated
$1,685,000 sales benefit related to the sale of inventory on hand to fill the distribution
pipeline in conjunction with the appointment of an exclusive third party distributor for
Canada in the second quarter of 2005, sales in Canada increased 4.0% (a decrease of 2.5%
adjusted for foreign exchange). This performance is less than recent historical growth
rates and reflects a very competitive marketplace for the Companys line of
traditional wound care products that make up the majority of Canada sales. Unit volume
growth and successful product cost reduction efforts have enabled the Company to remain
competitive in an environment of declining prices for its products. The Company continues
to focus on contract compliance, exploring opportunities in other market segments (other
than its traditional strength in the acute care segment) and working closely with its
exclusive distributor to capitalize on sales growth opportunities presented by this
relationship.

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

Operating
expenses increased 19.7% (17.5% adjusted for foreign exchange) in 2006 over 2005. The
increase is attributable to incremental Western Medical costs (intangible asset
amortization, planned sales and marketing and one-time integration expenses), non-cash
equity based compensation expense commencing in 2006, planned increases in marketing and
sales expenses in support of the Companys growth initiatives and higher professional
service fees as a result of increasing regulatory requirements. Excluding these expenses,
growth in the balance of operating expenses is in line with inflation and continues to be
closely monitored.

The
Company has reported profitability in 2006. With the addition of the Western Medical
business, anticipated Canadian sales improvement, continued growth of the private label
business in the U.S. and the introduction of new products coupled with ongoing
manufacturing cost reduction initiatives and operating expense management, the Company
anticipates being able to continue this trend going forward.

On
April 18, 2006, the Company acquired certain assets and assumed the trade payables and the
business of Western Medical for $6,500,000 of which $6,000,000 was paid in cash and
$500,000 was paid via a three-year promissory note issued to Western Medical by the
Company. In addition, the Company incurred a total of $819,052 of transaction costs
related to the acquisition. The purchased assets consist of trade receivables, inventory,
equipment and certain identifiable intangibles. To fund the purchase, the Company raised
$5,803,304 (net of $568,952 in commissions and other offering expenses) from the private
sale of 2,655,098 units at $2.40 per unit each unit consisting of four shares of common
stock and one five-year warrant to purchase one share of common stock at $1.00 per share.
In addition, the placement agent for the units received 754,806 five-year warrants each to
purchase one share of common stock at $0.72 per share. The Company also received
$1,000,000 in cash from a new three-year term loan that bears interest at prime plus 5%
from its U.S. lender through an amendment to its existing three-year revolving credit
facility. The amendment amends and restates various loan covenants of the revolving credit
facility and increases the revolving credit facility cap from $2,000,000 to $3,500,000.

16

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

On
August 3, 2006, the Company entered into an agreement to sell 2,000,000 shares of its
common stock at $0.75 per share for a total selling price of $1,500,000 to an existing
shareholder. The shareholder paid $500,000 on August 3, 2006 and the balance due of
$1,000,000 with interest on December 5, 2006.

The
$500,000 received on August 3, 2006 was used to prepay (as permitted, without penalty) the
U.S. term loan entered into in connection with the acquisition of Western Medical in April
2006. The $1,000,000 received on December 5, 2006 was used to repay the balance of the
U.S. term loan outstanding and the balance will be used prospectively for general working
capital purposes.

In
June 2005, in connection with implementation of the new distribution agreement, the
Company sub-leased its Canadian distribution center through June 2008 at its existing
rates and terms. The sub-lessee has the right to continue leasing the facility after June
2008 on a month-to-month basis with the Companys approval or extend the lease term
for up to two additional years. The Companys lease expires August 2009. Total
payments under the sub-lease agreement through June 2008 aggregate approximately $360,000.

In
June 2005, the Company announced its intention to close its skin care manufacturing
facility in St. Louis, Missouri and outsource the facilitys production with a view
to reducing overhead and improving cost competitiveness. The facility was closed on
schedule at the end of August 2005. In 2005, one-time closure related and ongoing costs of
approximately $169,000 consisting of severance, lease costs, inventory write-offs, fixed
asset write-offs and post closing maintenance costs were incurred. Ongoing estimated
monthly lease and facility maintenance costs of $7,500, net of existing committed lease
cost and estimated sub-lease income through lease expiration on January 31, 2007, are
being expensed as incurred.

On
May 9, 2005 the Company entered into a five-year agreement expiring May 1, 2010 with a
Canadian company to serve as the exclusive distributor of its products in Canada. The
Company believes that the agreement will provide better service to its customers
throughout Canada and greater opportunity for prospective sales and profit growth. In
connection with implementing the agreement, the Company sold to the distributor its
existing inventory of saleable finished product on hand to initially stock and maintain
its distribution pipeline. Other than the one-time sale in May and June 2005 of its
existing inventory on hand, which is estimated to represent two to three months sales,
prospective sales are expected to resume historical trends affected only by existing
market conditions and the growth opportunities inherent in the agreement. In addition, the
Company incurred one-time costs consisting of severance and other costs to dismantle its
distribution capabilities and sub-lease its distribution warehouse. A summary of the
estimated one-time benefit and costs of the agreement recognized in the year
ended December 31, 2005 (as restated) is outlined below:

| |               |  |             | 
| | ------------- |  | ----------- | 
| | Net Sales     |  | $1,685,000  | 
| | Cost of Sales |  | 1,240,000   | 
|
| | Gross Profit  |  | 445,000     | 
| | Expenses      |  | 105,000     | 
|
| | Pretax Income |  | $   340,000 | 

Further,
implementation of the agreement resulted in an estimated one-time positive cash flow
benefit of $2,705,000 stemming from lower receivable and inventory requirements going
forward and the one-time pretax income benefit of the sale of existing saleable finished
product inventory on hand to the distributor.

17

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On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,666, net of $159,334 in offering expenses, were used for
working capital. The offering was initiated in December 2004. In 2004, the Company sold
1,555,000 units and received offering proceeds of $698,859, net of $78,641 in offering
expenses. In 2005, the Company sold 1,205,000 units and received offering proceeds of
$521,808, net of $80,692 in offering expenses.

Cash Flow and Working
Capital

At
December 31, 2006 and 2005, the Company had cash and cash equivalents on hand of
$1,285,943 and $1,105,330, respectively. The $180,613 increase reflects net cash provided
by operating activities of $1,999,179, net cash used in investing activities of
$7,686,691, net cash provided in financing activities of $5,856,236 and cash provided as a
result of exchange rate changes of $11,889. The December 31, 2006 cash balance reflects
overall improved cash flow due to improving operations and the addition of the Western
Medical business which was successfully absorbed into the Company while adding only a
modest amount of incremental overhead expense. The increase in cash and cash equivalents
is particularly significant given that the December 2005 cash balance was higher than
normal due to the timing of receipt of a large Canadian receivable payment at year-end.

Net
cash provided by operating activities of $1,999,179 stems from $2,663,215 cash provided
from operations (net income plus non cash items), partially offset by $664,036 cash used
from the net change in operating assets and liabilities (excluding Western Medical
operating assets and liabilities acquired as of the date of acquisition). Higher
receivables, partially offset by a decrease in inventory and higher accounts payable and
accrued expenses, were the main drivers behind the net change in ongoing operating assets
and liabilities. The 2006 increase in receivables principally reflects the growing private
label and Western Medical (post acquisition) sales and the fact that the 2005 year-end
balance was unusually low due to receipt of a large payment at year-end. The increase in
accounts payable principally reflects an increase in the level of inventory procurement
activity to support the ongoing Western Medical business (post acquisition), an increase
in the level of operating expenses in support of product development initiatives and
higher professional service fees at year-end 2006. The decrease in inventory reflects the
post acquisition reduction of Western Medical inventory as the inventory was integrated
into the Companys supply chain along with planned reductions in certain products to
better balance inventory on hand with demand. In addition, at 2006 year-end the quantity
of inventory on hand for some products was temporarily lower than normal due to unexpected
increases in sales and production delays caused by the equipment and facility improvement
activities underway at the Companys manufacturing operation in Canada. The increase
in accrued liabilities is attributable to bonus accruals.

Net
cash used in investing activities of $7,686,691 reflects funds used for the acquisition of
Western Medical of $6,000,000 together with capitalized business acquisition related
expenses of $769,675. In addition, $931,968 was expended principally on purchases of
equipment at the Companys manufacturing operation in Canada to expand manufacturing
capability in response to an increase in private label business and to bring the
manufacture of the Companys wound closure-specialty securement device line of
products in-house. Both of these initiatives are anticipated to generate an above average
long term return on investment.

Net
cash provided in financing activities of $5,856,236 reflects cash received of $7,281,829,
net of offering expenses of $590,407 from the private sale of common stock and warrants
together with term loan proceeds of $1,000,000 from the Companys U.S. lender,
partially offset by Western Medical asset purchase related deferred financing costs of
$48,722, together with the use of available funds to pay down the Companys
outstanding line of credit balance by $1,080,561, pre-pay the $1,000,000 U.S. term loan
and make other regularly scheduled debt repayments of $296,310.

Working
capital increased $2,616,120, or 83.0%, at December 31, 2006 to $5,768,049 from $3,151,929
at December 31, 2005. The increase is principally attributable to the net working capital
acquired as part of the Western Medical asset purchase and the net proceeds from the sale
of stock in the second half of 2006 and improving operating performance. Working capital
of this magnitude is considered sufficient to support ongoing operations.

18

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Financing Arrangements

In
December 2006, the Company renewed its annual revolving credit facility agreement with its
Canadian lender for a maximum principal amount of $430,000 ($500,000 Canadian). Maximum
potential advances under the agreement at December 31, 2006 were $430,000. Advances
outstanding against the agreement were zero at December 31, 2006, leaving $430,000
available for borrowing.

In
addition, the Canadian lender has granted Derma Sciences Canada Inc. a $644,000 ($750,000
Canadian) non-revolving term line of credit to finance equipment purchases and equipment
upgrades to Derma Sciences Canada Inc.s manufacturing facility. Advances against the
line are limited to 75% of the actual cost of the capital expenditure. Interest on
outstanding advances is payable monthly in arrears at prime (as defined), plus 1.25%. Each
advance shall be amortized and repaid over sixty months. Prepayment of advances in whole
or in part are not permitted during the eighteen months following initial disbursement.
Prepayment thereafter is permitted in whole or once per annum in part with thirty days
written notice and payment of the greater of the following premium: (i) 3% of the
principal amount prepaid; or (ii) three months interest on such principal at the loan
interest rate in effect on the date prepayment is made. As of December 31, 2006, there
were no outstanding advances against the line.

On
April 18, 2006 the Company entered into an amended three-year revolving credit facility
agreement with its U.S. lender for a maximum principal amount of $3,500,000. Maximum
potential advances under the agreement at December 31, 2006 were $2,860,000. Advances
outstanding against the line were zero at December 31, 2006, leaving an additional
$2,860,000 available for borrowing.

Prospective Assessment

The
Companys objective is to continue to grow sales and gross profit in 2007. Beginning
in 2005, the Company expanded its product development efforts. As a result of these
efforts, the Company launched one new product in late 2006 and plans to launch additional
new products in 2007. The April 2006 acquisition of the Western Medical business has had
to date, and is expected to continue to have, a positive impact on the Companys U.S.
business going forward. Growth of the Companys private label business is anticipated
to continue as the existing business expands and new customers are brought on board. Plans
are in place to better leverage existing opportunities in the Companys basic and
advanced wound care lines in the U.S. by working more closely with several key existing
and potential new customers to increase business. In Canada, the exclusive distribution
agreement continues to represent an opportunity for sales growth. In addition, in 2006 the
Company renewed a five-year basic wound care supply agreement with a major Canadian buying
group.

The
Company plans to build upon its recent success in the area of product cost savings. Higher
throughput and improved operational efficiencies are expected to lower the Companys
overall internal cost of manufacturing going forward. The plan to bring the manufacture of
the Companys wound closure-specialty securement device line in-house at a savings
versus existing third party sourced product costs is complete. The Company also
anticipates realizing incremental savings in 2007 as the percentage of China sourced
product sterilized in China increases. Subject to commodity driven cotton prices and
fluctuations in foreign exchange, the Company anticipates continuing to build on its
successful relationships in China to keep its basic wound care costs competitive.

Given
the recent Western Medical acquisition and planned growth over the foreseeable future,
the Company is presently re-evaluating its personnel and infrastructure requirements
needed to support the business going forward. Increases in personnel are anticipated in
order to execute and manage planned business growth. In the area of information
technology, the Company is presently is in the midst of a two to three year program to
upgrade its capabilities. In addition, as a non-accelerated filer (as defined by the
SEC), the Company is required to be in compliance with Sarbanes-Oxley regulations as of
December 31, 2007. The Company is closely monitoring its requirements under
Sarbanes-Oxley and will incur incremental one-time costs to comply during 2007 and
through the first quarter 2008, with modest ongoing incremental cost thereafter. Steps
will continue to be taken to monitor operating expenses and to limit spending in this
area to that necessary to support existing operations.

Going
forward, capital expenditures will continue to be limited to those projects capable of
generating an acceptable level of return and those necessary to support ongoing
operations. The Company plans to continue to closely monitor inventory levels with the
objective of properly balancing customer service requirements while minimizing its
investment in inventory wherever possible.

19

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The
Company believes that available funds from operations and available lines of credit will
be sufficient to satisfy the Companys foreseeable liquidity requirements through the
next twelve months. In addition, the Company will continue to evaluate external
opportunities to leverage its core capabilities for growth.

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

Additional Financial
Information

Forward Looking Statements

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

Critical Accounting
Policies

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

Revenue Recognition and
Adjustments to Revenue

Revenue
is recognized when product is shipped and title passes to the customer and collectability
is reasonably assured. When the Company recognizes revenue from the sale of its products,
it simultaneously adjusts revenue for estimated trade rebates and distribution fees (in
Canada). A trade rebate represents the difference between the invoice price to the
wholesaler and the indirect customers contract price. These rebates are estimated
based on historical experience, estimated future trends, estimated customer inventory
levels, current contract sales terms with wholesale and indirect customers and other
competitive factors. The Company pays its exclusive Canadian distributor a fixed fee based
on sales subject to the fee (as defined) for distribution services in Canada. The
distribution fee is accrued monthly based on the estimated percentage of distribution fee
expense to net sales. If the assumptions used to calculate these rebates and fees do not
appropriately reflect future activity, the Companys financial position, results of
operations and cash flows could be impacted. The Company continually monitors the factors
that influence these rebates and makes adjustments as necessary.

Goodwill

At
December 31, 2006, the Company had $2,441,542 of goodwill relating to the Western Medical
acquisition in April 2006. The goodwill is included in the wound care segment for
reporting purposes. The Company tests goodwill for impairment in the fourth quarter of
each year or when impairment indicators are present. The process of evaluating the
potential impairment of goodwill is highly subjective and requires significant judgments
and assumptions in estimating future cash flows to determine the fair value of each
reporting unit. These assumptions include future growth rates, discount factors, future
tax rates and other factors. The Companys cash flow forecasts are

20

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based on assumptions that are
consistent with the plans and estimates used to manage the underlying business. In
addition, the Company makes certain judgments about allocating shared assets to the
balance sheet for this segment. If the expected cash flows are not realized, impairment
losses may be recorded in the future. As discussed in Note 6 of the Companys
financial statements, in 2006 and 2005 the Company recorded goodwill impairment charges
of $200,000 and $910,967, respectively, related to Sunshine Products goodwill.

Inventory

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

Stock-Based Compensation

Effective
January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123R,
Share-Based Payment (SFAS 123R), which revises SFAS 123
Accounting for Stock-Based Compensation (SFAS 123) and supercedes
Accounting Principles Board Opinion 25 Accounting for Stock Issued to
Employees. Under APB 25, the Company used the intrinsic value method for
employee stock options and did not record any expense because option exercise prices
equaled the market value at the date of grant. SFAS 123R requires that new, modified and
unvested share-based payment transactions with employees, such as grants of stock options
and restricted stock, be recognized in the financial statements based on their fair value
at the grant date and recognized as compensation expense over their vesting periods. The
Company estimates the fair value of stock options as of the date of grant using the
Black-Scholes pricing model and restricted stock based on the quoted market price. The
Company adopted SFAS 123R using the modified prospective method and, accordingly, prior
period financial statements were not revised. The Company recognized stock-based employee
compensation of $211,756 in the year ended December 31, 2006 under SFAS 123R. Assuming
compensation expense had been determined based on the fair value at the grant date for all
awards to employees, using the Black-Scholes option pricing model consistent with the
provisions of SFAS 123 and SFAS 123R, and amortized ratably over the vesting period,
instead of the intrinsic value method under APB 25, the Company would have recorded
compensation expense of $1,186,530 for the year ended December 31, 2005.

Recent Accounting
Pronouncements

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

Factors Affecting Future
Prospects

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

Up
to 15,773,032 shares of the Companys common stock are potentially issuable upon the
conversion, exercise or vesting of outstanding convertible preferred stock, warrants,
options and restricted stock awards (derivative securities). The shares of
common stock potentially issuable upon conversion, exercise or vesting of derivative
securities are substantial compared to the 25,258,335 shares of common stock currently
outstanding.

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

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

The
Company earned net income of $668,739 in 2006, $22,241 in 2003, $61,368 in 2002 and
$192,398 in 2001 and incurred losses of $1,099,990 in 2005, $2,338,693 in 2004, $2,581,337
in 2000 and $2,998,919 in 1999. At December 31, 2006, the Company had an accumulated
deficit of $13,417,281. Although the Company achieved profitability in 2006, 2003, 2002
and 2001, the Company cannot offer any assurance that it will be able to generate
sustained or significant earnings.

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

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

---

| |                                                          |  |       |  |       | 
| | -------------------------------------------------------- |  | ----- |  | ----- | 
| | Derma Sciences, Inc.Trading
        Range  Common Stock | 
|
| | Year                                                     |  | Low   |  | High  | 
|
| | 2001                                                     |  | $0.22 |  | $0.80 | 
| | 2002                                                     |  | $0.35 |  | $0.85 | 
| | 2003                                                     |  | $0.35 |  | $2.30 | 
| | 2004                                                     |  | $0.43 |  | $1.90 | 
| | 2005                                                     |  | $0.42 |  | $0.78 | 
| | 2006                                                     |  | $0.45 |  | $0.90 | 

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

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

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

22

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The Company has not paid,
and is unlikely to pay in the near future, cash dividends on its securities.

The
Company has never paid any cash dividends on its common or preferred stock and does not
anticipate paying cash dividends in the foreseeable future. The payment of dividends by
the Company will depend on its future earnings, financial condition and such other
business and economic factors as the Companys management may consider relevant.

The Companys
foreign operations are essential to its economic success and are subject to various
unique risks.

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

The rate of reimbursement
for the purchase of the Companys products by government and private insurance is
subject to change.

Sales
of several of the Companys wound care products depend partly on the ability of its
customers to obtain reimbursement for the cost of its products from government health
administration agencies such as Medicare and Medicaid. Both government health
administration agencies and private insurance firms continuously seek to reduce healthcare
costs. These cost reduction efforts may adversely affect both the eligibility of the
Companys products for reimbursement and the rate of reimbursement. Although
management believes that reimbursement policies relative to the Companys products
will remain stable for the foreseeable future, it can offer no assurance that the
Companys products will continue to be eligible for reimbursement indefinitely or
that the rate of reimbursement will not be reduced.

The Companys
success may depend upon its ability to protect its patents and proprietary technology.

The
Company owns patents, both in the United States and abroad, for several of its products,
and relies upon the protection afforded by its patents and trade secrets to protect its
technology. The Companys success may depend upon its ability to protect its
intellectual property. However, the enforcement of intellectual property rights can be
both expensive and time consuming. Therefore, the Company may not be able to devote the
resources necessary to prevent infringement of its intellectual property. Also, the
Companys competitors may develop or acquire substantially similar technologies
without infringing the Companys patents or trade secrets. For these reasons, the
Company cannot be certain that its patents and proprietary technology will provide it with
a competitive advantage.

If members of the
Companys management and their affiliates were to exercise all warrants and options
held by them, and if substantially all of the restricted stock awards were granted to
members of management and were to vest, members of management and their affiliates
could acquire a majority of the voting stock of the Company.

The
executive officers and directors of the Company, together with institutions with which
they are affiliated, own substantial amounts of the Companys common stock, together
with outstanding options and warrants to purchase the Companys common stock. In
addition, the Company has adopted, and its shareholders have approved, a restricted stock
plan pursuant to which the Companys outside directors and executive officers may be
awarded up to 2,500,000 shares of restricted stock. Outside directors have been awarded
to date 175,000 shares of restricted common stock that have not yet vested. Depending
upon the warrants and options exercised by outside investors, if directors and

23

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affiliates were to exercise their
options and warrants, and if additional shares of restricted stock are awarded to the
Companys directors and executive officers and such awards vest, members of
management and their affiliates could obtain a majority of the Companys voting
stock. As a result, these officers, directors and affiliates of the Company would be in a
position to significantly influence the strategic direction of the Company, the
composition of its board of directors and the outcome of fundamental transactions
requiring shareholder approval.

Government regulation
plays a significant role in the Companys ability to acquire and market products.

Government
regulation by the United States Food and Drug Administration and similar agencies in other
countries is a significant factor in the development, manufacturing and marketing of many
of the Companys products and in the Companys acquisition or licensing of new
products. Complying with government regulations is often time consuming and expensive and
may involve delays or actions adversely impacting the marketing and sale of the
Companys current or future products.

Approximately half of the
Companys products are manufactured by third party manufacturers.

Approximately
one half of the Companys products are manufactured by third party manufacturers. One
manufacturer produces advanced wound care products which account for about ten percent of
the Companys sales. Each of the Companys other manufacturers produces products
that individually account for less than ten percent of the Companys sales.

Management
considers the Companys relationships with its third party manufacturers to be
excellent. Although there are several manufacturers potentially available for each of the
Companys products, if a current manufacturer were unable or unwilling to continue to
manufacture the Companys products, distribution and sales of the affected products
could be delayed for the period necessary to secure a replacement.

Competitors could invent
products superior to those of the Company and cause its products and technology to become obsolete.

The
Company operates in an industry where technological developments occur at a rapid pace.
The Company competes with a large number of established companies and institutions many of
which have more capital, larger staffs and greater expertise than the Company. The
companies with which the Company competes include Bristol Myers Squibb-Convatec, Smith
& Nephew, Johnson & Johnson, 3M, Kendall, Hermitage, Medical Action, Cyprus,
DeRoyal, Provon, Calgon Vestal-Steris, Chester Laboratories, Medicom and Medical Mart,
together with a number of smaller companies. The Companys competitors currently
manufacture and distribute a variety of products that are in many respects comparable to
those of the Company. While management has no specific knowledge of products under
development by the Companys competitors, it is possible that these competitors may
develop technologies and products that are more effective than any the Company currently
has. If this occurs, any of the Companys products and technology affected by these
developments could become obsolete.

Although the Company is
insured, any material product liability claims could adversely affect its business.

The
Company sells over-the-counter products and medical devices and is exposed to the risk of
lawsuits claiming alleged injury caused by its products. Among the grounds for potential
claims against the Company are injuries due to alleged product inefficacy and injuries
resulting from infection due to allegedly non-sterile products. Although the Company
carries product liability insurance with limits of $1.0 million per occurrence and $2.0
million aggregate with $5.0 million in umbrella coverage, this insurance may not be
adequate to reimburse the Company for

24

---

all damages that it could suffer as
a result of successful product liability claims. No material product liability claim has
ever been made against the Company and management is not aware of any pending product
liability claims. However, a successful material product liability suit could adversely
affect the Companys business.

25

---



Item 7. Consolidated
Financial Statements

Index

|                                                                                                      |     
|----------------------------------------------------------------------------------------------------- | ----
|Description                                                                                           | Page
|                                                                                                      |     
|Report of Independent Registered Public Accounting
   Firm  Ernst & Young LLP                        | 27  
|                                                                                                      |     
|Report of Independent Registered Public Accounting
   Firm  J.H. Cohn LLP                            | 28  
|                                                                                                      |     
|Consolidated Balance Sheets as of December 31, 2006
   and 2005 (1)                                   | 29  
|                                                                                                      |     
|Consolidated Statements of Operations for the
   Years Ended December 31, 2006 and 2005 (1)           | 30  
|                                                                                                      |     
|Consolidated Statements of Shareholders
   Equity for the Years Ended December 31, 2006 and 2005 (1) | 31  
|                                                                                                      |     
|Consolidated Statements of Cash
   Flows for the Years Ended December 31, 2006 and 2005 (1)           | 32  
|                                                                                                      |     
|Notes to Consolidated Financial
   Statements (1)                                                     | 33  
|                                                                                                      |     

(1)    
          The Companyspreviouslyissued financial statements for the
          year ended December 31, 2005 have been restated for the correction of errors
          related to the accounting for an exclusive distribution agreement in Canada. The
          restatement is more fully described in the Notes to the Consolidated Financial
          Statements.

26

---



Financial Index

Report of Independent
Registered Public Accounting Firm

To the Shareholders and
Board of DirectorsDerma Sciences, Inc.

We have audited the accompanying
consolidated balance sheet of Derma Sciences, Inc. and Subsidiaries as of December 31,
2006, and the related consolidated statements of operations, shareholders equity and
cash flows for the year then ended. 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 audit.

We conducted our audit in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. We were not engaged to
perform an audit of the Companys internal control over financial reporting. Our
audit included consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not for the
purpose of expressing an opinion on the effectiveness of the Companys internal
control over financial reporting. Accordingly we express no such opinion. An audit also
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 audit provides a reasonable basis for our opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects, the
consolidated financial position of Derma Sciences, Inc. and Subsidiaries at December 31,
2006, and their consolidated results of operations and cash flows for the year then ended,
in conformity with accounting principles generally accepted in the United States of
America.

As discussed in Note 1 to the
consolidated financial statements, the Company changed its method of accounting for
stock-based compensation effective January 1, 2006.

| |                      
| | ---------------------
| | /s/ Ernst & Young LLP

Philadelphia, PennsylvaniaMarch
30, 2007

27

---



Financial Index

Report of Independent
Registered Public Accounting Firm

To the Shareholders and
Board of DirectorsDerma Sciences, Inc.

We have audited the accompanying
consolidated balance sheet of Derma Sciences, Inc. and Subsidiaries as of December 31,
2005 and the related consolidated statements of operations, shareholders equity and
cash flows for the year then ended. 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 audit.

We conducted our audit in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards 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. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis for our
opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects, the
consolidated financial position of Derma Sciences, Inc. and Subsidiaries at December 31,
2005, and their consolidated results of operations and cash flows for the year then ended,
in conformity with accounting principles generally accepted in the United States of
America.

As
discussed in Note 1, the Company has restated its consolidated financial
statements as of and for the year ended December 31, 2005.

/s/ J.H. Cohn LLP

Roseland, New Jersey
February 24, 2006, except for Note 1, as to which the date is March 22, 2007

28

---



Financial Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                          |  |               |   |               |  
|------------------------------------------------------------------------- |  | ------------- | - | ------------- | -
|Consolidated Balance Sheets                                              
|                                                                         
|                                                                          |  | December 31,  |  
|                                                                          |  | 2006          |   | 2005          |  
|ASSETS                                                                    |  |               |   | (Restated)    |  
|                                                                         
|Current Assets                                                            |  |               |   |               |  
|Cash and cash equivalents                                                 |  | $   1,285,943 |   | $   1,105,330 |  
|Accounts receivable, net                                                  |  | 2,270,552     |   | 928,579       |  
|Inventories                                                               |  | 4,678,107     |   | 3,868,663     |  
|Prepaid expenses and other
     current assets                            |  | 279,864       |   | 210,288       |  
|                                                                         
|Total current assets                                                      |  | 8,514,466     |   | 6,112,860     |  
|Equipment and improvements, net                                           |  | 4,133,595     |   | 3,385,862     |  
|Goodwill                                                                  |  | 2,441,542     |   | 200,000       |  
|Other intangible assets, net                                              |  | 3,197,365     |   | 299,776       |  
|Other assets, net                                                         |  | 218,953       |   | 299,688       |  
|                                                                         
|Total Assets                                                              |  | $ 18,505,921  |   | $ 10,298,186  |  
|                                                                         
|LIABILITIES AND SHAREHOLDERS EQUITY                                      | 
|                                                                         
|Current Liabilities                                                       | 
|Line of credit borrowings                                                 |  | -             |   | $   1,080,561 |  
|Current maturities of long-term
     debt                                 |  | 338,155       |   | 285,945       |  
|Accounts payable                                                          |  | 1,645,575     |   | 1,102,866     |  
|Accrued expenses and other
     current liabilities                       |  | 762,687       |   | 491,559       |  
|                                                                         
|Total current liabilities                                                 |  | 2,746,417     |   | 2,960,931     |  
|Long-term debt                                                            |  | 546,268       |   | 388,473       |  
|Other long-term liabilities                                               |  | 106,900       |   | 99,982        |  
|Deferred tax liability                                                    |  | 128,324       |   |              |  
|                                                                         
|Total Liabilities                                                         |  | 3,527,909     |   | 3,449,386     |  
|                                                                         
|Shareholders Equity                                                      | 
|Convertible preferred stock, $.01 par value; 11,750,000
     shares       | 
|authorized; issued and
     outstanding: 2,280,407 at December 31, 2006   | 
|and 2005 (liquidation
     preference of $4,210,231 at December 31, 2006) |  | 22,804        |   | 22,804        |  
|Common stock, $.01 par value, 50,000,000 and 30,000,000
     shares       | 
|authorized at December 31, 2006
     and December 31, 2005, respectively; | 
|issued and outstanding:
     24,906,160 shares at December 31, 2006 and   |  | 249,062       |   | 122,858       |  
|12,285,768 shares at December 31, 2005                                    | 
|Additional paid-in capital                                                |  | 27,272,440    |   | 19,905,059    |  
|Accumulated other comprehensive income -                                  | 
|cumulative translation
     adjustments                                   |  | 850,987       |   | 884,099       |  
|Accumulated deficit                                                       |  | (13,417,281   | ) | (14,086,020   | )
|                                                                         
|Total Shareholders Equity                                                |  | 14,978,012    |   | 6,848,800     |  
|                                                                         
|Total Liabilities and Shareholders Equity                                |  | $ 18,505,921  |   | $ 10,298,186  |  
|                                                                         

See accompanying consolidated notes.

29

---



Financial Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                       |  |                         |   |                  |  
|---------------------------------------------------------------------- |  | ----------------------- | - | ---------------- | -
|Consolidated Statements of Operations                                 
|                                                                      
|                                                                       |  | Year Ended December 31, |  
|                                                                       |  | 2006                    |   | 2005             |  
|                                                                       |  |                         |   | (Restated)       |  
|                                                                      
|Net Sales                                                              |  | $ 27,887,391            |   | $  22,799,640    |  
|Cost of sales                                                          |  | 18,235,003              |   | 15,756,053       |  
|                                                                      
|Gross Profit                                                           |  | 9,652,388               |   | 7,043,587        |  
|                                                                      
|Operating expenses                                                     |  | 8,339,227               |   | 6,966,037        |  
|Goodwill impairment                                                    |  | 200,000                 |   | 910,967          |  
|Total operating expenses                                               |  | 8,539,227               |   | 7,877,004        |  
|Interest expense                                                       |  | 374,079                 |   | 336,867          |  
|Other income, net                                                      |  | (47,998                 | ) | (70,294          | )
|                                                                      
|Total Expenses                                                         |  | 8,865,308               |   | 8,143,577        |  
|                                                                      
|Income (loss) before provision for income taxes                        |  | 787,080                 |   | (1,099,990       | )
|Provision for income taxes                                             |  | 118,341                 |   |                 |  
|                                                                      
|Net Income (Loss)                                                      |  | $      668,739          |   | $ (1,099,990     | )
|                                                                      
|Income (loss) per common share  basic                                 |  | $            0.03       |   | $          (0.09 | )
|                                                                      
|Income (loss) per common share  diluted                               |  | $            0.03       |   | $          (0.09 | )
|                                                                      
|Shares used in computing income (loss) per common share
      basic   |  | 20,591,085              |   | 12,216,804       |  
|                                                                      
|Shares used in computing income (loss) per common share
      diluted |  | 24,409,760              |   | 12,216,804       |  
|                                                                      

See accompanying consolidated notes.

30

---



Financial Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                |  |                       |   |                    |  |                           |   |             |  |                          |   |                                            |  |                    |   |                          |  
|----------------------------------------------- |  | --------------------- | - | ------------------ |  | ------------------------- | - | ----------- |  | ------------------------ | - | ------------------------------------------ |  | ------------------ | - | ------------------------ | -
|Consolidated Statements of Shareholders Equity
|                                               
|                                                |  | PreferredSharesIssued |   | CommonSharesIssued |  | ConvertiblePreferredStock |   | CommonStock |  | AdditionalPaid-InCapital |   | AccumulatedOtherComprehensiveIncome (Loss) |  | AccumulatedDeficit |   | TotalShareholdersEquity |  
|                                               
|Balance, December 31, 2004                      |  | 2,280,407             |   | 11,079,007         |  | $      22,804             |   | $   110,790 |  | $19,371,225              |   | $699,960                                   |  | $(12,986,030       | ) | $  7,218,749             |  
|                                               
|Net loss                                        |  |                       |   |                    |  |                           |   |             |  |                          |   |                                            |  | (1,099,990         | ) | (1,099,990               | )
|Foreign currency translation adjustment         |  |                       |   |                    |  |                           |   |             |  |                          |   | 184,139                                    |  |                    |   | 184,139                  |  
|Comprehensive loss  total                      |  | (915,851              | )
|Issuance of common stock in                     | 
|private placement, net of issuance              | 
|costs of $80,692                                |  |                       |   | 1,205,000          |  |                           |   | 12,050      |  | 509,758                  |   |                                            |  |                    |   | 521,808                  |  
|Adjustment of shares issued and issuable        | 
|in connection with acquisition                  |  |                       |   | 1,761              |  |                           |   | 18          |  | (18                      | )
|Employee stock option expense                   |  | 24,094                |   |                    |  |                           |   | 24,094      | 
|                                               
|Balance, December 31, 2005 (Restated)           |  | 2,280,407             |   | 12,285,768         |  | $      22,804             |   | $   122,858 |  | $19,905,059              |   | $884,099                                   |  | $(14,086,020       | ) | $  6,848,800             |  
|                                               
|Net income                                      |  | 668,739               |   | 668,739            | 
|Foreign currency translation adjustment         |  | (33,112               | ) |                    |  | (33,112                   | )
|Comprehensive income - total                    |  | 635,627               |  
|Issuance of common stock in                     | 
|private placements, net of issuance             | 
|costs of $590,407                               |  |                       |   | 12,620,392         |  |                           |   | 126,204     |  | 7,155,625                |   |                                            |  |                    |   | 7,281,829                |  
|Employee stock option expense                   |  | 211,756               |   |                    |  |                           |   | 211,756     | 
|                                               
|Balance, December 31, 2006                      |  | 2,280,407             |   | 24,906,160         |  | $      22,804             |   | $   249,062 |  | $27,272,440              |   | $850,987                                   |  | $(13,417,281       | ) | $14,978,012              |  
|                                               

See accompanying consolidated notes.

31

---



Financial Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                              |  |                         |   |              |  
|------------------------------------------------------------- |  | ----------------------- | - | ------------ | -
|Consolidated Statements of Cash Flows                        
|                                                             
|                                                              |  | Year Ended December 31, |  
|                                                              |  | 2006                    |   | 2005         |  
|                                                              |  |                         |   | (Restated)   |  
|                                                             
|Operating Activities                                          |  |                         |   |              |  
|Net income (loss)                                             |  | $    668,739            |   | $(1,099,990  | )
|Adjustments to reconcile net income (loss) to net             | 
|cash provided by operating activities:                        | 
|Depreciation of equipment and improvements                    |  | 611,229                 |   | 490,274      |  
|Amortization of intangible assets                             |  | 402,411                 |   | 84,136       |  
|Amortization of deferred financing costs                      |  | 86,234                  |   | 71,598       |  
|Provision for bad debts and rebates                           |  | 305,825                 |   | 1,196,504    |  
|Provision for cash discounts and sales returns                |  | 24,500                  |   |             |  
|Provision for distribution fee                                |  | 4,096                   |   | 282,394      |  
|Provision for inventory obsolescence                          |  | 73,497                  |   | 289,946      |  
|Goodwill impairment                                           |  | 200,000                 |   | 910,967      |  
|Loss on disposal of equipment                                 |  | 19,624                  |   | 65,753       |  
|Deferred rent expense                                         |  | 6,934                   |   | 39,037       |  
|Compensation charge for employee stock options                |  | 181,494                 |   | 24,094       |  
|Compensation charge for restricted stock                      |  | 30,262                  |   |             |  
|Gain on settlement of accounts payable                        |  | (64,971                 | ) |             |  
|Deferred tax provision                                        |  | 113,341                 |   |             |  
|Changes in operating assets and liabilities:                  | 
|Accounts receivable                                           |  | (1,197,229              | ) | 159,163      |  
|Inventories                                                   |  | 252,488                 |   | 808,849      |  
|Prepaid expenses and other current assets                     |  | (83,997                 | ) | (11,412      | )
|Other assets                                                  |  | 43,245                  |   | (84,956      | )
|Accounts payable                                              |  | 65,125                  |   | (157,491     | )
|Accrued expenses and other current liabilities                |  | 256,332                 |   | (118,208     | )
|Other long-term liabilities                                   |  |                        |   | 7,356        |  
|                                                             
|Net cash provided by operating activities                     |  | 1,999,179               |   | 2,958,014    |  
|                                                             
|Investing Activities                                          | 
|Acquisition of Western Medical, Inc. assets                   |  | (6,000,000              | ) |             |  
|Costs of acquiring Western Medical, Inc.                      |  | (769,675                | ) | (49,376      | )
|Purchase of equipment and improvements                        |  | (931,968                | ) | (223,754     | )
|Proceeds from sale of equipment                               |  | 14,952                  |   | 34,460       |  
|                                                             
|Net cash used in investing activities                         |  | (7,686,691              | ) | (238,670     | )
|                                                             
|Financing Activities                                          | 
|U.S. term loan proceeds                                       |  | 1,000,000               |   |             |  
|Net change in bank line of credit                             |  | (1,080,561              | ) | (1,682,388   | )
|Deferred financing costs                                      |  | (48,722                 | ) | (116,590     | )
|Long-term debt repayments                                     |  | (1,296,310              | ) | (445,919     | )
|Proceeds from issuance of stock, net of issuance costs        |  | 7,281,829               |   | 521,808      |  
|                                                             
|Net cash provided by (used in) financing activities           |  | 5,856,236               |   | (1,723,089   | )
|                                                             
|Effect of exchange rate changes on cash                       |  | 11,889                  |   | 62,567       |  
|                                                             
|Net increase in cash and cash equivalents                     |  | 180,613                 |   | 1,058,822    |  
|Cash and cash equivalents                                     | 
|Beginning of year                                             |  | 1,105,330               |   | 46,508       |  
|                                                             
|End of year                                                   |  | $ 1,285,943             |   | $ 1,105,330  |  
|                                                             
|Supplemental disclosures of cash flow information:            | 
|Issuance of promissory note in connection with acquisition of | 
|Western Medical, Inc. (see Note 2)                            |  | $    500,000            |   |             |  
|Cash paid during the year for:                                | 
|Interest                                                      |  | $    297,720            |   | $    291,209 |  
|                                                             

See accompanying consolidated notes.

32

---



Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

1.     Organization and
Summary of Significant Accounting Policies

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

Restatement
of Financial Statements

In
May 2005, the Company entered into a five-year distribution agreement with a Canadian
company to serve as the Companys exclusive distributor in Canada (see Note 19).
Prior to October 1, 2006, the Company classified this distribution fee in operating
expenses. The Company has since concluded that this fee should be classified as an
adjustment to gross sales in arriving at net sales, similar to trade rebates and other
adjustments to gross sales. Further, the Company has concluded that the distribution fee
should be accrued and expensed at the time of sale. Previously the Company expensed the
fee when billed by the distributor to the Company. Accrued distribution fees are recorded
as a credit to accounts receivable on the consolidated balance sheet. Previously, accrued
distribution fees were recorded in accounts payable on the consolidated balance sheet. As
a result of the foregoing errors, the Company has restated its financial statements and
accompanying notes for the correction of these errors in the application of U.S.
generally accepted accounting principles. A summary of the restatement impact on the
consolidated balance sheet at December 31, 2005 and on the consolidated statement of
operations for the year ended December 31, 2005 is outlined below:

|                                          |                       |  |             |            |        |   |            |  |   |          |  
|----------------------------------------- | --------------------- |  | ----------- | ---------- | ------ | - | ---------- |  | - | -------- | -
|                                          | December 31, 2005     | 
|                                          | As PreviouslyReported |  | As Restated |            | Change |  
|Selected consolidated balance sheet data: |                       | 
|                                         
|Total current assets                      |                       |  | $           | 6,409,920  |        | $ | 6,112,860  |  | $ | (297,060 | )
|Total assets                              |                       |  | $           | 10,595,246 |        | $ | 10,298,186 |  | $ | (297,060 | )
|Total current liabilities                 |                       |  | $           | 3,055,127  |        | $ | 2,960,931  |  | $ | (94,196  | )
|Total liabilities                         |                       |  | $           | 3,543,582  |        | $ | 3,449,386  |  | $ | (94,196  | )
|Total shareholders equity                |                       |  | $           | 7,051,664  |        | $ | 6,848,800  |  | $ | (202,864 | )

The
$297,060 adjustment to total current assets and total assets represents incremental
accrued distribution fees of $202,864 and a reclassification of $94,196 previously accrued
distribution fees. The $94,196 adjustment to total current liabilities and total
liabilities represents a reclassification of previously accrued distribution fees from
accounts payable to a credit to accounts receivable. The $202,864 restatement to total
shareholders equity represents the incremental accrued distribution fee expense of
$190,886 together with $11,978 of cumulative translation adjustment associated with the
restatement.

|                                                    |                              |  |             |            |        |   |            |   |   |          |  
|--------------------------------------------------- | ---------------------------- |  | ----------- | ---------- | ------ | - | ---------- | - | - | -------- | -
|                                                    | Year Ended December 31, 2005 | 
|                                                    | As PreviouslyReported        |  | As Restated |            | Change |  
|Selected consolidated statement of operations data: |                              | 
|                                                   
|Net sales                                           |                              |  | $           | 23,545,475 |        | $ | 22,799,640 |   | $ | (745,835 | )
|Gross profit                                        |                              |  |             | 7,789,422  |        |   | 7,043,587  |   |   | (745,835 | )
|Total expenses                                      |                              |  |             | 8,698,526  |        |   | 8,143,577  |   |   | 554,949  |  
|Net loss                                            |                              |  | $           | (909,104   | )      | $ | (1,099,990 | ) | $ | (190,886 | )
|Loss per common share  basic and diluted           |                              |  |             | $(0.07     | )      |   | $(0.09     | ) |   | $(0.02   | )

33

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

The
$745,835 credit to net sales represents the total of the incremental accrued distribution
fees of $190,886 together with the reclassification of $554,949 of distribution fee
expense that was previously recorded in operating expenses.

A
summary of the restatement for the quarterly periods ended June 30, 2005 (unaudited) and
September 30, 2005 (unaudited) and the year ended December 31, 2005 (audited) and the
unaudited quarterly periods for the first three quarters of 2006 are outlined in Note
21.

Summary
of Significant Accounting Policies:

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

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

Foreign
Currency Translation  Assets and liabilities are translated using the exchange
rates in effect at the balance sheet date, while income and expenses are translated using
average rates. Translation adjustments are reported as a component of shareholders
equity in accumulated other comprehensive income (loss). For the Companys Canadian
subsidiary, whose functional currency is the Canadian dollar, exchange rate fluctuations
on foreign currency denominated assets and liabilities other than the functional currency
resulted in $60,055 and $22,423 of expense for the years ended December 31, 2006 and 2005,
respectively.

Cash
and Cash Equivalents  The Company considers cash and cash equivalents as amounts
on hand, on deposit in financial institutions and highly liquid investments purchased with
an original maturity of three months or less.

Concentration
of Credit Risk  Financial instruments that subject the Company to a
concentration of credit risk consist principally of cash and cash equivalents and accounts
receivable. The Company maintains cash and cash equivalents with various financial
institutions in amounts which at times may exceed federally insured limits. Accounts are
guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. The Company
has not experienced any losses in such accounts. The Companys accounts receivable
balance is net of an allowance for doubtful accounts. The Company does not require
collateral or other security to support credit sales, but provides an allowance for
doubtful accounts based on historical experience and specifically identified risks.
Accounts receivable are charged off against the allowance for doubtful accounts when
management determines that recovery is unlikely and the Company ceases collection efforts.

Foreign
Operations Risk  The Companys future operations and earnings will depend
to a large extent on the results of its operations in Canada and its ability to continue
to maintain a continuous supply of basic wound care products from its own operation and/or
its suppliers in China. While the Company does not envision any adverse change to the
manner in which operations in Canada and China are presently being conducted, there can be
no assurance that the Company will be able to successfully conduct such operations in the
future, and a failure to do so may have a material adverse effect on the Companys
consolidated financial position, results of operations and cash flows. Also, the success
of the Companys operations will be subject to numerous contingencies, some of which
are beyond managements control. These contingencies include general and regional
economic conditions, prices for the Companys products, prices for materials and
products purchased from suppliers, competition and changes in regulations.

34

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Inventories
 Inventories consist primarily of raw materials, packaging materials, work in
process and finished goods valued at the lower of cost or market. Cost is determined on
the basis of the first-in, first-out method.

Equipment
and improvements  Equipment and improvements are stated at cost and are
depreciated principally by the straight-line method over the estimated useful lives of the
assets ranging from three to ten years. Leasehold improvements are amortized over the
lesser of their useful lives or the remaining lease term.

Fair
Value of Financial Instruments  The carrying value of cash and cash equivalents,
accounts receivable, prepaid expenses and other current assets, accounts payable and
accrued expenses reported in the consolidated balance sheets equal or approximate fair
value due to their short term nature. The fair value of the Companys long-term debt
approximates book value as such notes are at market rates currently available to the
Company.

Other
Intangible Assets  Patents and trademarks and other intangible assets with
definite lives are stated on the basis of cost or fair value as determined as of the date
of acquisition. Patent and trademarks are amortized over 12 to 17 years on a straight-line
basis. Other intangible assets consisting of product rights, formulations and
specifications, regulatory approvals, customer lists and non-compete agreements are
amortized over 5 to 10 years on a straight-line basis.

Long
Lived Assets  In accordance with Statement of Financial Accounting Standards No.
144 (SFAS 144), Accounting for Impairment or Disposal of Long Lived
Assets the Company reviews its long-lived assets with definitive lives whenever
events or changes in circumstances indicate that the carrying amount of such assets may
not be recoverable. If the carrying amount of the asset or group of assets exceeds its net
realizable value, the asset will be written down to its fair value.

Goodwill
 The Company tests goodwill for impairment using the two-step process prescribed by
Statement of Financial Accounting Standards No. 142 Goodwill and Other Intangible
Assets (SFAS 142). The first step tests for potential impairment, while
the second step measures the amount of impairment, if any. The Company uses a discounted
cash flow analysis to complete the first step in this process. If the first step indicates
an impairment, i.e. when the carrying value exceeds the fair value, then the second step
is required to determine the implied fair value of goodwill. The implied fair value of
goodwill is calculated in the same manner that goodwill is calculated in a business
combination. The allocation is to be performed as if the reporting unit had just been
acquired and the fair value of the unit was the purchase price. The goodwill impairment
equals the carrying value of goodwill less the implied fair value of goodwill.

In
connection with the acquisition of Western Medical in April 2006 (see Note 2), the Company
recorded goodwill of $2,441,542 representing the excess of the purchase price over the
fair value of identifiable assets acquired and liabilities assumed. The Western Medical
products acquired in connection with the acquisition consist of a line of medical textile
compression, support and protective dressings which are included in the Companys
wound care segment. For tax purposes, the Western Medical goodwill is deductible and is
being amortized over fifteen years.

As
stated in Note 6, the Company recorded goodwill impairment charges of $200,000 and
$910,967, respectively, in 2006 and 2005 related to its Sunshine Products
(Sunshine) product line.

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

35

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

On
December 30, 2005, the Board of Directors approved the acceleration of vesting of
unvested stock options held by officers, directors and employees of the Company. The
vesting of options to purchase 828,533 shares of common stock, with exercise prices
ranging from $0.37 to $1.70 per share and with a weighted average exercise price of $0.80
per share, was accelerated. Of the options whose vesting was accelerated, 116,250 options
were in the money when compared to a per share market price of $0.43,
representing the closing price of the Companys stock on December 29, 2005. No
charge was recorded for the vesting of the in the money options as, in the opinion of
management, all of these options would have ultimately vested pursuant to the options original
vesting schedule. The decision to accelerate the vesting of the foregoing options was
made primarily to reduce non-cash compensation expense of approximately $422,000 that
would otherwise have been recorded in future periods in compliance with SFAS 123(R).

Income
Taxes  Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to temporary differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax bases.
Deferred tax assets, including tax loss and credit carryforwards, and liabilities are
measured using enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. Deferred income tax expense represents the
change during the period in the deferred tax assets and deferred tax liabilities. The
components of the deferred tax assets and liabilities are individually classified as
current and non-current based on their characteristics. Deferred tax assets are reduced by
a valuation allowance when, in the opinion of management, it is more likely than not that
some portion or all of the deferred tax assets will not be realized.

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

Advertising
and Promotion Costs  Advertising and promotion costs are expensed as incurred
and were $353,583 and $304,690 in 2006 and 2005, respectively.

Net
Income (Loss) per Share Net income (loss) per common share  basic is
computed by dividing net income (loss) by the weighted average number of common shares
outstanding for the period. Net income (loss) per common share  diluted reflects the
potential dilution of earnings by including the effects of the assumed exercise,
conversion or issuance of potentially issuable shares of common stock (potentially
dilutive securities), including those attributable to stock options, warrants,
convertible preferred stock and restricted common stock in the weighted average number of
common shares outstanding for a period, if dilutive. The effects of the assumed exercise
of warrants and stock options are determined using the treasury stock method. Potentially
dilutive securities have not been included in the computation of diluted loss per share
for the year ended December 31, 2005 as the effect would be anti-dilutive.

Total
dilutive shares that have or would have been used to compute diluted income per common
share for the year ended December 31, 2006 and 2005 are outlined below:

36

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

| |                                  |                         |            |  |            | 
| | -------------------------------- | ----------------------- | ---------- |  | ---------- | 
| |                                  | Year Ended December 31, |           
| |                                  | 2006                    | 2005       | 
|
| | Weighted average common shares   |                         |            |  |            | 
| | outstanding  basic              |                         | 20,591,085 |  | 12,216,804 | 
| | Dilutive shares attributable to: |                        
| | Convertible preferred stock      |                         | 2,280,407  |  |           | 
| | Restricted common stock          |                         | 112,192    |  |           | 
| | Warrants                         |                         | 299,329    |  |           | 
| | Stock options                    |                         | 1,126,747  |  |           | 
|
| | Sub-total dilutive shares        |                         | 3,818,675  |  |           | 
|
| | Weighted average common shares   |                         |            |  |            | 
| | outstanding  diluted            |                         | 24,409,760 |  | 12,216,804 | 

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

| |                       |                         |           |  |            | 
| | --------------------- | ----------------------- | --------- |  | ---------- | 
| |                       | Year Ended December 31, |          
| |                       | 2006                    | 2005      | 
|
| | Dilutive shares:      |                        
| | Preferred stock       |                         |          |  | 2,280,407  | 
| | Stock options         |                         | 2,161,155 |  | 5,773,280  | 
| | Warrants              |                         | 5,415,098 |  | 4,069,441  | 
|
| | Total dilutive shares |                         | 7,576,253 |  | 12,123,128 | 

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

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

2.     Acquisition of
Western Medical, Inc.

On April
18, 2006, the Company acquired certain assets and assumed the trade payables and the
business of Western Medical, Inc. (Western Medical) for $6,500,000 of which
$6,000,000 was paid in cash and $500,000 was paid via a three-year promissory note issued
to Western Medical by the Company. In addition, the Company incurred a total of $819,052
of transaction costs related to the acquisition. The purchased assets consist of trade
receivables, inventories, equipment and certain identifiable intangibles. To fund the
purchase, the Company raised $5,803,304 (net of $568,932 in commissions and other offering
expenses) from the private sale of 2,655,098 units (the Units) at $2.40 per
Unit, each Unit consisting of four shares of common stock and one five-year warrant to
purchase one share of common stock at $1.00 per share. In addition, the placement agent
for the Units received 754,806 five-year warrants each to purchase one share of common
stock at $0.72 per share. The Company also received $1,000,000 in cash from a new term
loan that bears interest at prime plus 5% from its U.S. lender through an amendment to its
existing three-year revolving credit facility.

37

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Western
Medical was a privately held manufacturer and marketer of a line of specialty medical
textile compression, support and protective dressing products. For the year ended December
31, 2005, Western Medical reported audited sales of $6,684,160, gross profit of $2,664,997
and net income of $838,865. Western Medicals product line is complementary to and
will serve to expand the Companys existing basic wound care line. The Company
anticipates being able to leverage cross selling opportunities presented by the
acquisition to grow sales. In addition, the Company anticipates being able to absorb
Western Medicals business within its existing operating infrastructure. Both of
these initiatives are anticipated to increase the contribution of the business going
forward.

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

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

The
allocation of the purchase price to the assets acquired and liabilities assumed as
reflected in the consolidated financial statements is based on finalization of the
Companys valuation study to establish the fair market value of the assets,
liabilities and the identifiable intangible assets and goodwill acquired. The identifiable
intangible assets acquired consist of customer lists, trademarks and a non-compete
agreement. The final valuation of the tangible assets acquired and liabilities assumed did
not differ significantly from the preliminary valuation.

Management
is responsible for the determination of the fair market value of the net assets acquired
and management considered a number of factors including an independent valuation and
appraisals. See Note 7 for additional information concerning other identifiable intangible
assets. Based on the final valuation, the annual amortization of identifiable intangible
assets will be $450,000 versus the $432,000 estimated in the preliminary valuation.
Identifiable intangible asset amortization expense was adjusted through December 31, 2006
to agree with the final valuation.

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

38

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

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

| |                                     |                         |             |  |             |  
| | ----------------------------------- | ----------------------- | ----------- |  | ----------- | -
| |                                     | Year Ended December 31, |            
| |                                     | 2006                    | 2005        | 
| |                                     | (Unaudited)             |            
|
| | Revenues                            |                         | $29,687,924 |  | $29,483,800 |  
|
| | Net income (loss)                   |                         | $877,692    |  | $(286,286   | )
| | Net income (loss) per common share: |                        
|
| | Basic                               |                         | $0.04       |  | (0.01       | )
| | Diluted                             |                         | $0.04       |  | (0.01       | )

3.     Accounts Receivable

Accounts
receivable include the following:

| |                                          |              |                  |   |              |  
| | ---------------------------------------- | ------------ | ---------------- | - | ------------ | -
| |                                          | December 31, |                 
| |                                          | 2006         | 2005    Restated |  
|
| | Trade accounts receivable                |              | $ 4,223,995      |   | $ 2,619,581  |  
| | Less:  Allowance for doubtful accounts   |              | (81,425          | ) | (79,841      | )
| | Allowance for trade rebates              |              | (1,727,559       | ) | (1,404,290   | )
| | Allowance for distribution fee           |              | (300,438         | ) | (297,060     | )
| | Allowance for cash discounts and returns |              | (24,500          | ) |             |  
| | Net trade receivables                    |              | 2,090,073        |   | 838,390      |  
| | Other receivables                        |              | 180,479          |   | 90,189       |  
|
| | Total receivables                        |              | $ 2,270,552      |   | $    928,579 |  

4.     Inventories

Inventories
include the following:

| |                     |              |            |  |            | 
| | ------------------- | ------------ | ---------- |  | ---------- | 
| |                     | December 31, |           
| |                     | 2006         | 2005       | 
|
| | Finished goods      |              | $2,784,612 |  | $2,516,114 | 
| | Work in process     |              | 92,780     |  | 144,390    | 
| | Packaging materials |              | 777,046    |  | 398,463    | 
| | Raw materials       |              | 1,023,669  |  | 809,696    | 
|
| | Total inventory     |              | $4,678,107 |  | $3,868,663 | 

39

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

5.     Equipment and
Improvements, net

Equipment
and improvements include the following:

| |                                       |              |             |   |             |  
| | ------------------------------------- | ------------ | ----------- | - | ----------- | -
| |                                       | December 31, |            
| |                                       | 2006         | 2005        |  
|
| | Machinery and equipment               |              | $ 4,408,244 |   | $ 3,337,306 |  
| | Furniture and fixtures                |              | 274,299     |   | 245,357     |  
| | Leasehold improvements                |              | 1,112,897   |   | 887,286     |  
| |                                       |              | 5,795,440   |   | 4,469,949   |  
| | Less:  accumulated depreciation       |              | (1,661,845  | ) | (1,084,087  | )
|
| | Total equipment and improvements, net |              | $ 4,133,595 |   | $ 3,385,862 |  

Included
in equipment and improvements at December 31, 2006 was machinery and equipment with a cost
of $221,518 and accumulated amortization of $86,321 attributable to leased equipment.
Amortization of assets under capital leases is included in depreciation expense.

6.     Goodwill Impairment

In
connection with the acquisition of Sunshine in 1998, the Company recorded goodwill
representing the excess of the purchase price over the fair value of the identifiable
assets acquired. The Sunshine products (the Product Line) acquired in
connection with this acquisition consist of hair and body soaps, lotions and moisturizers
and skin cleansers that comprise approximately 95% of the Companys skin care
segment. At December 31, 2004, the carrying value of this goodwill was $1,110,967.

In
2005 and 2006, the Product Line continued to experience competitive pressure leading to
declining sales and gross profit. Despite various attempts to improve the financial
performance of the Product Line, the Company has been unable to overcome the sales and
marketing breadth and product cost advantage held by its larger competitors. Utilizing the
Companys methodology for evaluating goodwill impairment (see Note 1), the results of
the 2006 and 2005 goodwill impairment tests are outlined below:

| |                                            |      |          |  |             | 
| | ------------------------------------------ | ---- | -------- |  | ----------- | 
| |                                            | 2006 | 2005     | 
|
| | Fair value of reporting unit with goodwill |      | $275,000 |  | $   624,000 | 
| | Less fair value of assets and liabilities, |     
| | excluding goodwill, and including          |     
| | unrecognized intangible assets of $60,000  |     
| | in 2006 and 2005                           |      | 275,000  |  | 424,000     | 
| | Implied value of goodwill                  |      |         |  | 200,000     | 
| | Carrying amount of goodwill                |      | 200,000  |  | 1,110,967   | 
|
| | Goodwill impairment                        |      | $200,000 |  | $   910,967 | 

Excluding
goodwill, the Company believes the balance of the assets and liabilities related to the
Product Line are fairly valued and recovery is reasonably assured. In 2006, the Company
updated its evaluation of the prospective sale price of the Product Line excluding the
fair value of any unrecorded intangible assets (customer lists, intellectual property
etc.). In 2006, the sale value is comparable to the value of the unrecognized intangible
assets and, accordingly, the implied value of goodwill is zero.

The
goodwill impairment of $200,000 in 2006 and $910,967 in 2005 has been recorded as a
separate line item within the consolidated statement of operations. As the Company
purchased the outstanding stock of Sunshine when it acquired the company, the impairment
write-downs are non-deductible for tax purposes. Accordingly, no tax benefit has been
provided relative to the impairment losses.

40

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

7.     Other Intangible
Assets, net

Other
intangible assets, net include the following:

| |                               |              |              |   |           |  
| | ----------------------------- | ------------ | ------------ | - | --------- | -
| |                               | December 31, |             
| |                               | 2006         | 2005         |  
|
| | Patents and trademarks        |              | $    444,067 |   | $ 444,067 |  
| | Other intangible assets       |              | 3,642,797    |   | 342,797   |  
|
| | Gross other intangible assets |              | 4,086,864    |   | 786,864   |  
| | Less accumulated amortization |              | (889,499     | ) | (487,088  | )
|
| | Other intangible assets, net  |              | $ 3,197,365  |   | $ 299,776 |  

In
connection with the April 18, 2006 acquisition of certain assets and assumption of trade
payables and the business of Western Medical, the Company allocated $3,300,000 of the
purchase price to identifiable intangible assets as outlined below:

| |                       |  |             |  |                     |  |                     | 
| | --------------------- |  | ----------- |  | ------------------- |  | ------------------- | 
| |                       |  | Fair Value  |  | Annual Amortization |  | Amortization Period | 
|
| | Trademarks            |  | $   600,000 |  | $  60,000           |  | 10 years            | 
| | Customer list         |  | 1,500,000   |  | 150,000             |  | 10 years            | 
| | Non-compete agreement |  | 1,200,000   |  | 240,000             |  | 5 years             | 
|
| | Total                 |  | $3,300,000  |  | $450,000            | 

Amortization
expense recorded in 2006 related to the Western Medical identifiable intangible assets
acquired was $318,750.

41

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

The
weighted average useful life of patent and trademarks and other intangibles as of December
31, 2006 is 2.6 years and 6.0 years, respectively. Actual amortization expense for 2006
and 2005 and estimated thereafter by year is outlined below:

|                                                             |                       |         |                      |              |       |              |  |             | 
|------------------------------------------------------------ | --------------------- | ------- | -------------------- | ------------ | ----- | ------------ |  | ----------- | 
|                                                             | Patents andTrademarks |         | Other    Intangibles |              | Total |             
|                                                            
|Actual amortization expense for year ended December 31, 2006 |                       | $15,148 |                      | $   387,263  |       | $   402,411  | 
|                                                            
|Actual amortization expense for year ended December 31, 2005 |                       | $15,614 |                      | $     68,522 |       | $     84,136 | 
|                                                            
|Estimated amortization expense for years ending December 31, |                      
|                                                            
|                                                             | 2007                  |         |                      | $29,639      |       | $   518,513  |  | $   548,152 | 
|                                                             | 2008                  |         |                      | 29,639       |       | 518,513      |  | 548,152     | 
|                                                             | 2009                  |         |                      | 17,935       |       | 451,876      |  | 469,811     | 
|                                                             | 2010                  |         |                      |             |       | 450,000      |  | 450,000     | 
|                                                             | 2011                  |         |                      |             |       | 280,000      |  | 280,000     | 
|                                                             | Thereafter            |         |                      |             |       | 901,250      |  | 901,250     | 
|                                                            
|                                                             | Total                 |         |                      | $77,213      |       | $3,120,152   |  | $3,197,365  | 

8.     Other Assets, net

Other
assets, net include the following:

| |                               |              |          |  |           | 
| | ----------------------------- | ------------ | -------- |  | --------- | 
| |                               | December 31, |         
| |                               | 2006         | 2005     | 
|
| | Deferred financing costs, net |              | $104,198 |  | $  92,235 | 
| | Deposits                      |              | 67,360   |  | 67,777    | 
| | Long-term receivable          |              | 47,395   |  | 90,300    | 
| | Other deferred costs          |              |         |  | 49,376    | 
|
| | Total other assets, net       |              | $218,953 |  | $299,688  | 

Deferred
financing costs related to the U.S. and Canadian credit facilities are being amortized
over the terms of the related facility.

9.     Line of Credit
Borrowings

Short-term
borrowings include the following:

| |                                 |              |                      |  |            | 
| | ------------------------------- | ------------ | -------------------- |  | ---------- | 
| |                                 | December 31, |                     
| |                                 | 2006         | 2005                 | 
|
| | U.S. line of credit             |              | $         
         |  | $1,080,561 | 
| | Canadian line of credit         |              |                     |  |           | 
|
| | Total line of credit borrowings |              | $         
         |  | $1,080,561 | 

42

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

U.S.
Line of Credit

In
connection with the acquisition of Western Medical (see Note 2), the Company entered into
an amended three-year revolving credit facility agreement (the Agreement)
dated April 18, 2006. The amended Agreement provides for maximum borrowings of $3,500,000
with its U.S. lender. The Agreement replaces the $2,000,000 revolving credit facility that
the Company entered into on January 31, 2005. At December 31, 2006 and 2005, zero and
$1,080,561, respectively, were outstanding under the Agreement. Advances will be utilized
to fund general working capital requirements, new product development and marketing
efforts and strategic initiatives.

The
Company may request advances under the Agreement up to the value of 85% of eligible
receivables (as defined) and 55% of eligible inventory (as defined). Interest on
outstanding advances is payable monthly in arrears at the prime rate (as defined) plus
2.0%, but not less than 7.50% per annum. At December 31, 2006, the effective interest rate
was 10.25%. In addition, the Company pays a monthly collateral management fee at the rate
of 1.5% per annum upon the daily average amount of advances outstanding and a monthly
unused line fee of 0.5% per annum upon the difference between the daily average amount of
advances outstanding and $3,500,000. Outstanding advances are secured by all of the
Companys existing and after-acquired tangible and intangible U.S. assets. In
addition, the Company has accorded the U.S. lender its guarantee of payment together with
a second lien security interest in the assets of the Companys wholly owned Canadian
subsidiary. The U.S. lender has agreed not to exercise its rights under its second lien
security interest and guarantee against the Canadian assets without the Canadian
lenders approval.

Over
the term of the Agreement, the Company has agreed to comply with certain financial
covenants. As it pertains to the Companys U.S. operations, cash collections may not
be less than a defined amount each calendar month. In addition, at all times the
Companys cash on hand (including unused borrowing capacity under the Agreement) must
not be less than $200,000. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Agreement. At
December 31, 2006, the Company was not in compliance with its minimum EBITDA and fixed
charge ratio financial covenants. The U.S. lender agreed to waive these covenant
violations.

At
December 31, 2005, based upon consolidated operating results for October, 2005 through
February, 2006, the Company was out of compliance with its EBITDA and fixed charge ratio
covenants as amended effective June 30, 2005. The U.S. lender agreed to waive these
covenant violations.

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

Canadian
Line of Credit

In
December 2006, the Company finalized the annual renewal of its revolving credit facility
(the Canadian Agreement) for a maximum principal amount of $430,000 ($500,000
Canadian) with its Canadian lender. At December 31, 2006 and 2005, the outstanding
balances under the Canadian Agreement were zero. Derma Sciences Canada Inc. may request
advances under the Canadian Agreement up to the value of 75% of eligible receivables (as
defined) plus the lesser of $343,000 ($400,000 Canadian) or 40% of eligible inventory (as
defined), less priority claims. Interest on outstanding advances is payable monthly in
arrears at the prime rate (as defined) plus 1.0%, or 7.0% for Canadian dollar advances and
9.75% for U.S. dollar denominated advances at December 31, 2006. The line of credit also
provides for direct advances in U.S. dollars limited to the U.S. dollar equivalent of
$343,000 ($400,000 Canadian). Outstanding advances are secured by all tangible and
intangible assets of Derma Sciences Canada Inc. In addition, the Company has accorded the
Canadian lender its guarantee of payment together with a second lien security interest in
the Companys assets located in the U.S.

43

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Over
the term of the Canadian Agreement, the Company has agreed to comply with certain
financial covenants. Additional covenants governing permitted indebtedness, liens,
payments of dividends and protection of collateral are included in the Canadian Agreement.
In the event of a margin deficiency (as defined) or covenant violation, the Company is
required to advance up to an additional $430,000 ($500,000 Canadian) of working capital to
Derma Sciences Canada Inc. in order to correct the deficiency. This additional working
capital may be repaid to the Company 45 days after the margin deficiency or covenant
violation has been cured upon the condition that such repayment not result in a margin
deficiency, covenant violation or any other event of default. At December 31, 2006 the
Company was in compliance with its Canadian line of credit covenants.

10.    Accrued Expenses and
Other Current Liabilities

Accrued
expenses and other current liabilities include the following:

| |                                                      |              |          |  |          | 
| | ---------------------------------------------------- | ------------ | -------- |  | -------- | 
| |                                                      | December 31, |         
| |                                                      | 2006         | 2005     | 
|
| | Accrued compensation and related taxes               |              | $472,402 |  | $124,718 | 
| | Accrued administrative fees                          |              | 166,857  |  | 215,357  | 
| | Other                                                |              | 123,428  |  | 151,484  | 
|
| | Total accrued expenses and other current liabilities |              | $762,687 |  | $491,559 | 

11.    Long-Term Debt

Long-term
debt includes the following:

| |                           |              |          |  |          | 
| | ------------------------- | ------------ | -------- |  | -------- | 
| |                           | December 31, |         
| |                           | 2006         | 2005     | 
|
| | Canadian term loan        |              | $295,881 |  | $533,809 | 
| | Promissory note           |              | 500,000  |  |         | 
| | Capital lease obligations |              | 88,542   |  | 140,609  | 
|
| | Total debt                |              | 884,423  |  | 674,418  | 
|
| | Less:  current maturities |              | 338,155  |  | 285,945  | 
|
| | Long-term debt            |              | $546,268 |  | $388,473 | 

The
following are Canadian term loan and promissory note maturities over the next three years:

| |                             |  |                                      | 
| | --------------------------- |  | ------------------------------------ | 
| | Year EndingDecember 31,     |  | Canadian TermLoan andPromissory Note | 
|
| | 2007                        |  | $295,881                             | 
| | 2008                        |  |                                     | 
| | 2009                        |  | 500,000                              | 
|
| | Total term loan obligations |  | 795,881                              | 
| | Less: current maturities    |  | 295,881                              | 
|
| | Long-term loan obligations  |  | $500,000                             | 

44

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Canadian
Term Loan

In
connection with the acquisition of Dumex Medical Inc. in August 2002, the Company entered
into a five-year term loan agreement with its Canadian lender. The loan is repayable in
monthly payments consisting of principal and interest. Interest on the outstanding
principal balance is payable monthly at the banks prime rate (as defined) plus
1.25%, or 7.25% at December 31, 2006. The term loan is secured by all tangible and
intangible assets of Derma Sciences Canada Inc. and is subject to the same conditions
applicable to the Canadian operating line of credit (see Note 9).

In
addition, the Canadian lender has granted in 2006 Derma Sciences Canada Inc. a $644,000
($750,000 Canadian) non-revolving term line of credit to finance equipment purchases and
equipment upgrades to Derma Sciences Canada Inc.s manufacturing facility. Advances
against the line are limited to 75% of the actual cost of the capital expenditure.
Interest on outstanding advances is payable monthly in arrears at prime (as defined), plus
1.25%. Each advance shall be amortized and repaid over sixty months. Prepayment of
advances in whole or in part are not permitted during the eighteen months following
initial disbursement. Prepayment thereafter is permitted in whole or once per annum in
part with thirty days written notice and payment of the greater of the following premium:
(i) 3% of the principal amount prepaid; or (ii) three months interest on such principal at
the loan interest rate in effect on the date prepayment is made. As of December 31, 2006,
there were no outstanding advances against the line.

Promissory
Note

In
connection with the acquisition of Western Medical in April 2006, a portion of the
purchase price was paid via a three-year unsecured promissory note issued to the seller.
The principal amount of the promissory note, together with simple interest of 12%, is
payable in 11 quarterly installments of interest only in the amount of $15,000 and a final
payment of accrued interest of $15,000 and the principal balance of $500,000 on April 18,
2009. The promissory note may be prepaid in part or in full at any time without penalty.

Capital
Lease Obligations

The
Company has three capital lease obligations for certain distribution and computer
equipment totaling $88,542 as of December 31, 2006. The capital lease obligations bear
interest at annual rates ranging from 3.9% to 10.2% with the longest lease term expiring
in April 2009.

The
future minimum lease payments required under the capital leases and the present value of
the minimum lease payments as of December 31, 2006 are as follows:

| |                                                        |  |                          | 
| | ------------------------------------------------------ |  | ------------------------ | 
| | Year EndingDecember 31,                                |  | Capital LeaseObligations | 
|
| | 2007                                                   |  | $47,364                  | 
| | 2008                                                   |  | 38,925                   | 
| | 2009                                                   |  | 9,731                    | 
|
| | Total minimum lease payments                           |  | 96,020                   | 
| | Less:  Amount representing interest                    |  | 7,478                    | 
|
| | Present value of capital lease obligations             |  | 88,542                   | 
| | Less:  Current maturities of capital lease obligations |  | 42,274                   | 
|
| | Long-term capital lease obligations                    |  | $46,268                  | 

45

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

U.S.
Term Loan

In
connection with the acquisition of Western Medical (see Note 2) in April 2006, the Company
entered into a three-year term loan agreement for $1,000,000 with its U.S. lender.
Utilizing funds received from the sale of common stock (see Note 12) on August 4 and
December 14, 2006, the Company accelerated, without penalty, the payment of the $1,000,000
loan. Upon full repayment of the loan, the Company paid the U.S. lender a $10,000
termination fee.

12.    Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at December 31,
2006. The series A preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $4.00 per share, votes as
a class on matters affecting the series A preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 440,003 shares of series B convertible preferred stock outstanding at December 31,
2006. The series B preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference of $6.00 per share, votes as
a class on matters affecting the series B preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 619,055 shares of series C convertible preferred stock outstanding at December 31,
2006. The series C preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.70 per share,
votes as a class on matters affecting the series C preferred stock and maintains voting
rights identical to the common stock on all other matters.

There
are 1,071,346 shares of series D convertible preferred stock outstanding at December 31,
2006. The series D preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.50 per share,
votes as a class on matters affecting the series D preferred stock and maintains voting
rights identical to the common stock on all other matters.

Common
Stock

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

During
2006, the Company raised $5,803,304 (net of $568,932 in commission and other offering
expenses) from a private offering of 2,655,098 units (10,620,392 shares in total) at $2.40
per unit, each unit consisting of four shares of the Companys common stock and one
five-year Series H warrant (2,655,098 warrants in total) to purchase one share of common
stock at the price of $1.00. In addition, the placement agent received 754,806 five-year
Series I warrants to purchase one share of common stock at $0.72. Total common shares
outstanding increased from 12,285,768 before the transaction to 22,906,160 afterwards. The
funds were used for the acquisition of certain assets of Western Medical.

On
August 3, 2006, the Company entered into an agreement to sell 2,000,000 shares of its
common stock at $0.75 per share for a total sales price of $1,500,000 to an existing
shareholder (the Purchaser). The Purchaser paid $500,000 on August 3, 2006 and
paid the balance due of $1,000,000, together with interest thereon at the annual rate of
2.5%, or $8,500, on December 5, 2006. The Company raised $1,478,525 (net of $21,475 in
offering expenses) related to this offering. A portion of the proceeds from this offering
was used to pay off the U.S. term loan entered into in connection with the acquisition of
Western Medical (see Note 2).

On
February 8, 2005, the Company closed a private offering of 2,760,000 units at $0.50 per
unit, each unit consisting of one share of the Companys common stock and one
four-year series G warrant to purchase one share of common stock at a price of $1.05.
Total offering proceeds of $1,220,666, net of $159,334 in offering expenses, were used for
working capital. The offering commenced prior to December 31, 2004. During 2005, the
Company sold 1,205,000 units at $0.50 per unit and received total offering proceeds of
$521,808, net of $80,692 in offering expenses.

46

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Stock
Purchase Warrants

At
December 31, 2006, the Company had warrants outstanding to purchase 7,479,345 shares of
the Companys common stock as outlined below:

| |        |                    |                |                   | 
| | ------ | ------------------ | -------------- | ----------------- | 
| | Series | Number of Warrants | Exercise Price | Expiration Date   | 
|
| | F      | 1,309,441          | $0.57          | January 6, 2007   | 
| | G      | 2,760,000          | $1.05          | December 31, 2008 | 
| | H      | 2,655,098          | $1.00          | April 30, 2011    | 
| | I      | 754,806            | $0.72          | April 30, 2011    | 
|
| | Total  | 7,479,345          |               

In
April 2006, the Company issued 2,655,098 series H warrants and 754,806 series I warrants
in connection with the acquisition of certain assets of Western Medical (see Note 2).

Stock
Options

The
Company has a stock option plan under which options to purchase a maximum of 5,000,000
shares of common stock may be issued. The plan permits the granting of both incentive
stock options and nonqualified stock options to employees and directors of the Company and
certain outside consultants and advisors to the Company. The option exercise price may not
be less than the fair market value of the stock on the date of the grant of the option.
The duration of each option may not exceed 10 years from the date of grant. Options under
the plan to purchase 585,000 shares of common stock were granted to officers, directors,
agents and employees in 2006 with exercise prices ranging from $0.70 to $0.83 per share
and 20,000 options were forfeited. As of December 31, 2006, options to purchase 3,601,625
shares of the Companys common stock were issued and outstanding under the plan. No
options granted under the plan have been exercised.

The
Company has previously granted nonqualified stock options to officers, directors, agents
and employees outside of the stock option plan (non-plan options). All
non-plan options were granted at the fair market value at the date of grant. As of
December 31, 2006, non-plan options to purchase 2,236,655 shares of the Companys
common stock were issued and outstanding. In September 2006, 500,000 options granted to a
former employee expired.

For
the years ended December 31, 2006 and 2005 the fair value of each option award was
estimated at the date of grant using the Black-Scholes option pricing model. The
weighted-average assumptions for the years ended December 31, 2006 and 2005 were as
follows:

| |                              |  |       |  |       | 
| | ---------------------------- |  | ----- |  | ----- | 
| |                              |  | 2006  |  | 2005  | 
|
| | Risk-free interest rate      |  | 4.56% |  | 4.13% | 
| | Volatility factor            |  | 127%  |  | 137%  | 
| | Dividend yield               |  | 0%    |  | 0%    | 
| | Expected option life (years) |  | 6.25  |  | 5     | 
| | Contractual life (years)     |  | 10    |  | 10    | 

47

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

In
both 2006 and 2005, the risk-free rate utilized represents the U.S. Treasury yield curve
rate which approximates the risk-free rate for the expected option life at the time of
grant. In 2006 and 2005, the volatility factor was calculated based on the seventy-five
and sixty month-end closing prices of the Companys common stock preceding the month
of stock option grant, respectively. Effective January 1, 2006, the Company adopted based
on guidance from Staff Accounting Bulletin 107, a stock option life of 6.25 years. As a
result, the Company also adopted on January 1, 2006, a seventy-five month volatility
period to coincide with the expected stock option life. The dividend yield is 0% since the
Company does not anticipate paying dividends in the near future. Based on the
Companys historical experience of options that cancel before becoming fully vested,
the Company effective January 1, 2006 has assumed an annualized forfeiture rate of 1.0%
for all options. Under the true-up provision of SFAS 123R, the Company will record
additional expense if the actual forfeiture rate is lower than estimated, and will record
a recovery of prior expense if the actual forfeiture rate is higher than estimated.

A
summary of the Companys stock option activity and related information for the years
ended December 31, 2006 and 2005 follows:

|                                |  |           |   |                               |  |           |   |                               | 
|------------------------------- |  | --------- | - | ----------------------------- |  | --------- | - | ----------------------------- | 
|                                |  | 2006      |   | 2005                          | 
|                               
|                                |  | Options   |   | WeightedAverageExercise Price |  | Options   |   | WeightedAverageExercise Price | 
|                               
|Outstanding  beginning of year |  | 5,773,280 |   | $0.92                         |  | 4,464,655 |   | $1.06                         | 
|Granted                         |  | 585,000   |   | $0.74                         |  | 1,526,000 |   | $0.48                         | 
|Forfeited/Expired               |  | (520,000  | ) | $0.51                         |  | (217,375  | ) | $0.72                         | 
|                               
|Outstanding - end of year       |  | 5,838,280 |   | $0.94                         |  | 5,773,280 |   | $0.92                         | 
|                               
|Exercisable at end of year      |  | 5,533,280 |   | $0.95                         |  | 5,773,280 |   | $0.92                         | 

The
weighted average fair value per share of options granted during 2006 and 2005 was $0.67
and $0.48, respectively. The fair value of options vested during 2006 was $113,737.

The
following table summarizes information related to stock options outstanding and
exercisable at December 31, 2006:

|                        |  |                                  |  |                                           |  |                                |  |                                  |  |                                | 
|----------------------- |  | -------------------------------- |  | ----------------------------------------- |  | ------------------------------ |  | -------------------------------- |  | ------------------------------ | 
|Range ofExercise Prices |  | Number    Outstanding at12/31/06 |  | Weighted-AverageRemainingContractual Life |  | Weighted-AverageExercise Price |  | Number    Exercisable at12/31/06 |  | Weighted-AverageExercise Price | 
|                       
|$0.37 - $0.50           |  | 2,186,125                        |  | 6.9                                       |  | $0.45                          |  | 2,186,125                        |  | $0.45                          | 
|$0.51 - $0.75           |  | 2,076,000                        |  | 6.1                                       |  | $0.63                          |  | 1,891,000                        |  | $0.63                          | 
|$0.83 - $1.20           |  | 930,000                          |  | 6.1                                       |  | $0.91                          |  | 810,000                          |  | $0.92                          | 
|$1.55 - $1.70           |  | 366,500                          |  | 6.8                                       |  | $1.64                          |  | 366,500                          |  | $1.64                          | 
|$1.71 - $12.50          |  | 279,655                          |  | 1.5                                       |  | $6.20                          |  | 279,655                          |  | $6.20                          | 
|                       
|                        |  | 5,838,280                        |  | 6.2                                       |  |                                |  | 5,533,280                        |  |                                | 

For
the years ended December 31, 2006 and 2005, no income tax benefit was recognized related
to stock option activity.

48

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

During
the year ended December 31, 2006, stock option compensation expense was recorded using the
fair value method under SFAS 123R as follows:

| | Cost of sales                           | $  16,030 | 
| | --------------------------------------- | --------- | 
| | Operating expenses                      | 165,464   | 
|
| | Total stock option compensation expense | $181,494  | 

As
of December 31, 2006, there was $192,011 of total unrecognized compensation cost related
to nonvested share-based awards granted under the Plan. That cost is expected to be
recognized over the options remaining weighted average vesting period of 2.25 years.

The
Companys net loss and loss per common share and pro forma net loss and loss per
common share assuming compensation expense had been determined for the year ended December
31, 2005 based on the fair value at the grant date for all awards, using the Black-Scholes
option pricing model consistent with the provisions of SFAS 123, and amortized ratably
over the vesting period, instead of the intrinsic value method under APB 25, are set forth
below:

| | Net loss  as restated                          | $(1,099,990   | )
| | ----------------------------------------------- | ------------- | -
| | Add:  stock-based employee compensation expense |              
| | included in reported net loss                   | 24,094        |  
| | Deduct:  pro forma compensation expense         | (1,186,530    | )
|
| | Pro forma net loss  as restated                | $(2,262,426   | )
|
| | Loss per common share  basic and diluted       |              
| | As restated                                     | $       (0.09 | )
| | Pro forma                                       | $       (0.19 | )

As
of December 31, 2005, the board of directors approved 461,875 stock options as part of the
Companys 2005 performance-based option plan as being earned by Company management.
In accordance with the terms of the performance based option plan, options earned are
immediately vested. In connection with the award of these options, the Company recorded a
non-cash charge of $23,094 to compensation expense.

In
May 2005, the Company modified the terms of a retired employees stock option
agreement to provide for the continued vesting in accordance with the terms of the subject
stock option agreement to the same extent as if the employees employment had
continued indefinitely. In connection with this modification, the Company recorded a
non-cash charge of $1,000 to compensation expense.

Shares
Reserved for Future Issuance

At
December 31, 2006, the Company had reserved the following shares of common stock for
future issuance:

| | Convertible preferred shares (series A - D)      | 2,280,407  | 
| | ------------------------------------------------ | ---------- | 
| | Common stock options available for grant         | 1,398,375  | 
| | Common stock options outstanding                 | 5,838,280  | 
| | Common stock warrants outstanding (series F - I) | 7,479,345  | 
| | Restricted common stock available for grant      | 2,325,000  | 
| | Restricted common stock grants                   | 175,000    | 
|
| | Total common stock shares reserved               | 19,496,407 | 

49

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Restricted
Common Stock

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

On
May 12, 2006, 175,000 shares of restricted common stock were granted to non-employee
members of the Companys board of directors and will vest three years from the date
of the grant. The fair market value at the date of grant, determined by the quoted market
price, was $145,250. The fair market value of the grant is being recognized to
compensation expense over the three-year service period. For the year ended December 31,
2006, $30,262 was recorded in operating expenses for these grants.

A
summary of restricted common stock activity as of December 31, 2006, and the changes
during the year then ended, is presented below:

| |                                |  |         |  |                                       | 
| | ------------------------------ |  | ------- |  | ------------------------------------- | 
| | Restricted Common Stock        |  | Shares  |  | Weighted-AverageGrant-Date Fair Value | 
|
| | Nonvested at January 1, 2006   |  | 0       |  | 0                                     | 
|
| | Granted                        |  | 175,000 |  | $0.83                                 | 
|
| | Nonvested at December 31, 2006 |  | 175,000 |  | $0.83                                 | 

At
December 31, 2006, the weighted-average remaining contractual term for the restricted
common stock grant is 2.36 years.

13.    Operating Segments

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

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

50

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Segment
sales, gross profit and other related information for 2006 and 2005 are as follows:

---

|                                        |  |               |   |                                               |  |                |   |              |   |                  |  
|--------------------------------------- |  | ------------- | - | --------------------------------------------- |  | -------------- | - | ------------ | - | ---------------- | -
|Year Ended December 31, 2006           
|                                       
|                                        |  | Wound Care    |   | Wound Closure-    Specialty SecurementDevices |  | Skin Care      |   | Other        |   | Total    Company |  
|                                       
|Net sales                               |  | $24,367,164   |   | $2,403,019                                    |  | $1,117,208     |   |             |   | $ 27,887,391     |  
|                                       
|Gross profit                            |  | 8,431,092     |   | 1,177,687                                     |  | 43,609         |   |             |   | 9,652,388        |  
|Total expenses                          |  |              |   |                                              |  |               |   | $(8,983,649  | ) | (8,983,649       | )
|                                       
|Net income                              |  | $     668,739 |  
|                                       
|Net long-lived assets                   |  | $  9,341,294  |   | $   163,076                                   |  | $             |   | $    268,132 |   | $   9,772,502    |  
|                                       
|Year Ended December 31, 2005 (Restated)
|                                       
|                                        |  | Wound Care    |   | Wound Closure-    Specialty SecurementDevices |  | Skin Care      |   | Other        |   | Total    Company |  
|                                       
|Net sales                               |  | $ 18,621,069  |   | $2,676,979                                    |  | $ 1,501,592    |   |             |   | $ 22,799,640     |  
|                                       
|Gross profit (loss)                     |  | 5,786,967     |   | 1,358,577                                     |  | (101,957       | ) |             |   | 7,043,587        |  
|Total expenses                          |  |              |   |                                              |  |               |   | $(8,143,577  | ) | (8,143,577       | )
|                                       
|Net loss                                |  | $(1,099,990   | )
|                                       
|Net long-lived assets                   |  | $   3,311,128 |   | $     58,450                                  |  | $    200,000   |   | $    316,060 |   | $   3,885,638    |  

Long-lived
assets consist of equipment and improvements, other intangible assets and goodwill. Wound
care long-lived assets consist principally of Derma Sciences Canada Inc. equipment and
improvements, other identifiable intangible assets and goodwill. The significant increase
in wound care net long-lived assets in 2006 relates to other identifiable intangible
assets and goodwill acquired in connection with the Western Medical acquisition (see Note
2). Wound closure and specialty securement products are both outsourced and manufactured
internally starting in the second half of 2005. Skin care long-lived assets in 2005
consist of goodwill associated with the acquisition of Sunshine Products, Inc. In 2005,
the Company closed its skin care manufacturing facility and outsourced the facilitys
production with a view to reducing overhead and improving cost competitiveness. In
connection with the closure, the Company sold or transferred the long-lived assets
(excluding goodwill) associated with the skin care segment. In addition, the Company
determined that the Sunshine goodwill was impaired and recorded a charge of $200,000 and
$910,967, respectively, in 2006 and 2005 (see Note 6). Corporate headquarters and the
Companys U.S. distribution center equipment and improvements are included in the
Other column since they service all three operating segments.

51

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

A
geographical breakdown of the Companys sales, gross profit and long-lived assets is
outlined below:

---

|                      |  |               |  |              |  |              |  |              | 
|--------------------- |  | ------------- |  | ------------ |  | ------------ |  | ------------ | 
|2006                  |  | United States |  | Canada       |  | Other        |  | Total        | 
|                     
|Net sales             |  | $15,981,237   |  | $10,680,639  |  | $1,225,515   |  | $27,887,391  | 
|Gross profit          |  | $  6,047,105  |  | $  3,176,353 |  | $   428,930  |  | $  9,652,388 | 
|Net long-lived assets |  | $  5,907,039  |  | $  3,461,824 |  | $   403,639  |  | $  9,772,502 | 
|                     
|2005 Restated         | 
|                     
|Net sales             |  | $  9,893,704  |  | $11,954,156  |  | $   951,780  |  | $22,799,640  | 
|Gross profit          |  | $  3,611,738  |  | $  3,098,726 |  | $   333,123  |  | $  7,043,587 | 
|Net long-lived assets |  | $     816,318 |  | $  3,031,311 |  | $     38,009 |  | $  3,885,638 | 

Other
sales and gross profit relate principally to wound closure and specialty securement
devices sales in Europe and are invoiced by the United States operation.

For
the year ended December 31, 2006, the Company has a major U.S. customer comprising 18% of
U.S. sales and 23% of U.S. operations trade accounts receivable at December 31, 2006. The Companys
wholly owned Canadian subsidiary sells to one customer who serves as its exclusive third
party distributor and comprises 100% of Canada operations trade accounts receivable at December 31, 2006.

14.    Income Taxes

Income
(loss) before income taxes consists of the following components:

| |                                         |      |                    |   |             |  
| | --------------------------------------- | ---- | ------------------ | - | ----------- | -
| |                                         | 2006 | 2005      Restated |  
|
| | Domestic                                |      | $(37,518           | ) | $(1,591,173 | )
| | Foreign                                 |      | 824,598            |   | 491,183     |  
|
| | Total income (loss) before income taxes |      | $ 787,080          |   | $(1,099,990 | )

52

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

The
components of the provision for income taxes are as follows:

|         |                                  |      |            |  |   | 
|-------- | -------------------------------- | ---- | ---------- |  | - | 
|         |                                  | 2006 | 2005       | 
|        
|Current: |                                  |      |            |  |  
|         | Federal                          |      | $    5,000 |  |  | 
|         | State                            |      |           |  |  | 
|         | Foreign                          |      |           |  |  | 
|        
|         | Total current                    |      | 5,000      |  |  | 
|        
|         | Deferred:                        |     
|         | Federal                          |      |           |  |  | 
|         | State                            |      |           |  |  | 
|         | Foreign                          |      | 113,341    |  |  | 
|        
|         | Total deferred                   |      | 113,341    |  |  | 
|        
|         | Total provision for income taxes |      | $118,341   |  |  | 

Significant
components of the Companys deferred tax assets and liabilities are as follows:

| |                                            |              |                  |   |             |  
| | ------------------------------------------ | ------------ | ---------------- | - | ----------- | -
| |                                            | December 31, |                 
| |                                            | 2006         | 2005    Restated |  
|
| | Deferred tax liabilities:                  |              |                  |   |             |  
| | Prepaids                                   |              | $   (70,518      | ) | $   (10,499 | )
| | Intangible amortization                    |              | (70,364          | ) | (37,492     | )
| | Deductible acquisition costs               |              | (113,936         | ) | --          |  
| | Depreciation                               |              | (365,368         | ) | (307,644    | )
|
| | Total deferred tax liabilities             |              | (620,186         | ) | (355,635    | )
|
| | Deferred tax assets:                       |             
| | Net operating loss carryforwards - U.S.    |              | 3,698,253        |   | 3,341,339   |  
| | Net operating loss carryforwards - foreign |              | 193,614          |   | 487,716     |  
| | Equity based compensation                  |              | 113,064          |   | 33,081      |  
| | Allowance for sales deductions             |              | 153,825          |   | 117,234     |  
| | Amortization of intangibles                |              | 166,466          |   | 69,932      |  
| | Inventory obsolescence reserve             |              | 106,047          |   | 60,890      |  
| | Other                                      |              | 61,933           |   | 54,340      |  
|
| | Gross deferred tax assets                  |              | 4,493,202        |   | 4,164,532   |  
| | Valuation allowance                        |              | (3,986,357       | ) | (3,808,897  | )
|
| | Total deferred tax assets                  |              | 506,845          |   | 355,635     |  
|
| | Net deferred tax liabilities               |              | $  (113,341      | ) | $          |  

The
net deferred tax liability relates to the Companys Canadian operation and consists of
a deferred tax asset  current of $14,983 and a net deferred tax liability 
long term of $128,324 as of December 31, 2006. The deferred tax asset  current is included in prepaid
expenses and other current assets in the consolidated balance sheet. The remaining
valuation allowance relates to the U.S. The timing in which the Company can utilize its
U.S. federal net operating loss carryforwards in any year or in total may be limited under the
Internal Revenue Code Section 382 regarding changes in ownership of corporations. Due to
uncertainties surrounding the Companys ability to use its U.S. net operating loss
carryforwards and net deferred tax assets, a full valuation allowance has been provided as
of December 31, 2006 and 2005.

53

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

The
reconciliation of income tax computed at the U.S. federal statutory tax rates to income
tax expense is:

---

| |                                                        |              |                  |   |              |  
| | ------------------------------------------------------ | ------------ | ---------------- | - | ------------ | -
| |                                                        | December 31, |                 
| |                                                        | 2006         | 2005    Restated |  
|
| | Tax expense at federal statutory rate                  |              | $ 267,607        |   | $(373,997    | )
| | State tax, net of federal benefit                      |              | (16,658          | ) | (104,858     | )
| | Expiration of state tax operating   loss carryforwards |              |                 |   | 270,108      |  
| | Differential in foreign taxes                          |              |                 |   | (40,924      | )
| | Goodwill impairment loss                               |              | 68,000           |   | 369,762      |  
| | Nondeductible expenses                                 |              | 12,633           |   | 22,489       |  
| | Other                                                  |              | 31,591           |   | --           |  
|
| | Total                                                  |              | 363,173          |   | 142,580      |  
|
| | Change in valuation allowance                          |              | (244,832         | ) | (142,580     | )
|
| | Provision for income taxes                             |              | $ 118,341        |   | $           |  

At
December 31, 2006, the Company has net operating loss carryforwards of approximately
$8,600,000 for federal income tax purposes that begin to expire in years 2017 through
2027. For state income tax purposes, the Company has net operating loss carryforwards in a
number of jurisdictions in varying amounts and with varying expiration dates. The most
significant state net operating loss carryforward is approximately $4,700,000 in New
Jersey, the site of the Companys headquarters. New Jersey currently allows the
deduction of net operating losses up to 100% of net income. The state has a seven year
carryforward period but such period is extended where an otherwise deductible net
operating loss was disallowed in full or in part because of previous limitations. The New
Jersey carryforwards begin to expire in years 2007 through 2012.

15.    Operating Leases

The
Company has operating lease agreements for its facilities and equipment expiring in
various years through 2012. Expense under these agreements amounted to $1,067,965 and
$1,014,029 in 2006 and 2005, respectively. In December 2006, the Company leased an
additional 15,499 square feet of space adjacent to its Toronto manufacturing facility for
additional manufacturing and warehouse space. The lease for this additional space runs
through August, 2012. Simultaneously, the Company, in agreement with the landlord, was
released from its lease on 6,068 square feet of non-adjacent property. Also in December
2006, the Company amended and extended its existing headquarters office lease due to
expire in August 2007. The Company will relocate to larger office space in the same
building under an amended lease that expires in August 2012. The leases provide for
increases in future minimum annual rental payments based on specified conditions over the
life of the lease and/or annual inflationary increases tied to a published price index.
The leases provide for renewal options consistent with the terms of the current lease. It
is expected that these leases will be renewed or replaced by leases on other properties.

54

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Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Net
minimum future rental payments under non-cancelable operating leases as of December 31,
2006 are:

| |                                      |  |             |  
| | ------------------------------------ |  | ----------- | -
| | Minimum Future Rental Payments       | 
| | Year Ending December 31,             |  | Amount      |  
|
| | 2007                                 |  | $ 1,332,086 |  
| | 2008                                 |  | 1,225,546   |  
| | 2009                                 |  | 831,997     |  
| | 2010                                 |  | 705,449     |  
| | 2011                                 |  | 711,204     |  
| | Thereafter                           |  | 483,474     |  
|
| | Total minimum future rental payments |  | $ 5,289,756 |  
| | Sublease income                      |  | (344,859    | )
|
| | Net minimum future rental payments   |  | $ 4,944,897 |  

Minimum
rental payments associated with the U.S. distribution lease range from $11,000 per month
in year one to $21,600 in year five of the lease term. The Company is recording lease
expense monthly at $16,300, the weighted average monthly lease expense over the life of
the lease. The difference between the monthly lease expense being recorded and the amount
paid is being recorded as deferred rent expense on the balance sheet. At December 31,
2006, $99,178 of deferred rent expense was recorded.

16.    Retirement Benefits

The
Company maintains a profit sharing/401(k) plan for eligible full-time U.S. employees.
Participants may contribute a fixed percentage of their salary to the plan, subject to IRS
limitations. The Company makes a matching contribution of 50% on the first 6% of each
participants annual earnings contributed to the plan. Company contributions to the
plan for the years ended December 31, 2006 and 2005 were $51,111 and $39,346,
respectively.

Effective
January 1, 2006, the Companys Canadian subsidiary adopted a group retirement savings
plan (Registered Retirement Savings Plan) for eligible full time Canadian employees. The
Canadian subsidiary makes a matching contribution of 50% of an employees
contribution to a maximum of 3% of annual gross earnings. Employee contribution limits to
the group retirement savings plan are set by the Canada Customs and Revenue Agency. The
Companys Canadian subsidiarys contributions to the plan for the year ended
December 31, 2006 were $48,692.

17.    Related Party
Transactions

The
Company has a consulting agreement with its founder, former president and former director.
In 2006 and 2005 compensation and reimbursed expenses under this agreement were $25,825
and $26,087, respectively.

18.    Comvita Licensing,
Manufacturing and Sales Agreement

On
February 13, 2006 the Company entered into an exclusive five year licensing, manufacturing
and sales agreement (the Agreement) with Comvita New Zealand Limited, whereby
the Company will manufacture and sell a line of Manuka Honey based wound care products
developed by Comvita. These products are supported by proprietary intellectual property
that will serve to provide a competitive advantage in the market place. Access to this
technology and these products represents a significant milestone in the Companys
strategy to build a larger presence in the advanced wound care market segment. Under the
Agreement, the Company receives exclusive rights to manufacture and sell its branded
products throughout North and South America within the professional medical-surgical
marketplace (i.e. extended care, acute care, home care, etc). Comvita retains the right to
these products in the consumer marketplace and has the option to purchase its branded
consumer product requirements from the Company at agreed upon pricing.

55

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

In
accordance with the Agreement, the Company will purchase its requirements for active honey
from Comvita at agreed upon pricing. As consideration for the grant of the license, the
Company will pay Comvita a royalty based on sales. The Agreement calls for the Company to
spend a minimum of either $200,000 or 8% of sales per year on Advertising and Promotion in
support of these products. Further, the Agreement calls for minimum sales achievement
targets beginning in the second year of the Agreement and each year thereafter to maintain
exclusivity. The agreement will commence upon regulatory approval of the first product
which had not occurred as of December 31, 2006.

19.    Appointment of
Canadian Distributor

On
May 9, 2005 the Company entered into a five-year agreement expiring May 1, 2010 with a
Canadian company to serve as the exclusive distributor of its products in Canada. The
Company believes that the agreement will provide better service to its customers
throughout Canada and greater opportunity for sales growth. The agreement also appoints
the distributor as the Companys servicing agent to fulfill supply contracts held
directly by the Company. The Company recognizes revenue under the agreement when title and
risk of loss pass to the distributor and collectability is reasonably assured which is at
the time product is shipped to the distributor. Payment terms from the distributor are 30
days. The agreement automatically renews after five-years for consecutive periods of one
year each on the same terms and conditions unless either party gives notice of its intent
not to renew 180 days prior to expiry. Either party has the right to terminate the
agreement when an event of default (as defined) has occurred with respect to the other
party. The distributor is entitled to continue to sell or otherwise dispose of all
inventory owned by it from and after the date of contract expiration or termination. If
termination of the agreement is not occasioned by breach by the distributor, the
distributor will be entitled on notice to the Company to return saleable inventory (as
defined) to the Company. In the event sales returns are expected, they will be reserved
for at the time of sale. Since the inception of the agreement, sales returns have been
minimal.

Effective
June 1, 2005 the distributor assumed responsibility for customer service, product delivery
and maintenance and warehousing of sufficient inventory to meet agreed upon order
fulfillment requirements. On an ongoing basis, the distributor will place inventory
replenishment orders with the Company at agreed upon prices, 120 days in advance of
scheduled delivery. Unless amended, each order becomes non-cancelable 90 days in advance
of scheduled delivery.

With
respect to sales made by the distributor, the Company will pay the distributor an agreed
upon distribution fee and a specified incentive for growth (as achieved). The Company will
reimburse the distributor for the difference between the price paid by the distributor and
the Companys contract price with the end customer upon submission by the distributor
of an agreed upon rebate report. Further, the agreement requires the distributor to meet
specified minimum regular sales growth targets in the first four years and achieve a
minimum annual private label product purchase target. Failure of the distributor to meet
the annual purchase requirements shall not be considered an event of default. In this
situation, the Company, at its discretion, may cancel the agreement. In the first fiscal
year of the agreement ending May 30, 2006 the distributor did not meet its growth targets
and no additional growth incentives were earned. The Company opted not to exercise its
option to cancel the agreement as a result of the distributors failure to meet its
growth targets.

In
connection with implementing the agreement, the Company sold to the distributor its
existing inventory of saleable finished product on hand and all saleable finished product
it committed to manufacture prior to signing of the agreement for delivery by the Company
through September 2005 at the agreed upon prices to initially stock and maintain the
distribution pipeline. Other than the one-time sale in May and June 2005 of its existing
inventory on hand which is estimated to represent two to three months sales, prospective
sales are expected to resume historical trends affected only by existing market
conditions. Given economic order quantities and normal lead times associated with the
products sold to the distributor, it is expected that a two to three month safety stock
will be required prospectively by the distributor to maintain required customer service
requirements. In addition, the Company incurred one-time costs consisting of severance and
other costs to dismantle its distribution capabilities and sub-lease its distribution
warehouse. A summary of the estimated one-time benefit and cost of the agreement
recognized in the year ended December 31, 2005 (as restated) is outlined below:

56

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

| | Net Sales     | $1,685,000  | 
| | ------------- | ----------- | 
| | Cost of Sales | 1,240,000   | 
|
| | Gross Profit  | 445,000     | 
| | Expenses      | 105,000     | 
|
| | Pretax Income | $   340,000 | 

Further,
implementation of the agreement resulted in an estimated one-time positive cash flow
benefit of $2,705,000 stemming from lower receivable and inventory requirements going
forward and the one-time pretax income benefit of the sale of existing saleable finished
product inventory on hand to the distributor.

20.    Subsequent Events

Cashless Exercise of
Warrants

In
accordance with the series F warrant agreement, effective January 4, 2007, the owners
effected a cashless exercise of all issued and outstanding series F warrants comprising
1,309,441 warrants with an exercise price of $0.57 per warrant. Based on the thirty day
trailing average closing price of $0.78 per share, the warrants had a calculated value of
$0.21 each ($0.78  $0.57), or $274,983 in the aggregate, and were exchanged for
352,175 shares of common stock.

Amendment To U.S.
Revolving Credit and Security Agreement

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

License Agreement

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

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

In
consideration for the license to the Technology, the Company paid QMT a license fee in the
amount of $50,000 and agreed to make additional advance royalty payments in the amount of
$25,000 each, three months, six months and nine months after the Effective Date. The
foregoing advance royalty payments are creditable against future royalties that become due
under the Agreement.

57

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

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

21.    Quarterly Financial
Information (Unaudited)

As
discussed in Note 1, the Company restated its financial statements for certain interim
periods during 2006 and 2005. The interim periods that were restated were the second and
third quarters of 2005 and the first three quarters of 2006. The table below reflects the
effects of these restatements for these interim quarters as well as for the year ended
December 31, 2005.

58

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

`March 31, 2006                    June 30, 2006                September 30, 2006
                                               ----------------------------     ----------------------------     ----------------------------
                                               As Previously                    As Previously                    As Previously
                                                  Reported      As Restated        Reported      As Restated        Reported      As Restated
                                               ------------     -----------     -------------    -----------     -------------    -----------
                                                        (Unaudited)                      (Unaudited)                      (Unaudited)
                                                        -----------                      -----------                      -----------
Selected consolidated balance sheet data:

    Total current assets                       $  6,453,411     $  6,135,290    $  8,216,701     $  7,897,810    $  8,239,993     $  7,933,385
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total assets                               $ 10,568,598     $ 10,250,477    $ 18,453,829     $ 18,134,938    $ 18,713,261     $ 18,406,653
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total current liabilities                  $  3,027,808     $  2,941,576    $  3,266,357     $  3,174,656    $  3,406,693     $  3,304,584
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total liabilities                          $  3,444,864     $  3,358,632    $  4,873,299     $  4,781,598    $  4,236,951     $  4,134,842
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total shareholders equity                  $  7,123,734     $  6,891,845    $ 13,580,530     $ 13,353,340    $ 14,476,310     $ 14,271,811
                                                 -----------     -----------     -----------      -----------     -----------      -----------

                                                       Quarter Ended                    Quarter Ended                    Quarter Ended
                                                       March 31, 2006           .         June 30, 2006               September 30, 2006
                                               ----------------------------     ----------------------------     ----------------------------
                                               As Previously                    As Previously                    As Previously
                                                  Reported      As Restated        Reported      As Restated        Reported      As Restated
                                               ------------     -----------     -------------    -----------     -------------    -----------
                                                        (Unaudited)                      (Unaudited)                      (Unaudited)
                                                        -----------                      -----------                      -----------
Consolidated statement of
     operations data:

    Net Sales                                    $5,756,914        $5,469,244     $7,386,681        $7,124,287     $7,876,307        $7,606,851
    Cost of sales                                 3,564,913         3,564,913      4,669,119         4,669,119      4,959,232         4,959,232
                                                  ---------         ---------      ---------         ---------      ---------         ---------
    Gross profit                                  2,192,001         1,904,331      2,717,562         2,455,168      2,917,075         2,647,619

    Operating expenses                            2,121,752         1,864,330      2,254,712         1,976,941      2,389,818         2,098,057
    Interest                                         82,050            82,050        110,145           110,145        106,505           106,505
    Other (income) expense, net                     (69,521)          (69,521)        21,915            21,915         21,558            21,558
                                                  ---------         ---------      ---------         ---------      ---------         ---------

    Total expense                                 2,134,281         1,876,859      2,386,772         2,109,001      2,517,881         2,226,120

    Income before provision for                      57,720            27,472        330,790           346,167        399,194           421,499
      income taxes
    Provision for income taxes                         -                 -              -                 -            19,000            19,000
                                                  ---------         ---------      ---------         ---------      ---------         ---------

    Net income                                   $   57,720        $   27,472     $  330,790        $  346,167     $  380,194        $  402,499
                                                  =========         =========      =========         =========      =========         =========

    Income per common share - basic                   $0.00             $0.00          $0.02             $0.02          $0.02             $0.02
                                                       ====              ====           ====              ====           ====              ====
    Income per common share - diluted
                                                      $0.00             $0.00          $0.01             $0.01          $0.01             $0.01
                                                       ====              ====           ====              ====           ====              ====
    Shares used in computing income
      per common share - basic                   12,285,768        12,285,768     20,805,423        20,805,423     24,188,769        24,188,769
                                                 ==========        ==========     ==========        ==========     ==========        ==========
    Shares used in computing income
      per common share - diluted                 15,659,185        15,659,185     25,207,546        25,207,546     27,959,757        27,959,757
                                                 ==========        ==========     ==========        ==========     ==========        ==========`

59

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

`June 30, 2005               September 30, 2005               December 31, 2005
                                               ----------------------------     ----------------------------     ----------------------------
                                               As Previously                    As Previously                    As Previously
                                                  Reported      As Restated        Reported      As Restated        Reported      As Restated
                                               ------------     -----------     -------------    -----------     -------------    -----------

                                                        (Unaudited)                      (Unaudited)
                                                        -----------                      -----------
Selected consolidated balance sheet data:

    Total current assets                       $  5,959,417      $  5,801,131   $  6,488,822     $  6,307,580   $  6,409,920      $  6,112,860
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total assets                               $ 11,145,232      $ 10,986,946   $ 11,702,367     $ 11,521,125   $ 10,595,246      $ 10,298,186
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total current liabilities                  $  2,921,662      $  2,921,662   $  3,226,836     $  3,226,836   $  3,055,127      $  2,960,931
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total liabilities                          $  3,525,174      $  3,525,174   $  3,779,591     $  3,779,591   $  3,543,582      $  3,449,386
                                                 -----------     -----------     -----------      -----------     -----------      -----------
    Total shareholders equity                  $  7,620,058      $  7,461,772   $  7,922,776     $  7,741,534   $  7,051,664      $  6,848,800
                                                 -----------     -----------     -----------      -----------     -----------      -----------


                                                       Quarter Ended                    Quarter Ended                     Year Ended
                                                         June 30, 2005            .  September 30, 2005               December 31, 2005
                                               ----------------------------     ----------------------------     ----------------------------

                                               As Previously                    As Previously                    As Previously
                                                  Reported      As Restated        Reported      As Restated        Reported      As Restated
                                               ------------     -----------     -------------    -----------     -------------    -----------
                                                        (Unaudited)                      (Unaudited)
                                                        -----------                      -----------
Consolidated statement of
     operations data:

    Net Sales                                    $6,934,218        $6,704,107     $5,712,457        $5,469,230    $23,545,475       $22,799,640
    Cost of sales                                 4,693,456         4,693,456      3,750,384         3,750,384     15,756,053        15,756,053
                                                  ---------         ---------      ---------         ---------      ---------         ---------

    Gross profit                                  2,240,762         2,010,651      1,962,073         1,718,846      7,789,422         7,043,587

    Operating expenses                            1,968,312         1,893,652      1,831,780         1,602,505      7,520,986         6,966,037
    Goodwill impairment                                -                 -              -                 -           910,967           910,967
    Interest                                         95,269            95,269         75,929            75,929        336,867           336,867
    Other expense, net                               18,997            18,997         11,259            11,259        (70,294)          (70,294)
                                                  ---------         ---------      ---------         ---------      ---------         ---------

    Total expense                                 2,082,578         2,007,918      1,918,968         1,689,693      8,698,526         8,143,577

     Income (loss) before provision for             158,184             2,733         43,105            29,153       (909,104)       (1,099,990)
      income taxes
    Provision for income taxes                         -                 -              -                 -              -                 -
                                                  ---------         ---------      ---------         ---------      ---------         ---------

    Net income (loss)                            $  158,184        $    2,733     $   43,105        $   29,153    $  (909,104)      $(1,099,990)
                                                  =========         =========      =========         =========      =========         =========

    Income (loss) per common share -
      basic                                           $0.01             $0.00          $0.00             $0.00         $(0.07)           $(0.09)
                                                       ====              ====           ====              ====           ====              ====
    Income (loss) per common share -
      diluted                                         $0.01             $0.00          $0.00             $0.00
                                                       ====              ====           ====              ====
    Shares used in computing income
      (loss) per common share - basic            12,284,007        12,284,007     12,285,768        12,285,768     12,216,804        12,216,804
                                                 ==========        ==========     ==========        ==========     ==========        ==========
    Shares used in computing income
      (loss) per common share -
      diluted                                    14,745,538        14,745,538     15,804,912        15,804,912
                                                 ==========        ==========     ==========        ==========`

60

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Item 8.  Changes In and
Disagreements With Accountants on Accounting and Financial Disclosure

On
December 5, 2006, the Company dismissed J.H. Cohn LLP as the Companys independent
registered public accounting firm. The Company, also on December 5, 2006, engaged Ernst
& Young LLP as the Companys new independent registered public accounting firm.
The decision to dismiss J.H. Cohn and engage Ernst & Young was made at the direction
of the Companys board of directors upon recommendation of the boards audit
committee and was motivated by the Companys desire to avail itself of Ernst &
Youngs health care industry expertise, breadth of resources and global reach.

The
report of J.H. Cohn on the consolidated financial statements of the Company for the fiscal
years ended December 31, 2005 and 2004 did not contain an adverse opinion or a disclaimer
of opinion, nor was such report qualified or modified as to uncertainty, audit scope or
accounting principles. J.H. Cohns report dated February 24, 2006, on the
consolidated financial statements of the Company expressed an unqualified opinion.

During
the Companys fiscal years ended December 31, 2005 and 2004, and through December 5,
2006, the Company did not have any disagreement with J.H. Cohn on any matter of accounting
principles or practices, financial statement disclosure or auditing scope or procedure
which, if not resolved to the satisfaction of J.H. Cohn, would have caused it to make a
reference to the subject matter of the disagreement in connection with its report.

During
the Companys fiscal years ended December 31, 2005 and 2004 and through December 5,
2006, no reportable events as defined in Item 304(a)(1)(iv)(B) of Regulation
S-B have occurred.

J.H.
Cohn has indicated to the Company that it concurs with the foregoing statements as they
relate to J.H. Cohn and has furnished a letter to the Securities and Exchange Commission
to this effect. A copy of this letter is attached as Exhibit 16.1 to the Companys
Form 8-K filed on December 8, 2006.

During
the Companys fiscal years ended December 31, 2005 and 2004 and through December 5,
2006, neither the Company nor anyone acting on its behalf consulted with Ernst & Young
regarding any of the matters specified in Item 304(a)(2) of Regulation S-B.

Item 8A. Controls and
Procedures

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of December 31, 2006. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer have concluded that, as
a result of the material weakness set forth below, the Companys disclosure controls
and procedures were not effective as of that date for gathering, analyzing and disclosing
the information the Company is required to disclose in the reports it files under the
Securities Exchange Act of 1934 within the time periods specified in the SECs rules
and forms.

After
management concluded that there was a material weakness, management performed additional
analysis and other post-closing procedures to determine that the Companys
consolidated financial statements included in this Annual Report on Form 10-KSB were
prepared in accordance with U.S. generally accepted accounting principles and present
fairly in all material respects the Companys financial position, results of
operations and cash flows for the periods presented.

A
material weakness, as defined under standards established by the Public Company Accounting
Oversight Boards Auditing Standard No. 2, is a significant deficiency, or a
combination of significant deficiencies, that results in more than a remote likelihood
that a material misstatement of annual or interim financial statements would not be
prevented or detected. We have concluded that there is a material weakness in our
disclosure controls and procedures because the Company did not have a formal process in
place to evaluate and document all of the accounting implications that may be associated
with new and non-routine contracts, including distribution agreements. As a result of this
deficiency, the Companys consolidated financial statements for the year ended
December 31, 2005 and for each of the quarters from June 30, 2005 through September 30,
2006, were restated to revise the accounting for and classification of certain fees
payable in connection with a distribution agreement that commenced in May 2005. The
Company now believes that this matter is resolved.

61

---

Financial Index

DERMA SCIENCES, INC.
Notes To Consolidated Financial Statements

---

Management
is responsible for maintaining effective internal controls over its financial statement
closing and reporting process. In order to remediate the aforementioned material weakness,
management has taken the following actions:

|1. |  | Management has prepared and implemented a formal policy outlining the process
                    for review and approval of all material contractual obligations entered into, or
                    amended, by the Company;
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2. |  | All new material contracts or amendments thereto will be reviewed and approved
                    by the Companys Chief Financial Officer prior to execution thereof.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

Other
than as described above, during the three months ended December 31, 2006 there was no
change in the Companys internal controls over financial reporting that materially
affected, or is reasonably likely to materially affect, the Companys internal
controls over financial reporting.

Part III

Item 9.  Directors, Executive
Officers, Promoters and Control Persons; Compliance with Section 16(a) of the
       Exchange Act

Information
in response to this Item is incorporated herein by reference to our definitive proxy
statement for our 2007 annual meeting of shareholders to be filed with the Securities and
Exchange Commission not later than April 30, 2007.

Item 10. Executive
Compensation

Information
in response to this Item is incorporated herein by reference to our definitive proxy
statement for our 2007 annual meeting of shareholders to be filed with the Securities and
Exchange Commission not later than April 30, 2007.

Item 11.  Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder Matters

Information
in response to this Item is incorporated herein by reference to our definitive proxy
statement for our 2007 annual meeting of shareholders to be filed with the Securities and
Exchange Commission not later than April 30, 2007.

Item 12. Certain
Relationships and Related Transactions

Information
in response to this Item is incorporated herein by reference to our definitive proxy
statement for our 2007 annual meeting of shareholders to be filed with the Securities and
Exchange Commission not later than April 30, 2007.

Item 13. Exhibits

(a) Exhibits

|ExhibitNumber |  | Description
|------------- |  | -----------

|3.01 |  | Articles of Incorporation effective June 3, 1996 (previously filed as Exhibit B to the
Companys Proxy Statement filed on April 23, 1996 and incorporated herein by
reference).
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.02 |  | Amendment to the Articles of Incorporation effective February 10, 1998 (previously filed
as Exhibit A to the Companys Proxy Statement filed on December 22, 1997 and
incorporated herein by reference).
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

62

---

|3.03 |  | Amendment to the Articles of Incorporation effective October 20, 1998 (previously filed as
Exhibit A to the Companys Proxy Statement filed on August 14, 1998 and incorporated
herein by reference).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.04 |  | Amendment to the Articles of Incorporation effective May 26, 1999 (previously filed as
Exhibit A to the Companys Proxy Statement filed on April 13, 1999 and incorporated
herein by reference).
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.05 |  | Amendment to the Articles of Incorporation effective August 2, 1999 (previously filed as
Exhibit 3 to the Companys Form 8-K filed on August 6, 1999 and incorporated herein
by reference).
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.06 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series A Convertible Preferred Stock
(previously filed as Exhibit 10.03 to the Companys Form 8-K filed on November 24,
1997 and incorporated herein by reference).
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.07 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series B Convertible Preferred Stock
(previously filed as Exhibit 10.05 to the Companys Form 8-K filed on July 9, 1998
and incorporated herein by reference).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.08 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series C Convertible Preferred Stock
(previously filed as Exhibit 10.05 to the Companys Form 8-K filed on August 20, 1999
and incorporated herein by reference).
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.09 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series D Convertible Preferred Stock
(previously filed as Exhibit 10.05 to the Companys Form 8-K filed on January 10,
2000 and incorporated herein by reference).
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.10 |  | Bylaws effective May 14, 1997 (previously filed as Exhibit 3.1 to the Companys Form
10-QSB filed on August 15, 1997 and incorporated herein by reference).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|10.01* |  | Employment Agreement, dated March 1, 2004, between the Company and Edward J. Quilty
(previously filed as Exhibit 10.01 to the Companys Form 10-KSB filed on March 30,
2004 and incorporated herein by reference).
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.02* |  | Senior Management Stock Option Agreement, dated April 30, 1997, between the Company and
Edward J. Quilty (previously filed as Exhibit 10.05 to the Companys Form 8-K filed
on May 6, 1997 and incorporated herein by reference).
|------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.03* |  | Employment Agreement, dated March 1, 2004, between the Company and John E. Yetter, CPA
(previously filed as Exhibit 10.06 to the Companys Form 10-KSB filed on March 30,
2004 and incorporated herein by reference).
|------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.04* |  | Employment Agreement, dated March 1, 2004, between the Company and Robert C. Cole
(previously filed as Exhibit 10.11 to the Companys Form 10-KSB filed on March 30,
2004 and incorporated herein by reference).
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.05* |  | Employment Agreement, dated March 1, 2005, between the Company and Frederic Eigner
(previously filed as Exhibit 10.42 to the Companys Form 10-KSB filed on March 31,
2005 and incorporated herein by reference).
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.06* |  | Employment Agreement, dated March 1, 2006, between the Company and Barry J. Wolfenson
(previously filed as Exhibit 10.06 to the Companys Form 10-KSB filed on March 30,
2006 and incorporated herein by reference).
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.07 |  | Agreement
and Plan of Merger, dated December 27, 1999, by and among Derma Sciences, Inc. and
Genetic Laboratories Wound Care, Inc. (previously filed as Exhibit 10.01 to the Company's
Form 8-K filed on January 10, 2000 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.08 |  | Asset
Purchase Agreement and amendments thereto, dated June 28, 2002, July 12, 2002 and July
18, 2002, by and between Derma Sciences, Inc. and Dumex Medical, Inc. (previously filed
as Exhibits 2.01, 2.02 and 2.03 to the Company's Form 8-K filed on September 10, 2002 and
incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.09 |  | The Derma Sciences, Inc. Stock Option Plan, as amended February 24, 2004 (previously filed
as Appendix C to the Companys Proxy Statement filed April 5, 2004 and incorporated
herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

63

---

|10.10 |  | Purchase Agreement, dated February 28, 2002, relative to the private placement of
securities (previously filed as Exhibit 10.01 to the Companys Form 8-K filed on
March 6, 2002 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.11 |  | Registration Rights Agreement, dated February 28, 2002, relative to the private placement
of securities (previously filed as Exhibit 10.02 to the Companys Form 8-K filed on
March 6, 2002 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.12 |  | Offer of Finance dated July 23, 2002 relative to financing by the Company of the purchase
of the assets of Dumex Medical Inc. through the Laurentian Bank of Canada (previously
filed as Exhibit 10.01 to the Companys Form 8-K filed on September 10, 2002 and
incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.13 |  | Guarantee of the Company dated on or about August 26, 2002 of indebtedness of Dumex
Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as Exhibit 10.03 to
the Companys Form 8-K filed on September 10, 2002 and incorporated herein by
reference).
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.14 |  | Guarantee of the subsidiary of the Company, Sunshine Products, Inc., dated on or about
August 26, 2002 of indebtedness of Dumex Medical Canada Inc. to the Laurentian Bank of
Canada (previously filed as Exhibit 10.04 to the Companys Form 8-K filed on
September 10, 2002 and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.15 |  | Security Agreement of the Company dated on or about August 26, 2002 pledging collateral to
secure its guarantee of indebtedness of Dumex Medical Canada Inc. to the Laurentian Bank
of Canada (previously filed as Exhibit 10.05 to the Companys Form 8-K filed on
September 10, 2002 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.16 |  | Security Agreement of the subsidiary of the Company, Sunshine Products, Inc., dated on or
about August 26, 2002 pledging collateral to secure its guarantee of indebtedness of Dumex
Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as Exhibit 10.06 to
the Companys Form 8-K filed on September 10, 2002 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.17 |  | Bond Conversion Agreement, dated January 7, 2002, between the Company and Galen Partners
III, Galen Partners International III, Galen Employee Fund III (previously filed as
Exhibit 10.01 to the Companys Form 8-K filed on March 7, 2002 and incorporated
herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.18 |  | Code of ethics applicable to the Companys principal executive officer, principal
financial officer and principal accounting officer (previously filed as Exhibit 10.42 to
the Companys Form 10-KSB filed on March 31, 2003 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.19 |  | Form of Purchase Agreement relative to private placement of securities (previously filed
as Exhibit 10.01 to the Companys Form 8-K filed on June 12, 2003 and incorporated
herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.20 |  | Form of Registration Rights Agreement relative to private placement of securities
(previously filed as Exhibit 10.02 to the Companys Form 8-K filed on June 12, 2003
and incorporated herein by reference).
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.21 |  | Asset Purchase Agreement, dated August 6, 2003, between the Company and GeriCare
Providers, Inc. (previously filed as Exhibit 10.01 to the Companys Form 8-K filed on
August 29, 2003 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.22 |  | Purchase Agreement, dated January 9, 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 2.01 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.23 |  | Security Agreement dated January 9, 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 10.01 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.24 |  | Lease Agreement, dated January 9, 2003 between the Company and Kimberly-Clark Corporation
(previously filed as Exhibit 10.02 to the Companys Form 8-K filed on January 23,
2004 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.25 |  | Supply Agreement dated January , 2004 between the Company and Kimberly-Clark Corporation
(previously filed as Exhibit 10.03 to the Companys Form 8-K filed on January 23,
2004 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

64

---

|10.26 |  | Trademark License Agreement dated January , 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 10.04 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.27 |  | Trademark Assignment dated January, 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 10.05 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.28 |  | Amendment to Purchase Agreement, dated as of January 9, 2004 between the Company and
Kimberly-Clark Corporation (previously filed as Exhibit 2.01 to the Companys Form
8-K/A-2 filed on February 6, 2004 and incorporated herein by reference).
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.29 |  | Form of Purchase Agreement relative to private placement of common stock (previously filed
as Exhibit 10.01 to the Companys Form 8-K filed on March 8, 2004 and incorporated
herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.30 |  | Form of Registration Rights Agreement relative to private placement of common stock
(previously filed as Exhibit 10.02 to the Companys Form 8-K filed on March 8, 2004
and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.31 |  | Form of Purchase Agreement relative to private placement of common stock and series G
warrants (previously filed as Exhibit 10.40 to the Companys Form 10-KSB filed on
March 31, 2005 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.32 |  | Form of Registration Rights Agreement relative to private placement of common stock and
series G warrants (previously filed as Exhibit 10.41 to the Companys Form 10-KSB
filed on March 31, 2005 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.33 |  | Amendment No. 2 to Revolving Credit and Security Agreement, dated April 18, 2006, between
the Company and CapitalSource Finance, LLC (previously filed as Exhibit 10.01 to the
Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.34 |  | Amendment
No. 3 to Revolving Credit and Security Agreement, dated March 12, 2007, between the
Company and CapitalSource Finance, LLC.
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------

|10.35 |  | Private Placement Memorandum with Amendments relative to the private placement of
securities effected on April 18, 2006 (previously filed as Exhibit 10.01 to the
Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.36 |  | Form of Purchase Agreement relative to the private placement of securities effected on
April 18, 2006 (previously filed as Exhibit 10.02 to the Companys Form 8-K filed on
April 24, 2006 and incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.37 |  | Form of Registration Rights Agreement relative to the private placement of securities
effected on April 18, 2006 (previously filed as Exhibit 10.03 to the Companys Form
8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.38 |  | Warrant Agreement between the Company and StockTrans, Inc. relative to the private
placement of securities effected on April 18, 2006 (previously filed as Exhibit 10.04 to
the Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.39 |  | Placement Agreement between the Company and Taglich Brothers, Inc. relative to the private
placement of securities effected on April 18, 2006 (previously filed as Exhibit 10.05 to
the Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.40 |  | Asset Purchase Agreement, dated January 26, 2006, relative to the Companys purchase
on April 18, 2006 of the assets of Western Medical, Inc. (previously filed as Exhibit
10.01 to the Companys Form 8-K filed on April 24, 2006 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.41 |  | Purchase Agreement, dated August 3, 2006, between the Company and Comvita New Zealand
Limited relative to the private sale of securities (previously filed as Exhibit 10.01 to
the Companys Form 8-K filed on August 7, 2006 and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.42 |  | Registration Rights Agreement, dated August 3, 2006, between the Company and Comvita New
Zealand Limited relative to the private sale of securities (previously filed as Exhibit
10.03 to the Companys Form 8-K filed on August 7, 2006 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

65

---

|16.1 |  | Letter from previous certifying accountants concurring with the Companys statements
relative to this firm in the Companys report concerning its change of certifying
accountants (previously filed as Exhibit 16.1 to the Companys Form 8-K filed
December 8, 2006 and incorporated herein by reference).
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|21 |  | Information
relative to subsidiaries.
|-- |  | -------------------------------------

|23.1 |  | Consent
of Ernst & Young LLP.
|---- |  | -----------------------------

|23.2 |  | Consent
of J.H. Cohn LLP.
|---- |  | -------------------------

|31.1 |  | Certification
of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley act of
2002.
|---- |  | -----------------------------------------------------------------------------------------------------------

|31.2 |  | Certification
of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley act of
2002.
|---- |  | -----------------------------------------------------------------------------------------------------------

|32.1 |  | Certification
of the Principal Executive Officer pursuant to U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|32.2 |  | Certification
of the Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

_________________

* Management contract or compensatory
plan.

 Filed with this report

Item 14. Principal
Accountant Fees and Services

Information
in response to this Item is incorporated herein by reference to our definitive proxy
statement for our 2007 annual meeting of shareholders to be filed with the Securities and
Exchange Commission not later than April 30, 2007.

66

---

SIGNATURES

In
accordance with 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.

|               | DERMA SCIENCES, INC.                                
|-------------- | ----------------------------------------------------
|               |                                                     
|               |                                                     
|March 30, 2007 | By: /s/ Edward J. Quilty                            
|               | Edward J.
     Quilty                               
|               | Chairman,
     President and Chief Executive Officer

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 March 30, 2007.

| | Signatures: |  |  | Title: | 
| | ----------- |  |  | ------ | 

|/s/ Edward J. Quilty       | President, Chief Executive Officer and Chairman of the Board
|-------------------------- | ------------------------------------------------------------
|Edward J. Quilty           | of Directors (Principal Executive
     Officer)             
|                           |                                                             
|/s/ John E. Yetter         | Vice President and Chief Financial Officer                  
|John E. Yetter, CPA        | (Principal Financial and Accounting
     Officer)           
|                           |                                                             
|/s/ Srini Conjeevaram      | Director                                                    
|Srini Conjeevaram          |                                                             
|                           |                                                             
|/s/ Stephen T. Wills       | Director                                                    
|Stephen T. Wills, CPA, MST |                                                             
|                           |                                                             
|/s/ James T. O'Brien       | Director                                                    
|James T. O'Brien           |                                                             
|                           |                                                             
|/s/ C. Richard Stafford    | Director                                                    
|C. Richard Stafford, Esq.  |                                                             
|                           |                                                             
|/s/ Richard J. Keim        | Director                                                    
|Richard J. Keim            |                                                             
|                           |                                                             
|/s/ Robert G. Moussa       | Director                                                    
|Robert G. Moussa           |                                                             

67

---

EXHIBIT INDEX

|ExhibitNumber |  | Description
|------------- |  | -----------

|3.01 |  | Articles of Incorporation effective June 3, 1996 (previously filed as Exhibit B to the
Companys Proxy Statement filed on April 23, 1996 and incorporated herein by
reference).
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.02 |  | Amendment to the Articles of Incorporation effective February 10, 1998 (previously filed
as Exhibit A to the Companys Proxy Statement filed on December 22, 1997 and
incorporated herein by reference).
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.03 |  | Amendment to the Articles of Incorporation effective October 20, 1998 (previously filed as
Exhibit A to the Companys Proxy Statement filed on August 14, 1998 and incorporated
herein by reference).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.04 |  | Amendment to the Articles of Incorporation effective May 26, 1999 (previously filed as
Exhibit A to the Companys Proxy Statement filed on April 13, 1999 and incorporated
herein by reference).
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.05 |  | Amendment to the Articles of Incorporation effective August 2, 1999 (previously filed as
Exhibit 3 to the Companys Form 8-K filed on August 6, 1999 and incorporated herein
by reference).
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.06 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series A Convertible Preferred Stock
(previously filed as Exhibit 10.03 to the Companys Form 8-K filed on November 24,
1997 and incorporated herein by reference).
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.07 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series B Convertible Preferred Stock
(previously filed as Exhibit 10.05 to the Companys Form 8-K filed on July 9, 1998
and incorporated herein by reference).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.08 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series C Convertible Preferred Stock
(previously filed as Exhibit 10.05 to the Companys Form 8-K filed on August 20, 1999
and incorporated herein by reference).
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.09 |  | Certificate of Designations, Voting Powers, Preferences and Rights of the Series of
Preferred Stock of Derma Sciences, Inc. Designated Series D Convertible Preferred Stock
(previously filed as Exhibit 10.05 to the Companys Form 8-K filed on January 10,
2000 and incorporated herein by reference).
|---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3.10 |  | Bylaws effective May 14, 1997 (previously filed as Exhibit 3.1 to the Companys Form
10-QSB filed on August 15, 1997 and incorporated herein by reference).
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|10.01* |  | Employment Agreement, dated March 1, 2004, between the Company and Edward J. Quilty
(previously filed as Exhibit 10.01 to the Companys Form 10-KSB filed on March 30,
2004 and incorporated herein by reference).
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.02* |  | Senior Management Stock Option Agreement, dated April 30, 1997, between the Company and
Edward J. Quilty (previously filed as Exhibit 10.05 to the Companys Form 8-K filed
on May 6, 1997 and incorporated herein by reference).
|------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.03* |  | Employment Agreement, dated March 1, 2004, between the Company and John E. Yetter, CPA
(previously filed as Exhibit 10.06 to the Companys Form 10-KSB filed on March 30,
2004 and incorporated herein by reference).
|------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.04* |  | Employment Agreement, dated March 1, 2004, between the Company and Robert C. Cole
(previously filed as Exhibit 10.11 to the Companys Form 10-KSB filed on March 30,
2004 and incorporated herein by reference).
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.05* |  | Employment Agreement, dated March 1, 2005, between the Company and Frederic Eigner
(previously filed as Exhibit 10.42 to the Companys Form 10-KSB filed on March 31,
2005 and incorporated herein by reference).
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.06* |  | Employment Agreement, dated March 1, 2006, between the Company and Barry J. Wolfenson
(previously filed as Exhibit 10.06 to the Companys Form 10-KSB filed on March 30,
2006 and incorporated herein by reference).
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.07 |  | Agreement
and Plan of Merger, dated December 27, 1999, by and among Derma Sciences, Inc. and
Genetic Laboratories Wound Care, Inc. (previously filed as Exhibit 10.01 to the Company's
Form 8-K filed on January 10, 2000 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.08 |  | Asset
Purchase Agreement and amendments thereto, dated June 28, 2002, July 12, 2002 and July
18, 2002, by and between Derma Sciences, Inc. and Dumex Medical, Inc. (previously filed
as Exhibits 2.01, 2.02 and 2.03 to the Company's Form 8-K filed on September 10, 2002 and
incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.09 |  | The Derma Sciences, Inc. Stock Option Plan, as amended February 24, 2004 (previously filed
as Appendix C to the Companys Proxy Statement filed April 5, 2004 and incorporated
herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.10 |  | Purchase Agreement, dated February 28, 2002, relative to the private placement of
securities (previously filed as Exhibit 10.01 to the Companys Form 8-K filed on
March 6, 2002 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.11 |  | Registration Rights Agreement, dated February 28, 2002, relative to the private placement
of securities (previously filed as Exhibit 10.02 to the Companys Form 8-K filed on
March 6, 2002 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.12 |  | Offer of Finance dated July 23, 2002 relative to financing by the Company of the purchase
of the assets of Dumex Medical Inc. through the Laurentian Bank of Canada (previously
filed as Exhibit 10.01 to the Companys Form 8-K filed on September 10, 2002 and
incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.13 |  | Guarantee of the Company dated on or about August 26, 2002 of indebtedness of Dumex
Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as Exhibit 10.03 to
the Companys Form 8-K filed on September 10, 2002 and incorporated herein by
reference).
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.14 |  | Guarantee of the subsidiary of the Company, Sunshine Products, Inc., dated on or about
August 26, 2002 of indebtedness of Dumex Medical Canada Inc. to the Laurentian Bank of
Canada (previously filed as Exhibit 10.04 to the Companys Form 8-K filed on
September 10, 2002 and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.15 |  | Security Agreement of the Company dated on or about August 26, 2002 pledging collateral to
secure its guarantee of indebtedness of Dumex Medical Canada Inc. to the Laurentian Bank
of Canada (previously filed as Exhibit 10.05 to the Companys Form 8-K filed on
September 10, 2002 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.16 |  | Security Agreement of the subsidiary of the Company, Sunshine Products, Inc., dated on or
about August 26, 2002 pledging collateral to secure its guarantee of indebtedness of Dumex
Medical Canada Inc. to the Laurentian Bank of Canada (previously filed as Exhibit 10.06 to
the Companys Form 8-K filed on September 10, 2002 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.17 |  | Bond Conversion Agreement, dated January 7, 2002, between the Company and Galen Partners
III, Galen Partners International III, Galen Employee Fund III (previously filed as
Exhibit 10.01 to the Companys Form 8-K filed on March 7, 2002 and incorporated
herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.18 |  | Code of ethics applicable to the Companys principal executive officer, principal
financial officer and principal accounting officer (previously filed as Exhibit 10.42 to
the Companys Form 10-KSB filed on March 31, 2003 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.19 |  | Form of Purchase Agreement relative to private placement of securities (previously filed
as Exhibit 10.01 to the Companys Form 8-K filed on June 12, 2003 and incorporated
herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.20 |  | Form of Registration Rights Agreement relative to private placement of securities
(previously filed as Exhibit 10.02 to the Companys Form 8-K filed on June 12, 2003
and incorporated herein by reference).
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.21 |  | Asset Purchase Agreement, dated August 6, 2003, between the Company and GeriCare
Providers, Inc. (previously filed as Exhibit 10.01 to the Companys Form 8-K filed on
August 29, 2003 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.22 |  | Purchase Agreement, dated January 9, 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 2.01 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.23 |  | Security Agreement dated January 9, 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 10.01 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.24 |  | Lease Agreement, dated January 9, 2003 between the Company and Kimberly-Clark Corporation
(previously filed as Exhibit 10.02 to the Companys Form 8-K filed on January 23,
2004 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.25 |  | Supply Agreement dated January , 2004 between the Company and Kimberly-Clark Corporation
(previously filed as Exhibit 10.03 to the Companys Form 8-K filed on January 23,
2004 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.26 |  | Trademark License Agreement dated January , 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 10.04 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.27 |  | Trademark Assignment dated January, 2004 between the Company and Kimberly-Clark
Corporation (previously filed as Exhibit 10.05 to the Companys Form 8-K filed on
January 23, 2004 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.28 |  | Amendment to Purchase Agreement, dated as of January 9, 2004 between the Company and
Kimberly-Clark Corporation (previously filed as Exhibit 2.01 to the Companys Form
8-K/A-2 filed on February 6, 2004 and incorporated herein by reference).
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.29 |  | Form of Purchase Agreement relative to private placement of common stock (previously filed
as Exhibit 10.01 to the Companys Form 8-K filed on March 8, 2004 and incorporated
herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.30 |  | Form of Registration Rights Agreement relative to private placement of common stock
(previously filed as Exhibit 10.02 to the Companys Form 8-K filed on March 8, 2004
and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.31 |  | Form of Purchase Agreement relative to private placement of common stock and series G
warrants (previously filed as Exhibit 10.40 to the Companys Form 10-KSB filed on
March 31, 2005 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.32 |  | Form of Registration Rights Agreement relative to private placement of common stock and
series G warrants (previously filed as Exhibit 10.41 to the Companys Form 10-KSB
filed on March 31, 2005 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.33 |  | Amendment No. 2 to Revolving Credit and Security Agreement, dated April 18, 2006, between
the Company and CapitalSource Finance, LLC (previously filed as Exhibit 10.01 to the
Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.34 |  | Amendment
No. 3 to Revolving Credit and Security Agreement, dated March 12, 2007, between the
Company and CapitalSource Finance, LLC.
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------

|10.35 |  | Private Placement Memorandum with Amendments relative to the private placement of
securities effected on April 18, 2006 (previously filed as Exhibit 10.01 to the
Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.36 |  | Form of Purchase Agreement relative to the private placement of securities effected on
April 18, 2006 (previously filed as Exhibit 10.02 to the Companys Form 8-K filed on
April 24, 2006 and incorporated herein by reference).
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.37 |  | Form of Registration Rights Agreement relative to the private placement of securities
effected on April 18, 2006 (previously filed as Exhibit 10.03 to the Companys Form
8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.38 |  | Warrant Agreement between the Company and StockTrans, Inc. relative to the private
placement of securities effected on April 18, 2006 (previously filed as Exhibit 10.04 to
the Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.39 |  | Placement Agreement between the Company and Taglich Brothers, Inc. relative to the private
placement of securities effected on April 18, 2006 (previously filed as Exhibit 10.05 to
the Companys Form 8-K filed on April 24, 2006 and incorporated herein by reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.40 |  | Asset Purchase Agreement, dated January 26, 2006, relative to the Companys purchase
on April 18, 2006 of the assets of Western Medical, Inc. (previously filed as Exhibit
10.01 to the Companys Form 8-K filed on April 24, 2006 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.41 |  | Purchase Agreement, dated August 3, 2006, between the Company and Comvita New Zealand
Limited relative to the private sale of securities (previously filed as Exhibit 10.01 to
the Companys Form 8-K filed on August 7, 2006 and incorporated herein by reference).
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|10.42 |  | Registration Rights Agreement, dated August 3, 2006, between the Company and Comvita New
Zealand Limited relative to the private sale of securities (previously filed as Exhibit
10.03 to the Companys Form 8-K filed on August 7, 2006 and incorporated herein by
reference).
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|16.1 |  | Letter from previous certifying accountants concurring with the Companys statements
relative to this firm in the Companys report concerning its change of certifying
accountants (previously filed as Exhibit 16.1 to the Companys Form 8-K filed
December 8, 2006 and incorporated herein by reference).
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|21 |  | Information
relative to subsidiaries.
|-- |  | -------------------------------------

|23.1 |  | Consent
of Ernst & Young LLP.
|---- |  | -----------------------------

|23.2 |  | Consent
of J.H. Cohn LLP.
|---- |  | -------------------------

|31.1 |  | Certification
of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley act of
2002.
|---- |  | -----------------------------------------------------------------------------------------------------------

|31.2 |  | Certification
of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley act of
2002.
|---- |  | -----------------------------------------------------------------------------------------------------------

|32.1 |  | Certification
of the Principal Executive Officer pursuant to U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|32.2 |  | Certification
of the Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

_________________

* Management contract or compensatory
plan.

 Filed with this report