<PAGE>   1


                                  FORM 10-KSB

                    U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934

    For the Fiscal year ended      August 31, 1998
                              -------------------------------------------------

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934

    For the transition period from                    to
                                   ------------------    ----------------------

    Commission file number              0-20554
                          -----------------------------------------------------

                           DYNACQ INTERNATIONAL, INC.
-------------------------------------------------------------------------------
                 (Name of Small Business Issuer in its charter)

            NEVADA                                     76-0375477
-------------------------------          --------------------------------------
(State or other jurisdiction of          (I.R.S. Employer Identification No.)
 incorporation of organization)

  10304 INTERSTATE 10 EAST, SUITE 369
            HOUSTON, TEXAS                                    77029
-----------------------------------------         -----------------------------
(Address of principal executive offices)                    (Zip Code)

Issuer's telephone number, including area code          (713) 673-6432
                                               --------------------------------
          Securities registered pursuant to Section 12(b) of the Act:

      Title of each class             Name of each exchange on which registered

           None                                        None
--------------------------            -----------------------------------------

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

                         Common Stock - $.001 Par Value
                   -----------------------------------------
                                (Title of Class)

         Check whether the issuer (1) has filed all reports required to be
filed by Section 13 or 15 (d) of the Exchange Act during the past 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days. 
Yes   X   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 such 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.
                                            ---
         The issuer's gross revenues for the most recent fiscal year:
$10,980,369

         As of December 10, 1998, there were 3,281,845 shares of the
registrant's common stock, $.001 par value, issued and outstanding, 1,010,626
of which having an aggregate market value of approximately $2,463,401 (based on
the last trade price of $2.44 as of December 10, 1998) were held by
non-affiliates of the registrant. In determining the number of shares held by
non-affiliates, shares held by officers, directors and the Company's majority
shareholder were excluded.

                      DOCUMENTS INCORPORATED BY REFERENCE

                                      None
                         ------------------------------

        Transitional Small Business Disclosure Format. Yes        No  X
                                                           ---       ---



<PAGE>   2


                                  FORM 10-KSB

                           DYNACQ INTERNATIONAL, INC.

                               TABLE OF CONTENTS
<TABLE>
<CAPTION>

<S>                        <C>                                                                                            <C>
PART I....................................................................................................................1
         ITEM 1.           DESCRIPTION OF BUSINESS........................................................................1
         ITEM 2.           DESCRIPTION OF PROPERTY........................................................................7
         ITEM 3.           LEGAL PROCEEDINGS..............................................................................8
         ITEM 4.           SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................8
PART II...................................................................................................................8
         ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................8
         ITEM 6.           MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION......................................9
         ITEM 7.           FINANCIAL STATEMENTS..........................................................................13
         ITEM 8.           CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
                           ON ACCOUNTING AND FINANCIAL DISCLOSURE........................................................13
PART III.................................................................................................................13
         ITEM 9.           DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
                           COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.............................................13
         ITEM 10.          EXECUTIVE COMPENSATION........................................................................14
         ITEM 11.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
                           AND MANAGEMENT................................................................................15
         ITEM 12.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................................15
         ITEM 13.          EXHIBITS AND REPORTS ON FORM 8-K..............................................................16
</TABLE>



<PAGE>   3


                                     PART I


ITEM 1.       DESCRIPTION OF BUSINESS

GENERAL

         Dynacq International, Inc., a Nevada corporation incorporated on June
16, 1989 (the "Company"), is engaged in the business of providing home infusion
health care services and supplies to patients in their homes, the operation of
an outpatient surgical facility, the operation of a medical office complex, and
the management of physician practices, all located in the Houston metropolitan
area. In addition, in May 1998, the Company organized Vista Community Medical
Center, L.L.C., a Texas limited liability company ("Vista Medical") for the
purpose of operating a General Acute Care Hospital now under construction and
located adjacent to the "Vista Facility" (defined below), which is expected to
be complete in February 1999 (the "Hospital"). Unless otherwise indicated, all
references to the Company herein include its subsidiaries. See Note 1.B. of
Notes to Consolidated Financial Statements.

         In July, 1992, the Company's current management acquired a controlling
interest in the common stock, $.001 par value of the Company (the "Common
Stock"), in a private placement and prior management resigned. Effective August
1, 1992, the Company commenced operations as a provider of health care services
and supplies to patients in their homes specializing in home infusion therapy.
Home infusion therapy is the administration to a patient of nutrients,
antibiotics or other medications whether intravenously or through a feeding
tube, usually as a continuation of treatment initiated in a hospital. The
Company's home infusion services include training patients and their care
givers, compounding prescriptions and conducting other pharmacy operations,
delivering supplies, providing certain nursing services, monitoring patient
compliance with the prescribed plan of care, monitoring patient outcome,
maintaining patient records, consulting with attending physicians, maintaining
equipment and processing reimbursement claims. While historically the Company's
core business has been home infusion therapy, the Company has taken several
steps during the past three fiscal years to diversify its operations and use of
assets, including (i) the acquisition of Vista Healthcare, Inc., a Texas
corporation ("Vista") described below in August 1994 which owns a 15,000 square
foot outpatient surgical facility located in Pasadena, Texas, (ii) the
formation of Doctors Practice Management, Inc., a Texas corporation ("DPMI") to
manage physician practices, (iii) the ownership and operation of a professional
building, and (iv) the ownership and operation of the Hospital currently under
construction.

         Effective March 8, 1993, the Company's shareholders approved a reverse
split of the outstanding shares of the Company's Common Stock on the basis of
one share for every eight shares outstanding, with the par value of each share
remaining at $.001. The reverse split was recommended by the Board of Directors
because of its belief that the pre-split per share price level adversely
affected the marketability of the Company's Common Stock and that an increase
in the per share price was important to qualify for a listing on the National
Association of Securities Dealers, Inc. Automated Quotation System (NASDAQ). In
September 1993, the Company's Common Stock received its listing and began
trading on the NASDAQ Small Cap System under the symbol DYII. In February 1998,
the Company amended its Articles of Incorporation to effectuate a four (4) to
one (1) reverse stock split in order to increase the price of its Common Stock
to, among other things, maintain the listing of the Common Stock on the NASDAQ
Small Cap System and to attempt to enhance the acceptability and marketability
of the Common Stock.

         On August 25, 1994, the Company completed the acquisition of
approximately 65% of the outstanding common stock of Vista in exchange for
approximately 5% of its Common Stock issued to 30 shareholders of Vista in
exchange for their shares of Vista common stock pursuant to an Exchange
Agreement dated July 15, 1994. Vista operates a 15,000 square foot medical
clinic and outpatient surgical center in Pasadena, Texas (the "Vista
Facility"). Vista provides a variety of surgeries, medical treatments and
laboratory services on an outpatient basis. Under the Company's control, Vista
continues to utilize its facilities and equipment in the same manner, however,
the Company expanded the services offered and purchased new equipment. Revenues
from the Vista Facility substantially increased in fiscal 1998 and it became
the Company's largest revenue producer, exceeding the combined revenues from
the Company's home infusion therapy business and revenues from the Company's
management of physician practices described below.

         In September, 1994, the Company commenced construction of a 35,900
square foot medical office building adjacent to the Vista Facility which was
completed in 1995 at a total cost of approximately $1,925,000 (the "Office
Building"). Several of the offices in the Office Building are currently
utilized by physicians with whom the Company has management contracts through
its wholly-owned subsidiary DPMI. Offices are also leased to other physician
practices that are not subject to

                                       1

<PAGE>   4


management agreements with DPMI. In March, 1994, the Company formed DPMI for
the purpose of providing (i) fee based management services to physicians'
groups, and (ii) assistance in consolidating medical providers into integrated
delivery systems. These systems are intended to build a concentrated critical
mass of primary care physicians, specialty physicians, clinics and outpatient
surgical centers. DPMI plans to offer participating medical providers health
care management agreements and management systems that include standards to
better manage costs, shared administrative and clinical services and individual
or shared office facilities.

         DPMI began managing Vista in January 1996. It currently has agreements
to manage three (3) physician practices and it has a Management Agreement to
manage the Vista Facility.

THE HOME INFUSION HEALTH CARE MARKET

         The Company's home infusion health care business principally involves
the administration of physician-prescribed nutrients, antibiotics or other
medications to patients in their homes, usually as a continuation of a
treatment program initiated in a hospital. The market for home infusion health
care has grown rapidly since its initial development in the late 1970's.
Management believes that the growth of this market is primarily attributable to
(i) increased cost containment efforts that have encouraged home health care,
(ii) medical advances that enable doctors to treat more illnesses through home
health care, and (iii) the desire of hospitalized patients to be treated in
their homes. The growth of the industry is also the result of improved delivery
technology that permits the treatment of more diseases at home and the growing
awareness and acceptance among physicians and third-party payers of home health
care as an alternative to hospital treatment.

         Home health care is favorable for insurance companies because it is
much cheaper to pay for similar patient services performed by home health care
companies than by hospitals. The trend for insurance companies to pressure
hospitals and physicians to release patients to their homes to recover at the
earliest possible time to save cost is substantial. This enhances favorable
market growth for the home health care industry. The Company selects only
referral patients with proper adequate private insurance, with confirmation
from the insurance company of ability to pay, to ensure both profitability and
collectability of performed services and concentrates on two patient service
areas, Parenteral Nutrition Therapy and Antibiotic Therapy. Home health care is
not a capital intensive business and does not require high inventory levels. It
is a skilled labor intensive business that provides professional medical
services to patients with personal care.

PARENTERAL NUTRITION THERAPY. Parenteral nutrition therapy is prescribed for
individuals unable to eat or digest food due to a failure of their
gastrointestinal tracts. Parenteral nutrition is typically administered through
central vein catheters that are surgically implanted during hospitalization.
The Company formulates, compounds and dispenses solutions pursuant to a
physician's order. Solutions used in this therapy typically contain amino acids
(protein), dextrose (carbohydrate), lipids (fat), electrolytes, vitamins and
trace minerals. Some patients requiring this type of therapy periodically
require routine rehospitalization throughout their treatment. Some patients
may require therapy for the remainder of their life.

ANTIBIOTIC THERAPY. Antibiotic and anti-infection therapies are used to treat a
variety of infections, including osteomyelitis (bone infections), bacterial
endocarditis (heart valve infections), septicemia (blood infections), wound
infections, bone and joint infections and infections associated with cystic
fibrosis and diabetes. By intravenously administering antibiotics into the
bloodstream (as opposed to ingesting them orally), the effectiveness of the
medication is generally increased. Antibiotic therapy is also a significant
therapy for treating individuals suffering from Acquired Immune Deficiency
Syndrome ("AIDS"). Because of the gradual destruction of the immune system by
the AIDS virus, orally administered drugs typically become less effective
against opportunistic infections, and consequently antibiotics must be
introduced intravenously.

         The decision to proceed with home infusion therapy is made jointly by
the patient, the attending physician and the Company. This decision involves
obtaining and evaluating information about the patient's medical history, home
environment and insurance, as well as discussing the patient's willingness and
ability to participate in the self-administration of home health care. After a
patient is referred to the Company, a pharmacist takes the prescription order
from the attending physician and Company personnel coordinate the delivery of
patient care tailored to the individual's specific needs.

         Throughout the course of treatment, a company licensed pharmacist
compounds or supervises the preparation of all prescribed drugs, solutions and
related supplies and answers questions concerning the prescribed therapy and
the Company's services. In certain cases where the patient is incapable of
self-administering the therapy, a nurse is also present at each administration
of the therapy. Company nurses visit patients periodically to review training,
catheter placement and compliance with the patient care plan. The Company's
personnel are available to respond to patient needs 24 hours a day, seven days
a week.

                                       2

<PAGE>   5


PHYSICIANS' PRACTICE MANAGEMENT

         During fiscal 1998, DPMI had agreements to manage the medical
practices of three physician practices and the Vista Facility. Each physician
practice management agreement is called a "Full Service Facility and Management
Agreement" (the "Management Agreement") . The Management Agreements generally
require DPMI, at its expense, to: (i) act as the sole and exclusive agent of
the physician or physician group for the management and administration of
business functions and services related to the physicians' medical practice;
(ii) undertake marketing, billing, record keeping, collection, clerical
staffing and support services; (iii) provide physical office space, facilities
and equipment necessary for the physician's practice, including the repair and
maintenance thereof and all utilities and supplies related thereto including
licenses and permits; (iv) undertake the hiring, firing, selection, training
and supervision of all non-medical personnel; (v) prepare and maintain
accounting and financial records and patient files; and (vi) undertake other
management and administrative functions related to the foregoing. In
consideration of its services, DPMI receives a management fee ranging from 35%
to 65% of revenues generated by the physicians. DPMI attempts to negotiate
long-term (5 years or longer) noncancellable Management Agreements due to its
large initial costs in setting up and equipping fully staffed and functional
facilities for physicians. The Management Agreements may be terminated by the
non-defaulting party in the event of a breach by the defaulting party. DPMI and
the physicians each agree to indemnify the other for claims which may arise in
connection with the performance of their respective obligations. Pursuant to
the Management Agreements, DPMI is entitled to a fixed percentage of
collections from the physicians' practice and is obligated to pay certain fixed
categories of expenses which obligation is not limited in amount. To the extent
DPMI's share of collections is not sufficient to cover its expense obligations
under the Management Agreements, DPMI is obligated to pay the excess expenses
and is subject to losses under the Management Agreements.

OUTPATIENT SURGICAL FACILITY, OFFICE BUILDING AND HOSPITAL

         The Company's Vista Facility, consisting of approximately 15,000
square feet, provides outpatient surgical facilities, x-ray diagnostic services
and full service laboratory testing to physicians and their patients. The Vista
Facility, Office Building and Hospital are located adjacent to each other.
Effective October 1, 1998, DPMI entered into a one (1) year Management
Agreement renewable for two (2) additional years for the Vista Facility which
entitles DPMI to 60% of the revenues generated by the facility in exchange for
comprehensive management services provided by DPMI. The Management Agreement
for the Vista Facility is similar in scope to the ones entered into by DPMI to
manage physician practices. The Office Building, consisting of approximately
35,900 square feet, is utilized by DPMI for the location of physician practices
under Management Agreements and for leasing space to physician practices which
are not under management with DPMI. The Hospital is currently under
construction and it is expected to be completed in February 1999. It will have
42 beds and consist of approximately 30,000 square feet. See "Item 2.
Description of Property."

BUSINESS GROWTH STRATEGY

         Beginning in late fiscal 1994 and during fiscal 1995, the Company
commenced implementation of a new business strategy of diversifying from an
almost exclusively home infusion service provider into an integrated
medical/health services Company. The foundation of this strategy was the
acquisition of a majority interest in Vista in August 1994 and the completion
of the Office Building adjacent to the Vista Facility in April 1995. The
Company also formed DPMI to provide management services to medical practices.
DPMI provides office space and fee-based management services to client
physicians located in the Office Building and in other locations. Vista
provides outpatient surgical facilities, x-ray diagnostic services and full
service laboratory testing to physicians and their patients in the Vista
Facility. In fiscal 1998, the Company decided to build a 42-bed hospital
adjacent to its Vista Facility (the outpatient surgical center) and its Office
Building which is expected to be completed in February 1999. With the addition
of the Hospital, the Company will broaden the range of medical services it can
provide including major surgical cases which require hospitalization.

         The Company intends to grow as a provider of health care services by
(i) expanding the business of its existing operations locally, (ii) acquiring
established health care providers, and (iii) opening new branch facilities in
selected local markets. The Company will periodically evaluate possible
acquisitions and suitable locations for new facilities. The Company does not
presently have any agreements, arrangements or understandings regarding any
acquisitions or the opening of additional facilities. The Company leased and
opened an additional facility in fiscal 1997 pursuant to a Management Agreement
for a medical practice. See "Item 2. Description of Property." The Company's
growth strategy is dependent in a large part on the ability of the Company to
attract and retain key management, marketing and operating personnel at the
local facility level. Such persons are in high demand and are often subject to
competing offers from other health care service companies and related
businesses.

                                       3

<PAGE>   6


         The Company's target markets are areas with major industrial companies
and middle class blue-collar workers, generally with strong union ties and with
superior insurance coverage. This population group has proven to be very open
to the type of health care center concept offered by the Company. The Company's
operations are in Pasadena, Texas, a petrochemical industry hub which provides
a stable patient base of insured patients. The Company anticipates growth
within a targeted area by purchasing or constructing an outpatient surgical
center and, if it is successful, adding a professional building onto a hospital
at the same location or nearby. It is anticipated that each hub area will
consist of a central core of outpatient surgical, diagnostic and laboratory
centers, infusion therapy facilities and specialized practices serving outlying
clusters of general practitioners. Subsequent alliances of physicians,
specialists and clinics are feasible in other areas around Houston, such as
Clear Lake, La Porte, Baytown, Deer Park, and other industrial/petrochemical
centers.

COMPETITION

         The Company is one of many in the greater Houston metropolitan area
that provide medical practice management, outpatient surgical facilities,
professional buildings, hospitals or home infusion therapy. Several major
hospital organizations with greater financial resources are planning to or have
entered the Pasadena area (the Company's principal market) which will directly
compete with the Company's operations. Such competition could be particularly
acute with respect to the Company's outpatient surgical facility and the
Hospital and have an adverse effect on the ability of the Company to attract
and retain physician practices in the Office Building.

         The home infusion health care therapy market is highly competitive and
management anticipates that competition, particularly for patient referrals,
will intensify in all metropolitan areas. The industry has been subject to
market consolidation in recent years and the Company believes that this trend
will continue. The Company currently competes with other home infusion therapy
companies, hospitals, physician groups and other health care organizations,
many of which operate on a regional or national basis and are larger and have
significantly greater resources than the Company. In the past two years, the
Company has experienced substantial pressure from insurance companies with
respect to the need for and the cost of home infusion therapy treatments. This
pressure has resulted in a declining patient base and reimbursable charges per
patient resulting in substantially lower revenues to the Company from home
infusion operations.

         Presently, the Company operates only in the greater Houston
metropolitan area. However, the Company would expand its operations into other
markets through acquisitions if suitable acquisition candidates are identified
and the acquisition terms are acceptable to the Company.

         With respect to the Company's health care operations, the primary
competitive factors are (i) quality of care, including responsiveness of
service and quality of professional personnel, (ii) the ability to establish
and maintain relationships with referring physicians, hospitals, health
maintenance organizations, clinics and nursing agencies, (iii) price, (iv)
breadth of services offered, and (v) general reputation with physicians, other
referral sources and potential patients. Management believes that the Company
competes successfully in all of these areas.

MARKETING AND SALES

         With respect to the Company's home infusion business and its
outpatient surgical facility, the Company relies primarily on patient referrals
from physicians, including those officing in the Office Building. With respect
to home infusion therapy, these referral sources tend to be concentrated among
a limited number of physician specialists, allowing the Company to conduct a
directed selling effort. Primarily due to escalating pressures to contain
health care costs, insurance companies and other third-party payers are
participating to a greater extent in decisions regarding health care
alternatives. Consequently, management believes that such third-party payers
will be increasingly important in marketing the Company's services in the
future. Management will engage in traditional advertising in connection with
the opening of the Hospital, including newspaper, radio and billboard
advertising.

HEALTH CARE REGULATION

         The federal government and the state of Texas regulate various aspects
of the Company's business. The Company's Vista Facility is licensed as a
pharmacy and is subject to federal and state laws and regulations governing
pharmacies. Federal laws require, among other things, that the Company's
facilities comply with rules relating to controlled substances. These rules
include an obligation to register with the Drug Enforcement Administration of
the United States Department of Justice and to meet certain requirements
concerning security, record keeping, inventory controls, prescription forms,
order forms and labeling.

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The Company's pharmacists and nurses also are subject to state licensing
requirements and laws regarding standards of professional conduct. Each nurse
and pharmacist used by the Company must have a valid license. Management
believes that the Company's operations comply in all material respects with
applicable pharmacy licensing requirements.

         The health care industry is highly regulated at the federal and state
levels. The Company believes its business is in material compliance with
applicable law. The relationships between the Company and its affiliated
physician groups, however, are unique, and many aspects of these relationships
have not been the subject of judicial or regulatory interpretation. There can
be no assurance that a review of the Company's business by courts or by health
care, tax, labor or other regulatory authorities would not result in
determinations that could adversely affect the Company's operations or that the
health care regulatory environment will not change so as to restrict the
Company's existing operations or potential for expansion.

         A federal statute (the "federal anti-kickback statute") prohibits the
offer or payment of remuneration, or the solicitation or receipt of
remuneration, to induce either (i) the purchase of any item or service
reimbursable in whole or in part by Medicare or certain state health care
programs (including Medicaid); or (ii) the referral of an individual for the
furnishing of any item or service reimbursable in whole or in part by Medicare
or certain state health care programs. Both criminal and civil penalties can be
imposed for violations of the federal-kickback statute, including exclusion
from participation in the Medicare and Medicaid programs. The Department of
Health and Human Services and law enforcement authorities are increasingly
scrutinizing arrangements between health care providers and referring
physicians to ensure that those arrangements do not constitute mechanisms for
paying for referrals. In addition, a number of states have adopted similar
legislation that applies to patients not covered by Medicare or Medicaid
programs. The Company does not believe that its business operations violate
federal or state anti-kickback statutes. Medicare and state health care
programs do not reimburse medical practices for management fees paid to the
Company, and the Company does not refer patients to the medical practices.
Nevertheless, because of the breadth of federal and state anti-kickback
statutes and the absence of court decisions interpreting their application to
arrangements such as those entered into by the Company, there can be no
assurance that the Company's activities will not be challenged by regulatory
authorities or that the Company's position will prevail if challenged.

         Numerous legislative proposals have been introduced or proposed in the
U.S. Congress and in some state legislatures that would effect major changes in
the U.S. health care system nationally or at the state level. It is not clear
at this time what proposals, if any, will be adopted or, if adopted, what
effect, if any, such proposals would have on the Company's business. Certain
proposals, such as reducing Medicare and Medicaid, could adversely affect the
Company. There can be no assurance that currently proposed or future health
care legislation or other changes in the administration or interpretation of
governmental health care programs will not have a material adverse effect on
the Company.

         General business corporations (as opposed to professional corporations
which are wholly-owned by physicians) are generally not allowed to render
medical care. While the Company structures its operations to comply with
applicable laws concerning the corporate practice of medicine, there can be no
assurance that, given varying and uncertain interpretations of such laws, the
Company would be found to be in compliance with such laws. A determination that
the Company is in violation of applicable restrictions on the practice of
medicine could have a material adverse effect on the Company if the Company
were unable to restructure its operations to comply with applicable state
requirements.

RISKS INHERENT IN PROVISION OF MEDICAL SERVICES

         The Company's operations involve the delivery of health care services
to the public and the Company is exposed to the risk of professional liability
claims. Claims of this nature, if successful, could result in damage awards to
the claimants in excess of the limits of any applicable insurance coverage
maintained by the Company or health care providers utilized by the Company or
those who utilize the Company's facilities, equipment and services. Insurance
against losses related to claims of this type can be expensive and varies
widely from state to state. The Company or its affiliated physician groups and
professional service providers maintain liability insurance in amounts and
coverages believed to be usual and customary. Nevertheless, successful
malpractice or other liability claims asserted against the medical care
providers or the Company could have a material adverse effect on the Company.

REDUCTIONS IN THIRD PARTY REIMBURSEMENTS

         Health care providers typically bill various third party payers, such
as governmental programs (e.g., Medicare and Medicaid), private insurance plans
and managed care plans, for the health care services provided to their
patients. These third party payers are increasingly negotiating the prices
charged for medical services, pharmaceuticals and other supplies, with the

                                       5

<PAGE>   8


goal of lowering reimbursement and utilization rates. Third party payers can
also deny reimbursement for medical services, pharmaceuticals and other
supplies if they determine that a treatment was not performed in accordance
with treatment protocols established by such payers or for other reasons. Loss
of revenues to the Company caused by cost containment efforts could have a
material adverse effect on the Company. Although the Company does not have any
contracts to provide health care services on a capitated or other risk sharing
basis, the Company anticipates that it will eventually offer its services to
payers in the future on a capitated or other risk sharing basis. To the extent
that patients or enrollees covered by a contract require more frequent or
extensive care than is anticipated by the Company, the revenue to the Company
derived from such contracts may be insufficient to cover the costs of the
services provided. Insufficient revenue under capitated or other risk sharing
contracts could have a material adverse effect on the Company.

INSURANCE

         In recent years, physicians, hospitals and other participants in the
health care market have become subject to an increasing number of lawsuits
alleging malpractice, product liability or related legal theories, many of
which involve large claims and significant defense costs. With respect to its
home infusion health care business, the Company does not carry liability
insurance for any employee or contract representative. The Company requires
that all health care professionals, including registered nurses with whom the
Company contracts, carry personal professional liability insurance. However,
the Company does not require continuing proof of insurance, mandate policy
limits or deductibles or require that the Company be named as an additional
insured. Should one of the Company's agents or contracting health care
professionals commit a negligent or other liability producing act or omission
in the Company's home infusion operations, the patient could have a direct
claim against the Company which would be uninsured. Mr. Chiu Chan has in force
personal professional liability insurance with coverage limits of $1 million
per incident. He has not experienced difficulty in obtaining insurance in the
past and believes the current insurance coverage is adequate to provide for any
claims that may arise and related settlements, if any, involving him
personally. As the pharmacist in charge of home infusion therapy, any claims
would probably involve Mr. Chiu Chan and the Company and Mr. Chan's insurance
may apply to the extent the loss is related to his pharmacy services. The
Company may, however, be exposed to the extent Mr. Chiu Chan's insurance does
not apply or is insufficient to cover any losses for which the Company is
jointly liable. Management believes the Company has reasonable and customary
insurance coverage with respect to the remainder of its business operations
although the Company cannot provide any assurance that its insurance would
cover all losses to which the Company may be subject to.

EMPLOYEES

         The Company and its subsidiaries employed approximately 48 full-time
and 5 part-time employees as of August 31, 1998. A number of other individuals
are utilized on an as needed contractual basis, with the number being dependent
on the patient load. The Company experienced a substantial decrease in the
number of its employees as a result of fewer physician management agreements.
The Company had approximately 75 employees for the fiscal year ended August 31,
1997. The Company expects to add approximately fifteen full-time employees in
connection with the opening of the Hospital.

EMPLOYEE BENEFIT PLANS

         Effective August 1, 1995, the Board of Directors approved a 1995
Non-Qualified Stock Option Plan for consultants and non-employee directors. The
Board believes that the Plan will advance the long term interests of the
Company (i) by providing consultants and non-employee directors with the
opportunity to obtain an equity interest in the Company, (ii) by furthering the
identity of interests of participants in the plan with those of the
shareholders of the Company through the ownership and performance of the common
stock of the Company, and (iii) by permitting the Company to attract and retain
qualified consultants and non-employee directors. Under the terms of the Plan,
the Company may grant stock options in the Company's Common Stock to
consultants and non-employee directors of the Company and its subsidiaries. The
options granted under the Plan are not intended to qualify as "incentive stock
options" as that term is defined under Section 422A of the Internal Revenue
Code and, as such, the nonstatutory options granted under the Plan are not
entitled to special treatment under Section 422 of the Code.

         Effective August 31, 1995, the Company's shareholders approved a 1995
Incentive Stock Option Plan. The 1995 Incentive Stock Option Plan was
recommended by the Board of Directors because of its belief that the Plan will
advance the interests of the Company by providing key employees, who have
substantial responsibility for the direction and management of the Company,
with additional incentive for them to promote the success of the Company by
increasing their proprietary interest in the success of the Company. It is
intended that options issued under the Plan will qualify as Incentive Stock
Options under

                                       6

<PAGE>   9


Section 422A of the Internal Revenue Code. The Company granted options to
purchase 106,250 shares under the 1995 Incentive Stock Option to ten (10)
employees during fiscal 1998 at a purchase price of $1.38 per share.

HOSPITAL OPERATIONS

         The Company has no experience with respect to the ownership and
operation of a hospital. The Company's Hospital is scheduled to open in
February 1999. The Hospital will be owned by the Company and managed by DPMI
and Vista Medical. The Company intends to lease the Hospital to Vista Medical
pursuant to a long-term lease for monthly rentals of approximately $35,000 per
month. Vista Medical will be owned 70% by DPMI and it is expected that an
outside investor group will own approximately 30% of Vista Medical. The Company
is funding the costs to construct and operate the Hospital. The Company cannot
provide any assurances that the operations of the Hospital will be successful
in the long-term or short-term. In the short-term, construction delays,
staffing, initial operating problems and low utilization could lead to
short-term losses and negative cashflow. In the long-term, the Company's
ability to manage the Hospital and competition will be key factors in the
success of the Hospital.


ITEM 2.       DESCRIPTION OF PROPERTY

         The Company commenced its health care operations in August 1992 and
leased 1,000 square feet of office space in East Houston for $600 per month. As
of March 1, 1993, the office space was expanded to a total of 1,915 square feet
and, accordingly, the monthly lease rate increased to $1,286. This lease
expired March 1, 1995 and is currently on a month-to-month basis. The lessor of
the office space is Capital Bank. One of the Company's directors is a director
of Capital Bank. Management believes that the lease rate being paid is
consistent with other commercial rates available in the East Houston area.

         In August 1994, the Company consummated the acquisition of 65% of the
outstanding common stock of Vista, which owned the Vista Facility, an
outpatient surgical center in Pasadena, Texas consisting of a one story
building containing approximately 15,000 square feet. The Vista Facility is
subject to and collateralized by a note payable and deed of trust to Met Life
Capital. The note bears a fixed interest rate of 9.65%, requires monthly
installment payments of $19,533, and has a maturity date of September 1, 2002.
As of August 31, 1998, the balance was $782,472. The Company entered into a
Guaranty Agreement with Met Life Capital whereby the Company guaranteed 65% of
the outstanding balance of the mortgage loan. Management believes the facility
is adequately covered by insurance. The depreciation on the Vista Facility is
computed using the straight line method over thirty-nine years, furniture and
fixtures are depreciated over seven years, and equipment is depreciated over
five years. The property tax rate is about 3% of appraised value and the annual
real and personal property taxes are about $77,000. The Vista Facility is 100%
utilized as an outpatient surgical center and to provide laboratory and
diagnostic testing services. On September 1, 1998, Vista sold the Vista
Facility and the land on which the Vista Facility, the Office Building and
Hospital are located to the Company for a total purchase price of $1,400,000
payable pursuant to a promissory note of like amount, bearing interest at 8.5%
per annum and payable in eighty-four monthly installments of $22,171.08. In
addition, the Company obtained the agreement of Met Life Capital to obtain the
release of the minority shareholders of Vista from their personal guaranties.

         In September 1994, the Company commenced construction of the Office
Building (adjacent to the existing Vista Facility described above) which was
completed in 1995. The total cost of the Office Building was approximately
$1,937,000, and was financed from working capital. The Office Building was
constructed as a professional office building for physician practices. There is
competition from several professional buildings in the surrounding area.
Management believes the Office Building is adequately covered by insurance. The
Office Building is comprised of two stories and contains approximately 35,900
square feet of space of which approximately 23,000 is utilized by physician
practices under the management of DPMI or is leased to other physicians not
under contract with DPMI. The remaining space is available for lease to
physicians or other third parties. A total of $707,000 has been spent for new
equipment and furnishings for the Office Building. All depreciation is
calculated on the straight line method, with the building being depreciated
over thirty-nine years, furniture and fixtures over seven years, and equipment
over five years. The property tax rate is approximately 3% of appraised value
and the annual real and personal property taxes are about $80,000. As of August
31, 1998, there were three physician practices under management with DPMI which
are located in the Office Building. Each physician practice utilizes more than
10% of the space in the building and comprises more than 10% of the management
fees payable to DPMI pursuant to the Management Agreements described below.
Revenues and income from the Office Building are derived, in part, from the
management fees received by DPMI under the Management Agreements, although the
Company does receive regular rental income from physicians who elect to rent
space in the building for their practices which are not under management with
DPMI. Pursuant to the Management Agreements which

                                       7

<PAGE>   10


provide DPMI with a percentage of revenues from each physician's practice, DPMI
agrees to provide fully-equipped office space and other services. Given the
limited number of Management Agreements and lease agreements which provide
revenue to DPMI and the Company from the Office Building, the loss or
cancellation of any agreement would be material. If any Management Agreement or
lease agreement relating to space in the Office Building is canceled or
terminated, the Company believes it will be able to find additional physicians
or other tenants. The Office Building is not subject to any lien or mortgages
and is owned 100% by the Company.

         On July 1, 1996, DPMI leased approximately 3,000 square feet of office
space from the City of Pasadena pursuant to a five (5) year lease (containing
an option for an additional five (5) years) which requires lease payments of
$7,200 annually. The property is located at 1001 East Shaw, Pasadena, Texas.
DPMI acquired the property for the location of a medical practice under a
Management Agreement. DPMI has invested approximately $124,000 for furniture,
fixtures and equipment at this location. The property is currently 100%
utilized for a physician's practice.

         In the second quarter of fiscal 1998, the Company entered into a
construction contract for the Hospital which is expected to be completed in
February 1999. The total construction price is approximately $2,500,000 and the
equipment and furnishings are expected to cost approximately $1,000,000. The
Company intends to fund the construction price and the equipment and
furnishings from internally generated funds. However, if necessary, the Company
may borrow a portion of the needed funds to complete the Hospital and encumber
the Hospital with a first or second mortgage. The Company believes that
financing for all or a part of the Hospital would be available, if required.
The Hospital is located in Pasadena, Texas and is adjacent to the Office
Building and Vista Facility. It will have 42 beds, two surgical rooms, an
intensive care area, nurse station, kitchen and other facilities to operate as
a complete hospital.


ITEM 3.       LEGAL PROCEEDINGS

         The Company is not a party to any material litigation.


ITEM 4.       SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         Not applicable.

                                    PART II.

ITEM 5.       MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         In September 1993, the Company's Common Stock began trading on
NASDAQ's Small Capitalization Market under the symbol DYII. Prior to obtaining
the NASDAQ listing, the Company's Common Stock had traded in the
over-the-counter market on the pink sheets and on the NASD Electronic Bulletin
Board.

         The following table sets forth the high and low closing bid prices for
the Company's Common Stock during each of the last eight fiscal quarters as
reported by the National Quotation Bureau, Inc.

<TABLE>
<CAPTION>

                                                      High              Low
                                                      ----              ---
<S>                                               <C>              <C>       
1998 Fiscal Year - Quarter Ended:
         November 30, 1997                        $     3.00       $     1.50
         February 28, 1998                              2.50             2.00
         May 31, 1998                                   2.75             2.00
         August 31, 1998                                2.50            2.375
</TABLE>

                                       8

<PAGE>   11

<TABLE>
<S>                                                <C>              <C>       
1997 Fiscal Year - Quarter Ended:
         November 30, 1996                         $     5.00       $     2.70
         February 28, 1997                               4.50             2.70
         May 31, 1997                                    3.50             2.00
         August 31, 1997                                 4.00             1.00
</TABLE>

         These quotations reflect inter-dealer prices, without retail markup,
mark-down or commission and may not represent actual transactions and are
adjusted to reflect the Company's four (4) to one (1) reverse stock split
effective February 1998.

         As of November 4, 1998, the Company had approximately 149 shareholders
of record. This number does not include shareholders who hold the Company's
securities in nominee accounts with broker-dealer firms or depository
institutions or shares issued to employees of the Company subsequent to the
Company's fiscal year end. Including the shares issued to the Company's
employees and the beneficial owners of shares held in nominee accounts or
depository institutions, the Company believes it has in excess of 300
beneficial owners of its Common Stock.

         The Company has not paid any cash dividends on its Common Stock and
intends to retain all earnings for the operation and expansion of its business.
The Company does not anticipate paying cash dividends in the foreseeable
future. Any future determination as to the payment of cash dividends will
depend upon the Company's results of operations, financial condition and
capital requirements, as well as such other factors as the Company's Board of
Directors may consider. There are no contractual or other restrictions which
limit the Company's right to declare and pay dividends should the Board of
Directors elect to do so.

         Vista Medical intends to offer up to 30% of its equity interests to an
outside investor group in a private placement under Section 4(2) of the
Securities Act of 1933, as amended, and pursuant to applicable state law
exemptions. It is expected that the investor group will be comprised of
individual investors, including physicians, who may form a limited liability
company to undertake the investment. Vista Medical expects to raise
approximately $360,000 from the sale of membership interests in the limited
liability company.


ITEM 6.       MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

GENERAL

         The Company (including its predecessor) did not generate any revenues
from inception in 1983 through July 1992. New management and other
individuals/entities invested $2,000,000 in 1992 and the Company began to
generate revenues from home health care therapy in August 1992, the first month
of operations.

ANALYSIS OF OPERATIONS

         The following discussion provides an analysis of the Company's results
of operations and reasons for material changes therein for the three years
ended August 31, 1998.

         The Company recorded consolidated net income of $945,843 for the year
ended August 31, 1998, as compared to consolidated net loss of $1,059,195 in
fiscal 1997 and net income of $559,473 in 1996. There were no significant,
unusual or non-recurring items of income or expense during the three years
ended August 31, 1998, except for writeoffs in fiscal 1997 of uncollectible
notes in the amount of $776,922 and the writeoff of $371,736 in uncollectible
advances to a subsidiary. As discussed below, the Company's loss for fiscal
1997 includes the writeoff of loans previously made by the Company to various
physician groups. The Company does not expect to record further significant
writeoffs due to uncollectible loans in future years.

         As a result of a significant increase in the Company's revenues and
expenses during fiscal 1997 relating to the Company's management of physician
practices and the recordation of physician practice revenues and expenses on a
combined or consolidated basis (see footnote 8 of Notes to Consolidated
Financial Statements), it is difficult to meaningfully compare on a
year-to-year basis the large differences in many of the expense categories.

                                       9

<PAGE>   12


AUGUST 31, 1998 VS. AUGUST 31, 1997

         For the fiscal year ended August 31, 1998, total consolidated revenues
increased by $1,208,420 to $10,980,369, a 12% increase. Of this amount,
revenues of $2,197,789 were recorded by DPMI in fiscal 1998 compared to
$5,188,381 in fiscal 1997 as a result of the Company's decision to limit its
management of physician practices and the termination or cancellation of five
(5) Management Agreements with physicians during fiscal 1997 and fiscal 1998.
The Company expects physician management revenues (and corresponding expenses)
to further decrease in fiscal 1999 as it reduces its business in the area of
physician management practice. The Company records revenues from the management
of physician practices on a combined or consolidated basis and reflects as
revenues all patient billings of the respective practices and expenses payments
to physicians and other physician practice costs.

         Revenues attributable to Vista operations were $6,951,253 in fiscal
1998, compared to $3,058,704 in fiscal 1997, an increase of 127%. Revenues from
home infusion therapy were $1,831,327 in fiscal 1998 compared to $1,524,864 in
fiscal 1997, an increase of 20%, primarily as a result of higher recoverable
charges per day per patient.

         Expenses for compensation and benefits to employees decreased by 22%
to $1,840,573 as a result of fewer employees needed by the Company to service
the decreased business associated with the management of physician practices by
DPMI. The number of employees employed by the Company and its subsidiaries
decreased from approximately 75 in fiscal 1997 to approximately 53 as of August
31, 1998. Expenses for contract payments to physicians decreased 58% to
$1,250,252 primarily as a result of fewer physician practices under management
during fiscal 1998. The Company's provision for uncollectible trade accounts
increased from $1,269,066 in fiscal 1997 to $2,240,258 in fiscal 1998 primarily
as a result of increased trade revenues resulting in corresponding increases
for uncollectible trade accounts. As a percentage of revenues, the Company's
provision for uncollectible trade accounts increased from 13% in fiscal 1997 to
20% in fiscal 1998. The Company expects its uncollectible trade accounts as a
percentage of revenues to remain relatively constant in the future at
approximately 20%. The Company recorded writeoffs for uncollectible loans in
fiscal 1998 of $149,698 as compared to $776,922 in prior years. The Company
does not expect to incur similar recurring writeoffs of notes receivable in
fiscal 1999 and does not intend to fund advances or loans to physician groups
in the future in connection with its management of physician practices.
Expenses for medical supplies decreased 18% to $1,051,194 associated with the
decreased revenues and business from the Company's physician management
practice.

         General and administrative expenses increased 22% to $1,669,832
primarily as a result of increased operational activities at the Vista
Facility. Rent and other income increased from $23,847 in fiscal 1997 to
$195,359 in fiscal 1998 primarily as a result of additional rental income
received from outside physicians not under DPMI management.

         The Company's physician management practice (exclusive of the Vista
Facility Management Agreement) and its home infusion division did not
significantly contribute to the Company's operating profit. Substantially all
of the Company's operating income of $1,760,754 was derived from the operations
of the Vista outpatient surgery clinic, primarily from the Vista Facility
Management Agreement. The future success of the Company is largely dependent on
successful operations at the Vista Facility and the Hospital upon commencement
of operations in the first quarter of fiscal 1999. The Company does not intend
to aggressively market its home infusion therapy services at this time
primarily because of reduced recoverable patient day rates being paid by
third-party payors. The Company will not continue to accept home infusion
patients if rates continue to decline. In the past two (2) years, the Company
has faced increasing pressure from insurance companies to justify the need for
continued home infusion therapy in some cases and the Company's charges
therefor. The Company expects these pressures to continue and to increase. With
respect to its physician's practice management services, the Company has yet to
establish a consistently successful operating history, particularly in view of
the writeoffs for uncollectible notes recorded in fiscal 1997. The Company does
not intend to pursue additional management agreements for physician practices
at this time. 

                                       10

<PAGE>   13


AUGUST 31, 1997 VS. AUGUST 31, 1996

         For the fiscal year ended August 31, 1997, total consolidated revenues
increased by $2,240,954 to $9,771,949, a 30% increase. Of this amount, revenues
of $5,188,381 were recorded by DPMI in fiscal 1997 compared to $2,737,993 in
fiscal 1996 as a result of the Company's aggressive efforts in signing up
physician practices for management by DPMI. However, as a result of the
termination or cancellation of five (5) Management Agreements with physicians
during fiscal 1997 and subsequent to the year ended August 31, 1997, physician
management revenues (and corresponding expenses) decreased significantly during
fiscal 1998. The Company records revenues from the management of physician
practices on a combined or consolidated basis and reflects as revenues all
patient billings of the respective practices and expenses payments to
physicians and other physician practice costs.

         Revenues attributable to Vista operations were $3,058,704 in fiscal
1997, compared to $3,025,249 in fiscal 1996, an increase of less than 1%.
Revenues from home infusion therapy were $1,524,864 in fiscal 1997 compared to
$1,767,753 in fiscal 1996, a decrease of 14 %, primarily as a result of fewer
patients and increasing cost and reimbursement constraints imposed by
third-party payors, resulting in lower recoverable charges per day per patient.

         Costs and expenses relating to home infusion therapy declined
primarily as a result of the Company's decreased patient load. Expenses for
compensation and benefits to employees increased by 78% to $2,360,433 as a
result of additional employees hired by the Company primarily to service the
increased business associated with the management of physician practices by
DPMI. The number of employees employed by the Company and its subsidiaries
increased from approximately 42 in fiscal 1996 to approximately 75 as of August
31, 1997. Expenses for contract payments to physicians increased 78% to
$2,962,888 primarily as a result of the additional physician practices under
management during all of fiscal 1997. The Company's provision for uncollectible
trade accounts increased from $893,486 in fiscal 1996 to $1,269,066 in fiscal
1997 primarily as a result of increased trade revenues resulting in
corresponding increases for uncollectible trade accounts. As a percentage of
revenues, the Company's provision for uncollectible trade accounts increased
from 11.8% in fiscal 1996 to 13% in fiscal 1997. The Company expects its
uncollectible trade accounts as a percentage of revenues to remain relatively
constant or to increase. Due to payment non- performance on two (2) physician
loans, the Company incurred a charge for uncollectible notes of $776,922 in
fiscal 1997. No similar writeoffs for uncollectible loans have been recorded by
the Company in prior years. In addition, the Company incurred a writeoff
associated with an uncollectible advance to a subsidiary of $371,736. Together
the uncollectible note and advance writeoffs totaled $1,148,658 which writeoffs
substantially contributed to the Company's consolidated net loss for the year
before taxes and minority interest of $1,593,285. The Company does not expect
to incur similar recurring writeoffs in the future and will strictly limit or
curtail advances or loans associated with the management of physician
practices. Expenses for medical supplies increased 64% to $1,283,112 primarily
as a result of the need for additional supplies associated with the increased
revenues and business from the Company's physician management practice.

         General and administrative expenses increased 24% to $1,369,233
primarily as a result of increased operational activities. Rent and other
income declined from $119,843 in fiscal 1996 to $23,847 in fiscal 1997
primarily as a result of the Company utilizing its Office Building for
physician practices under the Management Agreements which require the Company
to provide office space and the physicians are not separately charged for rent.

         As discussed above, of the Company's consolidated loss of $1,593,285
before income taxes and minority interest in fiscal 1997, approximately
$1,148,658 is attributable to the Company's writeoffs of physician loans and
certain advances determined by the Company to be uncollectible. DPMI had a
small operating profit of approximately $4,400 exclusive of losses associated
with the physician loans. Operations from Vista resulted in an operating profit
of approximately $38,000 in fiscal 1997 compared to an operating profit of
approximately $190,000 in fiscal 1996. Vista incurred reduced operating profits
despite an increase in revenues, principally as a result of the increase in
management fees payable to DPMI from 28% to 38% effective September 1, 1996.
The Company's home infusion therapy operations resulted in an operating loss of
approximately $1,636,010 in fiscal 1997 compared to a small operating loss of
approximately $51,418 in fiscal 1996. The significant increased loss associated
with the Company's home infusion operations is primarily attributable to the
writeoffs of the uncollectible notes and advances of $1,148,658 which were
originally recorded as loans and advances from the home infusion therapy
division. In addition, revenues from home infusion therapies declined
significantly as a result of fewer patients and lower recoverable rates
associated with the Company's home infusion patients.

         The Company faces certain general business risks with respect to all
of its operations. In addition to regulatory concerns and increasing
competition with respect to all of its operations, the Company's home infusion
therapy operations are subject to substantial risks because the Company serves
a relatively small number of patients. The Company's home infusion health care

                                       11

<PAGE>   14


revenues decreased from $ 2,730,753 in fiscal 1995 to $1,524,864 in fiscal 1997
as a result of a significant decrease in the number of full-time patients from
approximately ten (10) in fiscal 1995 to an average of three (3) full-time
patients in fiscal 1997. The Company does not intend to aggressively market its
home infusion therapy services at this time primarily because of reduced
recoverable patient day rates being paid by third-party payers. The Company
will not continue to accept home infusion patients if rates continue to
decline. In the past two (2) years, the Company has faced increasing pressure
from insurance companies to justify the need for continued home infusion
therapy in some cases and the Company's charges therefor. The Company expects
these pressures to continue and to increase. With respect to its physician's
practice management services, the Company has yet to establish a consistently
successful operating history, particularly in view of the writeoffs for
uncollectible notes recorded in fiscal 1997. Revenues from the Vista Facility
increased slightly during fiscal 1997 due to increased patient referrals. The
Company expects, and will aggressively pursue, increased patient referrals for
the Vista Facility during fiscal 1998 and expects to record revenue and
operating profit increases.

LIQUIDITY AND CAPITAL RESOURCES

         The Company maintained sufficient liquidity in fiscal 1998 and 1997 to
meet its business needs. The Company had working capital of $2,510,981 as of
August 31, 1998 and $1,824,162 as of August 31, 1997. The Company had net cash
provided by operating activities of $2,299,032 for fiscal 1998 as opposed to
$13,172 for fiscal 1997. As of August 31, 1998, the Company maintained a liquid
position evidenced by a current ratio of 2.53 to 1 and a total debt to equity
ratio of 0.47 to 1. The Company expects to have positive cash flow from
operations for fiscal 1998.

         The Company is actively targeting opportunities to expand in the
outpatient surgical clinic markets by acquisition of existing facilities or the
construction of new facilities. The Company will be required to fund
approximately $3,500,000 to equip and construct the Hospital of which
approximately $400,000 has been paid. The Company expects to fund the balance
from cash- on-hand and internally generated funds. The Company believes it has
the ability to borrow funds if necessary to meet its capital needs. However,
there can be no assurance that the Company will have sufficient funds available
to meet all of its capital needs.

         Management believes that available cash funds and funds generated from
operations will be sufficient for the Company to finance working capital
requirements for the foreseeable future and to meet its future payment
obligations on its long-term indebtedness of $954,144 as of August 31, 1998.

         The Company expects the operations of the Hospital to have a
material effect on the Company's consolidated operating results. While the
Company believes the operating results of the Hospital will be successful in
the long-term, it can provide no such assurance at this time to its
Shareholders. In the short-term, expected operating results from the Hospital
could be negatively impacted by construction delays, start-up delays or
problems including staffing and equipment, low patient utilization
(particularly in the first year), licensing or regulatory delays or other
problems, which could have a material adverse effect on the Company's liquidity
and capital resources. In the long-term, the skill and experience of the 
Hospital's management team and competition will play critical roles.

         YEAR 2000 COMPLIANCE ISSUES. The Company is currently evaluating its
entire operation as a result of potential problems associated with Year 2000.
The Company's personnel are evaluating all areas for compliance issues and are
developing correction plans if necessary. Some internal areas and processes
being evaluated include initial charge entry through billing and collections;
accounts payable invoice receipt through processing and payment; bank
processing of receipts and disbursements; computer hardware and software
functionality; and time and/or date-sensitive office and medical equipment
functionality. At present, the Company does not anticipate any material
disruption in its operations or significant costs to be incurred to attain
compliance. There can be no assurance, however, that the Company will identify
or adequately assess all aspects of its business that may be affected. Due to
this uncertainly, a contingency plan will be developed as each area is
evaluated to minimize any negative impact to the Company. The Company is in the
process of soliciting information concerning the Year 2000 compliance status of
its payors (including the Medicare and Medicaid governmental programs),
suppliers, and customers. In the event that any of the Company's significant
payors, suppliers, or customers do not successfully and timely achieve Year
2000 compliance, the Company's business and/or operations could be adversely
affected.

         INFLATION. Inflation has not significantly impacted the Company's
financial position or operations.

         FORWARD-LOOKING INFORMATION. Information in this Annual Report on Form
10-K contains forward-looking statements and information relating to the
Company that are based on the beliefs of the Company's management, as well as
assumptions made by, and information currently available to the Company's
management. When used in this Annual Report on Form 10-K, words such as
"anticipate", "believe", "estimate", "expect", "intend", and similar
expressions, as they relate to the Company or the Company's management,
identify forward-looking statements. Such statements reflect the current views
of the Company with respect to future events, and are subject to certain risks,
uncertainties, and assumptions relating to the operations and results of
operations of the Company, competitive factors and pricing pressures, costs of
products and services, general economic conditions, and the acts of third
parties, as well as other factors described in this Annual Report on Form 10-K,
and, from time to time, in the Company's periodic earnings releases and other
reports filed with the Securities and Exchange Commission. Should one or more
of these risks or uncertainties materialize, or should underlying assumptions
prove incorrect, actual results

                                       12

<PAGE>   15


or outcomes may vary materially from those described herein as anticipated,
believed, estimated, expected, or intended, or the like.


ITEM 7.       FINANCIAL STATEMENTS

         The information required by this item is included in a separate
section of this Annual Report on Form 10-K beginning on Page F-1 and is
incorporated herein by reference.


ITEM 8.       CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
              ON ACCOUNTING AND FINANCIAL DISCLOSURE

         Not Applicable.

                                   PART III.

ITEM 9.       DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
              COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

         The following table (and accompanying text) sets forth the names and
ages of all the directors and executive officers of the Company, all positions
and offices with the Company held by each person, each such person's term of
office as a director and business experience for the past five years.

<TABLE>
<CAPTION>
NAME                              AGE         POSITION
<S>                               <C>         <C>
Chiu Moon Chan                    46          Chairman of the Board of Directors, Chief Executive Officer,
                                              President and Secretary (July 1992-Present)
Philip Chan                       47          Vice President - Finance and Treasurer/Director
                                              (July 1992-Present)
Stephen L. Huber                  48          Director  (July 1992-Present)
Earl R. Votaw                     72          Director  (July 1992-Present)
Glenn Rodriguez                   52          CEO, Vista Healthcare, Inc. (November 1995-Present)
</TABLE>

         CHIU MOON CHAN is a registered pharmacist and since May 1978, has been
employed by health care service organizations in Houston, Texas. From March
1986 to May 1988, Mr. Chan was employed by the M.D. Anderson Cancer Center,
Houston, Texas. From June 1988 through September 1991, Mr. Chan operated his
own home infusion health care business in Houston, Texas as a sole
proprietorship. From October 1991 through July 1992, Mr. Chan was an executive
officer and employee of E.F.S.M., Inc. located in Houston, Texas, which is in
the home infusion health care business, specializing in Medicare and Medicaid
patients. Mr. Chan earned a Bachelor of Science degree in Pharmacy from the
University of Houston.

         PHILIP CHAN was self-employed with his own consulting, accounting and
tax firm from September 1990 through 1992. From September 1989 to September
1991, he was the controller for a management corporation, Related Management
Corporations of Florida, located in Miami, Florida. From March 1986 to August
1989, he was in charge of the accounting department for Hamel and Associates, a
Houston, Texas accounting firm. Mr. Chan has earned advanced accounting degrees
from the University of Houston and is a CPA in the State of Texas.

         Mr. Chiu Chan and Mr. Philip Chan are not related.

         STEPHEN L. HUBER is a registered pharmacist and has earned a Bachelor
of Science degree in Hospital Pharmacy from the University of Houston. He
served as director of pharmacy patient care services at the University of Texas
M.D. Anderson

                                       13

<PAGE>   16


Cancer Center from August 1986 to December 1991 when he was promoted to his
current position, Deputy Division Head for patient care services. Mr. Huber
joined M.D. Anderson in 1984 as assistant director of operations. He was a
director of pharmacy from May 1982 through August 1984 for Life Mark Pharmacy
Management.

         EARL R. VOTAW earned a Bachelor of Arts degree from the University of
the Americas in Mexico City and a certificate of graduation from the Graduate
School of Mortgage Banking from Northwestern University of Chicago. Mr. Votaw
has served as a director since 1981 and as an executive officer since 1985 of
Jacinto City Bancshares, Inc. ("Jacinto"), a Houston-based bank holding
company, which is publicly held. He has also served since 1989 as an executive
officer and a director of JACI, Inc., a Delaware corporation, that is
wholly-owned by Jacinto. Capital Bank, a Texas chartered bank located in
Houston, Texas of which Mr. Votaw has served as president, chief executive
officer, and a director since 1979 is wholly owned by JACI, Inc. As of December
31, 1993, Mr. Votaw resigned all of his positions with Jacinto, JACI, Inc. and
Capital Bank, except his director position with Capital Bank, to pursue
retirement plans.

         GLENN RODRIGUEZ earned a BBA in Accounting from Florida International
University in Miami, Florida, graduating in 1976. Mr. Rodriguez has served as
the CEO of Vista for the last three (3) years and for the prior two (2) years
served as the Chairman and CEO of Surgical Care Center of Texas, an outpatient
surgical center in Pasadena, Texas.

         Each director holds office until the earlier of the election of his
successor at the next annual meeting of stockholders or his resignation or
removal.

COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

         Based solely upon the Company's review of Forms 3, 4, and 5 filed by
the Company's officers and directors and persons who beneficially own 10% or
more of the Company's Common Stock and the written representations of such
persons, the Company is not aware that any of such persons failed to timely
file the foregoing forms during the last fiscal year, except for the failure by 
Philip Chan to timely file a Form 4 or Form 5 to report options to acquire 
20,000 shares under the Company's 1995 Incentive Stock Option Plan granted to 
him on December 18, 1997.


ITEM 10.      EXECUTIVE COMPENSATION

         The following summary compensation table sets forth in summary form
the compensation received during each of the Company's last three completed
fiscal years by the Registrant's Chief Executive Officer.

                           SUMMARY COMPENSATION TABLE

                              ANNUAL COMPENSATION
<TABLE>
<CAPTION>
NAME/PRINCIPAL POSITION                   FISCAL                                                            LONG-TERM
                                           YEAR              SALARY           BONUS             OTHER      COMPENSATION
                                           ----              ------           -----             -----      ------------
<S>                                        <C>            <C>                 <C>              <C>            <C>  
          Chiu Chan, CEO                   1998           $   80,000          $  -0-           $  -0-         $ -0-
                                           1997              100,000             -0-              -0-           -0-
                                           1996              160,000             -0-            6,010           -0-
</TABLE>

No other officer, director or employee of the COMPANY OR its
subsidiaries received total compensation in excess of $100,000 during the last
three fiscal years. The Company has no employment agreements with its
executives. Mr. Chiu Chan, Philip Chan, and Glenn Rodriguez devote 100% of
their time to the Company.

         Pursuant to the Company's Incentive Stock Option Plan, options to
purchase 68,882 shares were granted on May 14, 1996, which number includes
39,402 options granted to Mr. Philip Chan. The remaining options were granted
to approximately ten (10) nonexecutive employees of the Company and its
subsidiaries. These options are exercisable at $3.75 per share and expire May
14, 2001. The Board of Directors also adopted a non-qualified stock option plan
in August 1996 for non-director employees and consultants, and a total of
43,750 options were granted to two (2) consultants during fiscal 1996 under
that plan. In addition, in December 1997, the Company granted ten (10)
employees options to purchase 106,250 shares in the aggregate at an exercise
price of $1.38 per share which expire December 18, 2002, including options for
20,000 shares issued to Philip Chan and 22,500 to Glenn Rodriguez.

                                       14

<PAGE>   17

                     OPTIONS/SAR GRANTS IN LAST FISCAL YEAR


<TABLE>
<CAPTION>
                           Number of Securities        Percent of Total Options/
                           Underlying Options/SAR's    SAR's Granted to
          Name             Granted                     Employees in Fiscal Year      Exercise Price      Expiration Date
          ----             ------------------------    -------------------------     --------------      ---------------

<S>                   <C>
                      [No options were issued to or exercised by an named executive officer in fiscal 1998]
</TABLE>

         Directors of the Company do not receive any mandatory compensation for 
their services as directors, although directors will be reimbursed for expenses
incurred in attending board meetings.


ITEM 11.      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following sets forth certain information with respect to the
beneficial ownership of shares held by directors, executive officers and
persons known to management to own more than 5% of the outstanding Common Stock
of the Company as of December 10, 1998.

<TABLE>
<CAPTION>
                             NAME AND ADDRESS                    NUMBER OF SHARES AND
   TITLE OF CLASS           OF BENEFICIAL OWNER             NATURE OF BENEFICIAL OWNERSHIP          PERCENT OF CLASS
   --------------           -------------------             ------------------------------          ----------------

<S>                       <C>                                          <C>                               <C>
Common Stock              Chiu Moon Chan                               2,271,219(1)                       69.21%
                          323 Wood Loop
                          Houston, Texas  77015

Common Stock              Ella Chan                                    2,271,219(1)                       69.21%
                          323 Wood Loop
                          Houston, Texas  77015

Common Stock              Philip Chan                                     71,277(2)                        2.17%
                          7930 Millbrook Drive
                          Houston, Texas  77095

Common Stock              Glenn Rodriguez                                 31,062(3)                       0.946%
                          10304 I10 East, Suite 369
                          Houston, Texas  77029

Common Stock              Officers and Directors                       2,373,558                          72.32%
                          as a group (6)
</TABLE>


ITEM 12.      CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         None.



-----------------------
     (1)  Includes (i) 1,695,547 shares held individually by Chiu Moon Chan,
(ii) 474,281 shares held in the name of Mr. Chan's spouse, and (iii) 101,938
shares held by two of Mr. Chan's minor children. Mr. Chan disclaims any
beneficial ownership of the shares held by his spouse and minor children. Mrs.
Chan disclaims any beneficial ownership of the shares held by her spouse and
minor children.
          
     (2)  Includes 39,402 shares which may be acquired by Mr. Philip Chan
pursuant to options granted to him in May 1996 exercisable at $3.75 and expiring
May 14, 2001 and 20,000 shares which may be acquired by Mr. Chan pursuant to
options granted to him on December 18, 1997, which are exercisable at $1.375 and
expire on December 18, 2002.

     (3)  Includes options to purchase 22,500 shares which are exercisable at
$1.375 and expire on December 18, 2002, which were granted on December 18, 1997.

                                       15

<PAGE>   18



ITEM 13.      EXHIBITS AND REPORTS ON FORM 8-K

      A.      Exhibits. The exhibits required by Item 601 of Regulation S-B are
              included in this report commencing on page E-1 hereof which
              contains a list of such exhibits. The list of exhibits and the
              exhibits contained herein are incorporated into this part by
              reference.

      B.      Reports on Form 8-K. No reports on Form 8-K were filed by the
              Company during the fourth quarter of fiscal 1997.


                                       16

<PAGE>   19


                                   SIGNATURES

         In accordance with Section 13 or 15(d) of the Exchange Act, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

                           DYNACQ INTERNATIONAL, INC.

By:  /s/ Chiu Moon Chan                                 Date:  December 14, 1998
    --------------------
    Chiu Moon Chan, Chairman of the Board
    Chief Executive Officer, President and Secretary


         In accordance with the Exchange Act, this report has been signed below
by the following persons, on behalf of the Registrant and in the capacities and
on the dates indicated.


<TABLE>
<CAPTION>
                      NAME                              TITLE                        DATE
                      ----                              -----                        ----

<S>                                            <C>                             <C>
           /s/ Chiu Moon Chan                  Chairman of the Board,          December 14, 1998
          --------------------------------     Chief Executive Officer,
           Chiu Moon Chan                      President and Secretary

           /s/  Philip S. Chan                 Vice President,                 December 14, 1998
          --------------------------------     Chief Financial Officer,
           Philip S. Chan                      Controller, and Director

           /s/ Stephen L. Huber                Director                        December 14, 1998
          --------------------------------
           Stephen L. Huber

           /s/  Earl R. Votaw                  Director                        December 14, 1998
          --------------------------------
           Earl R. Votaw
</TABLE>


         SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT
TO SECTION 15(d) OF THE EXCHANGE ACT BY NON-REPORTING ISSUERS.

                                 Not Applicable.


                                       17
<PAGE>   20













                           DYNACQ INTERNATIONAL, INC.

                        CONSOLIDATED FINANCIAL STATEMENTS

                           YEARS ENDED AUGUST 31, 1998
                               AND AUGUST 31, 1997
<PAGE>   21



                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



<TABLE>
<CAPTION>
                                                                                                        Page
                                                                                                        ----

<S>                                                                                                      <C>
         Report of independent public accountants                                                        F-2

         Consolidated balance sheet as of August 31, 1998                                                F-3

         Consolidated statements of operations for the years ended                                       F-4
           August 31, 1998 and 1997

         Consolidated statements of changes in stockholders' equity for the                              F-5
           years ended August 31, 1998 and 1997

         Consolidated statements of cash flows for the years ended                                       F-6
           August 31, 1998 and 1997

         Notes to consolidated financial statements                                                      F-8
</TABLE>




<PAGE>   22



                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Shareholders and Board of Directors
Dynacq International, Inc.
Houston, Texas

We have audited the accompanying consolidated balance sheet of Dynacq
International, Inc. and its subsidiaries (the "Company") as of August 31, 1998,
and the related consolidated statements of operations, changes in stockholders'
equity and cash flows for the years ended August 31, 1998 and 1997. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated 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 audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of the Company as of
August 31, 1998, and the results of its operations and its cash flows for the
years ended August 31, 1998 and 1997 in conformity with generally accepted
accounting principles.



Sugar Land, Texas                                WOOD, HARPER & ASSOCIATES, P.C.
November 30, 1998
<PAGE>   23


                                                      DYNACQ INTERNATIONAL, INC.
                                                     Consolidated Balance Sheet
                                                                August 31, 1998
<TABLE>
<CAPTION>


---------------------------------------------------------------------------------------------------------------------------

ASSETS
<S>                                                                                       <C>        
   Current assets:
      Cash and cash equivalents                                                           $ 2,413,257
      Restricted short-term investments                                                        30,000
      Accounts receivable, net of allowance for doubtful accounts of $4,587,405             1,665,349
      Inventories                                                                              29,608
      Due from related party                                                                   15,856
                                                                                          -----------

        Total current assets                                                                4,154,070

   Property and equipment, net                                                              5,212,841

   Other assets                                                                               245,145
                                                                                          -----------

        Total assets                                                                      $ 9,612,056
                                                                                          ===========

LIABILITIES AND STOCKHOLDERS' EQUITY 
   Current liabilities:
      Notes payable                                                                       $   250,000
      Accounts payable                                                                        187,817
      Accrued liabilities                                                                     311,354
      Income taxes payable                                                                    465,306
      Deferred income taxes payable                                                           186,000
      Current maturities of long-term debt                                                    242,612
                                                                                          -----------

        Total current liabilities                                                           1,643,089

   Noncurrent liabilities:
      Long-term debt, net of current maturities                                               954,144
      Deferred income taxes                                                                   133,000
                                                                                          -----------

        Total noncurrent liabilities                                                        1,087,144

   Commitments and contingencies

   Minority interest                                                                        1,077,305

   Stockholders' equity:
      Preferred stock, $.01 par value, 5,000,000 shares authorized;
        none issued or outstanding                                                                 --
      Common stock, $.001 par value, 300,000,000 shares authorized;
        3,606,628 shares issued                                                                 3,607
      Additional paid-in capital                                                            3,552,761
      Retained earnings                                                                     2,874,049
      Less treasury stock; 326,039 shares at cost                                            (625,899)
                                                                                          -----------

          Total stockholders' equity                                                        5,804,518
                                                                                          -----------

          Total liabilities and stockholders' equity                                      $ 9,612,056
                                                                                          ===========

</TABLE>



               The accompanying notes are an integral part of the
                       consolidated financial statements.
                                      F-3
<PAGE>   24

                                                     DYNACQ INTERNATIONAL, INC.
                                          Consolidated Statements of Operations
                                   For the Years Ended August 31, 1998 and 1997
<TABLE>
<CAPTION>

------------------------------------------------------------------------------------------------------
                                                                       1998                  1997
                                                                       ----                  ----
<S>                                                               <C>                  <C>            
Revenues, net:
   Infusion therapy                                               $     1,831,327      $     1,524,864
   Physician practice management                                        2,197,789            5,188,381
   Clinic and outpatient surgical                                       6,951,253            3,058,704
                                                                  ---------------      ---------------

      Total revenues, net                                              10,980,369            9,771,949

Costs and expenses:
   Direct costs of infusion therapy revenues                              408,074              263,983
   Compensation and benefits                                            1,840,573            2,360,433
   Contract payments to physicians                                      1,250,252            2,962,888
   Provision for uncollectible trade accounts                           2,240,258            1,269,066
   Provision for uncollectible notes                                      149,698              776,922
   Medical supplies                                                     1,051,194            1,283,112
   Depreciation and amortization                                          527,876              455,009
   Rent and occupancy                                                      81,858              185,978
   Other general and administrative expenses                            1,669,832            1,369,233
                                                                  ---------------      ---------------

      Total costs and expenses                                          9,219,615           10,926,624
                                                                  ---------------      ---------------

      Income (loss) from operations                                     1,760,754           (1,154,675)
                                                                  ---------------      ---------------

Other income (expense):
   Rent and other income                                                  195,359               23,847
   Interest income                                                         58,707               26,674
   Uncollectible  advances                                                     --             (371,736)
   Interest expense                                                      (132,562)            (117,395)
                                                                  ---------------      ---------------

      Total other income (expense)                                        121,504             (438,610)
                                                                  ---------------      ---------------

      Income (loss) before income taxes and minority interest           1,882,258           (1,593,285)

Provision (benefit) for income taxes                                      716,000             (573,000)
                                                                  ---------------      ---------------

      Net income (loss) before minority interest                        1,166,258           (1,020,285)

Minority interest in earnings                                            (220,415)             (38,910)
                                                                  ---------------      ---------------

      Net income (loss)                                           $       945,843      $    (1,059,195)
                                                                  ===============      ===============

Basic earnings (loss) per common share                            $          0.28      $         (0.30)
                                                                  ===============      ===============

Diluted earnings (loss) per common share                          $          0.27      $         (0.30)
                                                                  ===============      ===============

Weighted average common shares-basic                                    3,432,005            3,540,950
                                                                  ===============      ===============

Weighted average common shares-diluted                                  3,467,542            3,540,950
                                                                  ===============      ===============

</TABLE>



               The accompanying notes are an integral part of the
                       consolidated financial statements.
                                      F-4
<PAGE>   25



                                                     DYNACQ INTERNATIONAL, INC.
                     Consolidated Statements of Changes in Stockholders' Equity
                                   For the years ended August 31, 1998 and 1997
<TABLE>
<CAPTION>

-------------------------------------------------------------------------------------------------------
                                                                             Treasury Stock,           
                                            Common Stock                         at Cost               
                                      Shares           Amount            Shares          Amount        
                                    ----------      -----------      -----------      -----------      
<S>                                 <C>             <C>              <C>              <C>              
Balance, August 31, 1996            14,235,136      $    14,235           71,335      $   (57,322)     

Net loss                                    --               --               --               --      
                                    ----------      -----------      -----------      -----------      
Balance, August 31, 1997            14,235,136           14,235           71,335          (57,322)     
                                    ----------      -----------      -----------      -----------      
Restricted stock issued                191,280              191               --               --      

Four-for-one reverse
  stock split at par
   value                           (10,819,788)         (10,819)         (53,501)              --      

Treasury stock acquired                     --               --          308,205         (568,577)     

Net income                                  --               --               --               --      
                                    ----------      -----------      -----------      -----------      
Balance, August 31, 1998             3,606,628      $     3,607          326,039      $  (625,899)     
                                    ==========      ===========      ===========      ===========      



                                    Additional
                                      Paid-In        Retained
                                      Capital         Earnings          Total
                                    -----------     -----------      -----------
Balance, August 31, 1996            $ 3,452,130     $ 2,987,401      $ 6,396,444

Net loss                                     --      (1,059,195)      (1,059,195)
                                    -----------     -----------      -----------
Balance, August 31, 1997              3,452,130       1,928,206        5,337,249
                                    -----------     -----------      -----------
Restricted stock issued                  89,812              --           90,003

Four-for-one reverse
  stock split at par
   value                                 10,819              --               --

Treasury stock acquired                      --              --         (568,577)

Net income                                   --         945,843          945,843
                                    -----------     -----------      -----------
Balance, August 31, 1998            $ 3,552,761     $ 2,874,049      $ 5,804,518
                                    ===========     ===========      ===========
</TABLE>



               The accompanying notes are an integral part of the
                       consolidated financial statements.
                                      F-5
<PAGE>   26


                                                     DYNACQ INTERNATIONAL, INC.
                                           Consolidated Statements of Cash Flow
                                   For the Years Ended August 31, 1998 and 1997
<TABLE>
<CAPTION>

------------------------------------------------------------------------------------------------------------------------
                                                                                         1998             1997
                                                                                         ----             ----
<S>                                                                                  <C>              <C>         
Cash flows from operating activities:
Net income (loss)                                                                    $   945,843      $(1,059,195)

Adjustments to reconcile net income (loss) to net cash 
  provided by operating activities:
   Deprecation and amortization                                                          527,876          455,009
   Bad debt expense                                                                    2,240,258        1,269,066
   Provision for uncollectible notes                                                     149,698          776,922
   Uncollectible advances                                                                     --          371,736
   Deferred income taxes                                                                  61,000         (312,000)
   Minority interest                                                                     220,415           38,910
   Changes in operating assets and liabilities:
      Accounts receivable                                                             (1,781,297)      (1,273,671)
      Income tax receivable                                                              181,294         (181,294)
      Inventories                                                                          2,071           (2,332)
      Due from related party                                                                 944           28,357
      Accounts payable                                                                  (243,549)         231,914
      Accrued liabilities                                                               (470,827)         (78,140)
      Income taxes payable                                                               465,306         (252,110)
                                                                                     -----------      -----------

      Net cash provided by operating activities                                        2,299,032           13,172
                                                                                     -----------      -----------

Cash flows from investing activities:
   Purchases of property and equipment                                                  (535,512)        (234,474)
   Redemption of short-term investments                                                  159,638           (9,638)
   Decrease in other assets                                                               26,780           27,103
                                                                                     -----------      -----------

      Net cash used in investing activities                                             (349,094)        (217,009)
                                                                                     -----------      -----------

Cash flows from financing activities:
   Proceeds from long-term debt                                                               --          190,000
   Principal payments on long-term debt                                                 (227,070)        (278,399)
   Acquisition of treasury stock                                                        (113,577)              --
   Purchase of minority interests                                                        (38,377)              --
                                                                                     -----------      -----------

      Net cash used in financing activities                                             (379,024)         (88,399)
                                                                                     -----------      -----------

      Net increase (decrease) in cash and cash equivalents                             1,570,914         (292,236)

Cash and cash equivalents at beginning of year                                           842,343        1,134,579
                                                                                     -----------      -----------

Cash and cash equivalents at end of year                                             $ 2,413,257      $   842,343
                                                                                     ===========      ===========
</TABLE>



               The accompanying notes are an integral part of the
                       consolidated financial statements.
                                      F-6


<PAGE>   27


                                                     DYNACQ INTERNATIONAL, INC.
                                           Consolidated Statements of Cash Flow
                                   For the Years Ended August 31, 1998 and 1997
<TABLE>
<CAPTION>

-------------------------------------------------------------------------------------------------------------------------

                                                                                         1998            1997
                                                                                         ----            ----
<S>                                                                                  <C>              <C>        
Supplemental cash flow disclosures: 
   Cash paid during year for:
      Interest                                                                       $   126,220      $   106,849
      Income taxes                                                                   $     8,400      $   185,191
Noncash investing and financing activities:
      Property and equipment financed by note payable                                $        --      $    60,000
      Treasury stock acquisition financed by note payable                            $   455,000      $        --
   The Company purchased certain tangible and intangible assets for a
   consideration which included stock and the assumption of certain debts as
   follows:
      Fair value of assets acquired                                                  $   153,300      $        --
      Liabilities assumed                                                            $   (63,300)     $        --
      Stock issued in connection with acquisition                                    $   (90,000)     $        --
</TABLE>



               The accompanying notes are an integral part of the
                       consolidated financial statements.
                                      F-7
<PAGE>   28

                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 1.        CORPORATE ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
               POLICIES

A.       BUSINESS AND ORGANIZATION

         Dynacq International, Inc. (the "Company") is engaged in the business
         of providing home infusion health care services and supplies to
         patients in their homes, the operation of an outpatient surgery
         facility, the operation of a medical office complex, and the
         management of group physician practices, all located in the Houston
         metropolitan area.

         The Company was incorporated under the laws of the State of Utah on
         September 16, 1983, as Rujo, Inc. On January 14, 1987, the
         shareholders of the Company approved the change of name of the Company
         to Jackson Brothers Industries, Inc. The Company merged into a Nevada
         corporation of the same name on June 16, 1989, pursuant to a
         share-for-share exchange of stock. On January 12, 1992, the
         shareholders of the Company again approved a change of corporate name
         to Dynacq International, Inc., elected directors of the Company and
         approved a plan of recapitalization whereby authorized capital was
         increased to an aggregate of 55,000,000 shares of stock, comprised of
         50,000,000 Common Shares and 5,000,000 Preferred Shares.

         On July 28, 1992, the Company completed the sale of 2,812,500 shares
         of its "restricted" common stock to several investors for a total
         purchase price of $2 million. As part of this recapitalization of the
         Company, the authorized number of common shares was increased from 50
         to 300 million and three holders of "restricted" stock returned a
         total of 309,375 shares to the Company's treasury.

         In February 1993, the Company became the beneficial owners of all of
         the outstanding common stock of Lucky China International Limited, a
         Hong Kong-chartered corporation, whose corporation name has since been
         changed to Dynacq (Asia), Limited ("Asia"). There are two shares
         outstanding. One share is held in the name of the Company and the
         other share is held in the name of Mr. Kwong Chung Wai, as a nominee
         for the Company. On April 13, 1995, Mr. Wai accepted an appointment as
         Director of Asia. During 1995, Asia disposed of substantially all of
         its assets and ceased its operations.

         Effective March 8, 1993, the Company's shareholders approved a reverse
         split of the outstanding shares of the Company's common stock on the
         basis of one share for every eight shares outstanding, with the par
         value of each share remaining at $.001. The reverse split was
         recommended by the Board of Directors because of its belief that the
         pre-split per share price level adversely affected the marketability
         of the Company's common stock and that an increase in the per share
         price was important to qualify for a listing on the National
         Association of Securities Dealer, Inc. Automated Quotation System
         (NASDAQ). In September 1993, the Company's common stock received its
         listing and began trading on the NASDAQ Small Cap system under the
         symbol DYII.

         In August 1994, the Company consummated the acquisition of
         approximately 65% of the outstanding stock of Vista Healthcare, Inc.
         ("Vista"), which operates a medical clinic and outpatient surgical
         center in Pasadena, Texas. The Company issued 179,093 shares of its
         common stock in a transaction valued at $1,289,461. This acquisition,
         which was accounted for as a purchase, resulted in the recording of
         excess costs over net assets acquired totaling $230,717. In 1994, the
         Company commenced construction of a new medical office building
         (adjacent to the Vista facility) which was completed in 1995 at a
         total cost of approximately $1,925,000. Several of the existing
         physician-minority shareholders of Vista have relocated their offices
         to the new facility.

         In September 1994, the Company formed Doctors Practice Management,
         Inc. ("DPMI") to provide fee based practice management services to
         physicians and to assist in consolidating medical providers into
         integrated delivery systems.


                                      F-8



<PAGE>   29


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 1.        CORPORATE ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING 
               POLICIES (CONTINUED)

         In May 1998, DPMI organized Vista Community Medical Center, L.L.C.
         ("Vista Medical"), a Texas limited liability company, for the purpose
         of operating a General Acute Hospital (the "Hospital"). The Hospital
         is presently under construction and is located adjacent to the Vista
         medical clinic and outpatient surgical center in Pasadena, Texas. On
         July 1, 1998, DPMI executed a subscription agreement for a 70%
         membership interest in Vista Medical.

         In November 1997, Aso Medical, Inc. ("ASO") was formed as a wholly
         owned subsidiary of DPMI to provide billing and related services to
         physicians. ASO's operations were insignificant during 1998.

         Effective January 15, 1998, the Company's shareholders approved a
         reverse split of the outstanding shares of the Company's Common Stock
         on the basis of one share for every four shares outstanding, with the
         par value of each share remaining at $.001. The reverse split was
         recommended by the Board of Directors because of its belief that the
         post-split per share price will enhance the acceptability and
         marketability of the Company's common stock by the financial community
         and investing public. Additionally, management believed that the
         reverse split would result in the Company's common stock having a
         minimum bid price in excess of $1.00 per share and would, therefore,
         enable the Company to maintain the listing of its common stock on the
         Nasdaq SmallCap Market.

B.       CONSOLIDATED STATEMENTS

         The accompanying financial statements present the consolidated
         accounts of Dynacq International, Inc., a Nevada corporation, and its
         wholly owned and majority owned subsidiaries. Accordingly, the
         consolidated financial statements include all of the assets,
         liabilities, income, expenses, and cash flows for these companies. All
         significant intercompany transactions and balances have been
         eliminated. In addition, all references in the consolidated financial
         statements and related footnotes to number of shares, except shares
         authorized, per share amounts, stock option data and market prices of
         the Company's common stock have been restated to reflect the
         four-for-one reverse stock split approved by the Company's
         shareholders effective February 10, 1998.

C.       REVENUE RECOGNITION

         The Company recognizes revenue from the performance of medical
         services in the period in which such services are provided.
         Substantially all of the Company's revenues are derived from claims
         filed under major medical policies, workers' compensation policies,
         Medicare or Medicaid, or personal injury claims. Allowances for
         discounts on services or adjustments for non-covered costs and
         expenses are recognized in the period in which the related revenues
         are earned. Allowances for doubtful accounts are determined by
         management based upon historical experience and an assessment of the
         circumstances applicable to individual accounts.

D.       STOCK-BASED COMPENSATION

         The Company accounts for employee stock options under the provisions
         APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25)
         and has adopted the "disclosure only" alternative described in
         Statement of Financial Accounting Standards No. 123, "Accounting for
         the Stock-Based Compensation" ("SFAS 123"), which requires proforma
         disclosure of compensation expense using fair value based method of
         accounting for stock-based compensation plans.


                                      F-9
<PAGE>   30


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 1.        CORPORATE ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING 
               POLICIES (CONTINUED)

E.       CASH AND CASH EQUIVALENTS

         The Company considers all highly liquid investments with maturity of
         three months or less as cash equivalents. At August 31, 1998, cash
         equivalents were composed primarily of investments in money market
         funds and certificates of deposits.

F.       RESTRICTED SHORT-TERM INVESTMENTS

         In connection with the Company's Pledge-Security Agreement with a
         financial institution (Note 10), the Company has restricted and
         pledged as collateral one of its highly liquid interest bearing
         deposits, with a maturity of one year. The short-term investment is
         being held to maturity and its carrying value approximates its current
         value.

G.       INVENTORIES

         Inventories are valued at the lower of cost or market with
         substantially all stated at the first-in, first-out (FIFO) method.

H.       PROPERTY AND EQUIPMENT

         Land, buildings and improvements, furniture, fixtures and equipment
         are stated at cost. Ordinary maintenance and repairs are charged to
         income as incurred. Expenditures which extend the physical or economic
         life of the assets are capitalized and depreciated. Gains or losses on
         the disposition of assets sold are recognized in income and the
         related asset and accumulated depreciation accounts are adjusted
         accordingly.

         Construction in progress represents the cost of material purchases and
         construction costs, including interest capitalized, if applicable,
         during construction, for a General Acute Hospital to be located
         adjacent to the Vista facility in Pasadena, Texas. During 1998,
         capitalized interest was insignificant.

         Depreciation is computed using the straight-line method over the
         estimated useful lives of the assets ranging from 3 to 39 years. No
         depreciation is recorded on construction in progress until the asset
         is placed in service. The Company provides tax depreciation using
         various accelerated methods in conformity with the provisions of
         applicable tax law.

I.       OTHER NON-CURRENT ASSETS

         Excess costs over net assets acquired from the Vista acquisition are
         amortized on a straight-line basis over a period of 14 years. Loan
         origination fees are amortized on a straight-line basis over the terms
         of the related debt.

J.       IMPAIRMENT OF LONG-LIVED ASSETS

         The Company reviews its property and equipment and unamortized
         intangible assets whenever events or changes in circumstances indicate
         that the carrying amount may not be recoverable. The Company estimates
         the future cash flows expected to result from operations and if the
         sum of the expected undiscounted future cash flows is less than the
         carrying amount of the long-lived asset, the Company recognizes an
         impairment loss by reducing the unamortized cost of the long-lived
         asset to its estimated fair value. To date the Company has not
         recognized any significant impairment on long-lived assets.


                                      F-10
<PAGE>   31


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 1.        CORPORATE ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING 
               POLICIES (CONTINUED)

K.       ADVERTISING COSTS

         The Company expenses advertising costs as incurred. Amounts expended
         for the years ended August 31, 1998 and 1997, were approximately
         $293,500 and $51,000, respectively.

L.       INCOME TAXES

         The Company utilized Statement of Financial Accounting Standards No.
         109, Accounting for Income Taxes (SFAS 109), which requires that
         deferred tax liabilities or assets be recognized for differences
         between the income tax basis and the financial reporting basis of
         assets and liabilities and are measured using the enacted marginal tax
         rates currently in effect when the differences reverse. The Company's
         principal differences giving rise to deferred income taxes are
         accounts receivable, reserve for bad debts, accounts payable, accrued
         liabilities, and accumulated depreciation. The deferred tax assets and
         liabilities represent the future tax return consequences of those
         differences, which will either be taxable or deductible when the
         assets and liabilities are recovered or settled. Deferred taxes also
         are recognized for operating losses that are available to offset
         future taxable income.

M.       EARNINGS PER COMMON SHARE
 
         Earning per common share for the years ended August 31, 1998 and 1997,
         are presented in accordance with the provisions of Statement of
         Financial Accounting Standards No. 128 Earnings Per Share (SFAS 128).
         SFAS 128 replaced the presentation of primary and fully diluted
         earnings per share (EPS), with a presentation of basic EPS and diluted
         EPS. Under SFAS 128, basic EPS excludes dilution for common stock
         equivalents and is computed by dividing income or loss available to
         common shareholders by the weighted average number of common shares
         outstanding during the period. Diluted EPS reflects the potential
         dilution that could occur if securities or other contracts to issue
         common stock were exercised or converted into common stock. For the
         year ended August 31, 1998, diluted common and common equivalent
         shares outstanding includes 35,537 of common share equivalents,
         consisting of stock options, determined under the treasury stock
         method. Common equivalent shares, consisting of stock options, are
         excluded from the diluted loss per share computation for fiscal 1997
         because the effect would be antidilutive.

N.       ESTIMATES

         In preparing financial statements in conformity with generally
         accepted accounting principles, management is required to make
         estimates and assumptions that effect the reported amounts of assets
         and liabilities and the disclosure of contingent assets and
         liabilities at the date of the balance sheet. Actual results could
         differ from those estimates.

         Accounts receivable and revenues in the health care industry are
         subject to possible third party payor adjustments. Management
         periodically reviews such estimates and it is reasonably possible that
         management's assessment of recoverability of accounts receivable may
         change based on actual results and other factors.


                                     F-11

<PAGE>   32


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 1.        CORPORATE ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING 
               POLICIES (CONTINUED)

O.       PROSPECTIVE ACCOUNTING CHANGES

         The Financial Accounting Standards Board (FASB) has issued SFAS No.
         130, Reporting Comprehensive Income, which establishes standards for
         reporting and display of comprehensive income and its components in a
         full set of general-purpose financial statements and SFAS No. 131,
         Disclosures about Segments of an Enterprise and Related Information,
         which requires that public business enterprises report certain
         information about operating segments in complete sets of financial
         statements of the enterprise and in condensed financial statements
         report certain information about their products and services, the
         geographic area in which they operate, and their major customers. The
         Company is not required to adopt and does not currently plan to adopt
         SFAS No. 130 or SFAS No. 131 until its fiscal year ending August 31,
         1999. The Company does not expect any significant disclosures will be
         necessary when SFAS No. 130 or SFAS No. 131 are adopted.


NOTE 2.  VISTA HEALTHCARE, INC.

         On August 25, 1994, the Company completed the acquisition of
         approximately 65% of the common stock of Vista in a transaction
         accounted for as a purchase. Accordingly, the accompanying financial
         statements reflect the results of operations of Vista for the period
         subsequent to August 25, 1994. During 1995, the Company sold a portion
         of its investment in Vista to certain affiliates for $80,000 cash.
         During 1996, Vista repurchased a portion of its common stock from
         certain affiliates for $134,958 and resold $20,000 of this stock to an
         affiliated Physician. During 1997, the remaining treasury stock was
         sold to the Company at Vista's cost of $114,958. During 1998, the
         Company purchased 1.45% of the common stock of Vista for $11,600 cash.
         Net assets purchased in excess of costs incurred have been included in
         consolidated operations. As of August 31, 1998, the Company owned
         approximately 68% of the outstanding common stock of Vista.

NOTE 3.  PROPERTY AND EQUIPMENT

<TABLE>
<CAPTION>

At August 31, 1998, property and equipment consisted of the following:

<S>                                                        <C>        
                   Land                                    $   252,589
                   Buildings and improvements                4,423,932
                   Construction in progress                    395,911
                   Furniture and fixtures                      142,663
                   Equipment                                 2,276,560
                   Automobile                                   24,125
                                                           -----------
                                                             7,515,780

                   Less, accumulated depreciation           (2,302,939)

                   Net property and equipment              $ 5,212,841
                                                           ===========
</TABLE>

Vista's existing physical facility is pledged as collateral on a long-term
mortgage to a financing company in the amount of $788,472 as of August 31,
1998. In connection with its 1994 acquisition of approximately 65% interest in
Vista, the Company has guaranteed 65% of the outstanding balance of this
long-term mortgage.

For the years ended August 31, 1998 and 1997, depreciation expense was $449,728
and $433,954, respectively.


                                     F-12
<PAGE>   33


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 4.   OTHER NON-CURRENT ASSETS

In connection with the acquisition of Vista, excess costs over net assets
acquired totaling $230,717 was incurred. This amount is being amortized over a
period of fourteen years on a straight-line basis beginning August 25, 1994.
For the years ended August 31, 1998 and 1997, amortization expense was $16,480
for each period.

NOTE 5.   NOTES PAYABLE

Notes payable consists of a 6.50% short-term note due to a physician group for
which the Company provides management services.

NOTE 6.   LONG-TERM DEBT

<TABLE>
<CAPTION>

At August 31, 1998, long-term debt consisted of the following:

<S>                                                                                  <C>
                     Note payable to a former shareholder, payable in
                     monthly installments of $10,007, including interest
                     at 11.50%, through December 2002, uncollateralized.             $   408,284

                     Note payable to a financing company payable in
                     monthly installments of $19,533, including interest
                     at 9.65%, through September 2002, collateralized by
                     land and guaranteed by certain minority
                     stockholders of Vista.                                              788,472
                                                                                     -----------
                                                                                       1,196,756

                     Less, current maturities                                          (242,612)
                                                                                     ---------- 

                                                                                     $   954,144
                                                                                     ===========
</TABLE>

The aggregate principal payments on long-term debt subsequent to August 31,
1998, are as follows:

<TABLE>
<CAPTION>

         Year ending August 31,
<S>           <C>                       <C>       
              1999                      $  242,612
              2000                         268,657
              2001                         297,522
              2002                         329,512
            Thereafter                      58,453
                                        ----------

     Total                              $1,196,756
                                        ==========
</TABLE>


                                     F-13
<PAGE>   34


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 7.   INCOME TAXES

The provision for income tax expense (benefit) consisted of the following at
August 31:

<TABLE>
<CAPTION>

                                                    1998           1997
                                                    ----           ----
<S>                                              <C>            <C>       
         Current tax expense (benefit):
                     Federal                     $ 604,000      $(261,000)
                     State                          51,000             --
                                                 ---------      ---------
                     Total current                 655,000       (261,000)
         Deferred tax expense (benefit):
                     Federal                        61,000       (312,000)
                                                 ---------      ---------

         Total                                   $ 716,000      $(573,000)
                                                 =========      =========
</TABLE>

Deferred taxes arise primarily due to the Company's filing of its income tax
return on a cash basis, the use of accelerated methods of computing
depreciation for tax purposes, and the use of the specific charge-off method
for tax reporting. The components of the provision (benefit) for deferred
income taxes, at August 31, were as follows:

<TABLE>
<CAPTION>

                                                    1998           1997
                                                    ----           ----
<S>                                              <C>            <C>      
         Applicable to:
         Cash basis of accounting for
         federal income tax purposes.            $ 819,000      $ 124,500

         Difference in methods of
         computing depreciation for tax
         and financial reporting purposes
         and other.                                 19,000         (7,500)

         Use of reserve for bad debts for
         financial reporting and specific
         charge-off method for tax reporting.     (785,000)      (410,000)

         Other                                       8,000        (19,000)
                                                 ---------      ---------

                                                 $  61,000      $(312,000)
                                                 =========      =========
</TABLE>

Significant components of the Company's deferred tax liabilities and assets, at
August 31, 1998, were as follows:

<TABLE>
<CAPTION>

                                                   Current       Noncurrent
                                                   -------       ----------
<S>                                              <C>            <C>         
         Deferred tax liabilities:
            Basis in property and equipment      $        --    $  (133,000)
            Receivables                           (2,125,000)            --
         Deferred tax assets:
            Payables and other                       154,000             --
            Reserve for bad debts                  1,786,000             --
            Other                                     (1,000)            --
                                                 -----------    -----------

         Net liability                           $  (186,000)   $  (133,000)
                                                 ===========    ===========
</TABLE>


                                     F-14

<PAGE>   35


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------

NOTE 7.   INCOME TAXES (CONTINUED)

The following table reconciles the Federal statutory income tax rate and the
Company's effective income tax rate:

<TABLE>
<CAPTION>

                                            1998      1997
                                            ----      ----
<S>                                         <C>       <C>  
    Provision for income taxes at federal
    statutory rate                          34.0%     34.0%
    State tax provision, net of federal
    benefits                                 2.7        --

    Other differences                        1.3       2.0
                                            ----      ----

    Effective tax rate                      38.0%     36.0%
                                            ====      ====
</TABLE>

NOTE 8.   RELATED PARTY TRANSACTIONS

The Company leases to its President his personal residence at a monthly rate of
$1,400. Total rent income for the years ended August 31, 1998 and 1997, was
$16,800 for each year. The amount due for rent for the year ended August 31,
1998 is included in current assets as due from related party.

Due to the legislative requirements concerning the practice of medicine in the
state of Texas, the Company has entered into agreements with various
Professional Associations and individual doctors (the "Physicians") for the
services of physicians.

The Physicians provide services to third parties and after covering the costs
associated with the Physicians, remit proceeds to the Company for management
services. The structure of the agreements between the Company for its clinic
and the Physicians require that all income be paid to the Company for
management services or to the physicians for compensation. The accompanying
financial statements reflect transactions with the Physicians on a basis as if
the Company and Physicians were "combined" or "consolidated" as revenues
reflect all clinic revenues billed to patients and expenses reflect
compensation incurred to the Physicians.

While the Company intends to maintain its management services to physicians,
its primary focus will be on increasing the patient volume and profitability of
the Vista clinic and outpatient surgical center.

NOTE 9.   CAPITAL STOCK

Pursuant to an Asset Purchase Agreement dated October 22, 1997, the Company
issued 45,000 shares of restricted common stock valued at $90,000. This
issuance was valued at fair market value based upon management's estimation of
the open market closing price. In exchange for the restricted common stock, the
Company assumed liabilities of $63,300 and received tangible and intangible
property with a fair value of $153,300. In addition to the restricted common
shares, the Company granted a two-year option to purchase an additional 37,500
restricted shares of common stock at $2.00 per share. Through August 31, 1998,
no shares were issued under the option agreement which expires October 22,
1999.

On February 26, 1998, the Company agreed to buy back 287,500 shares of common
stock for $517,500 or $1.80 per share. A cash payment of $62,500 was made, and
the balance of $455,000 is to be repaid pursuant to an unsecured promissory
note in sixty (60) monthly installments of $10,007 each including accrued
interest at an annual interest rate of 11.50%.


                                     F-15

<PAGE>   36


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
--------------------------------------------------------------------------------


NOTE 9.   CAPITAL STOCK (CONTINUED)

STOCK OPTIONS

Effective August 1, 1995, the Board of Directors approved and reserved 250,000
shares of its common stock for a 1995 Non-Qualified Stock Option Plan for
consultants and non-employee directors. Under the terms of the Plan, the
Company may grant stock options in the Company's common stock to consultants
and non-employee directors of the Company and its subsidiaries at no less than
the fair market value of the stock at the date of grant. Under the Plan, the
options become exercisable no earlier than six (6) months from date of grant
and expire on the date of the consultant's termination or the non-employee
directors' resignation. During 1996, the Company granted 43,750 options, all of
which are exercisable, at exercise prices per share ranging from $5.00 to
$6.50. There were no options granted, exercised, forfeited, or expired during
the year ended August 31, 1998.

Effective August 31, 1995, the Company's shareholders approved a 1995 Incentive
Stock Option Plan. The 1995 Incentive Stock Option Plan reserves 250,000 shares
of the Company's common stock for option grants to key employees at no less
than the fair market value of the stock at the date of grant. Under the Plan,
the options generally become exercisable cumulatively, beginning one year after
the date granted. During 1996, the Company reserved 68,882 shares for option
grants at an exercise price of $3.76. The share options outstanding became
exercisable in fiscal 1997, and expire through fiscal 2001. During 1998, the
Company reserved 106,250 shares for option grants at an exercise price of
$1.375. The share options outstanding become exercisable in fiscal 1999, and
expire through fiscal 2003. There were no options exercised, forfeited, or
expired during the year ended August 31, 1998.

The Company has not recorded compensation expense pursuant to the grants of its
options under APB 25. Had the Company determined compensation cost based on the
fair value at the grant date for its stock options under SFAS 123, the
Company's net earnings and net earnings per common share would not be
materially different than those reported in the accompanying consolidated
financial statements.

NOTE 10.  COMMITMENTS AND CONTINGENCIES

PLEDGE-SECURITY AGREEMENT

In connection with the acquisition of Vista on August 25, 1994, the Company
issued 179,093 shares of its common stock in exchange for approximately 65% of
the outstanding common stock of Vista owned by approximately 30 individual
stockholders and/or related entities. Simultaneous with the closing of this
acquisition, fifteen of the Vista stockholders pledged a total of 103,820
shares of the Company's stock to a local bank as collateral for individual
loans aggregating $730,000. The proceeds from these loans were contributed to
the capital of Vista.

The Company entered into a Pledge-Security Agreement with the lending bank
whereby the Company has granted the bank a limited security interest in, and
has pledged certain cash funds contained in the Company's account at the bank.
The Company's liability is limited to the shortfall, if any, calculated by
taking the difference between (1) 130% of the dollar amount of the outstanding
loan balance (including principal and interest) attributed to a particular
Vista shareholder and (2) the value of the Company's shares pledged by that
Vista shareholder, such value to be based upon the quoted value of shares of
the Company's common stock as published by NASDAQ. The dollar amount of the
bank's security interest in funds on deposit will be adjusted upward or
downward every 90 days.

Upon default by one of the Vista shareholders in payment on his/her loan, the
bank has the option to exercise a right of offset with respect to the funds on
deposit or proceed to foreclose upon its security interest, but only to the
extent, if any, of a shortfall as described above.


                                      F-16

<PAGE>   37


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
-------------------------------------------------------------------------------

NOTE 10.  COMMITMENTS AND CONTINGENCIES (CONTINUED)

As of August 31, 1998, total Company shares pledged as collateral was 16,241
for individual loans aggregating $29,047. As of November 30, 1998, the value of
the Company's stock, as defined above, was approximately $2,000 more than 130%
of the aggregate balance of the remaining loans to these individuals. To the
best of management's knowledge, all of the individual loans were current and
the bank has not advised the Company that any of the loans were in default.

LEASES

The Company leases certain of its facilities and equipment under operating
leases with net aggregate future lease payments of $19,800 at August 31, 1998,
payable as follows:

<TABLE>
<CAPTION>

        Year ending August 31,
<S>           <C>             <C>    
              1999            $ 7,200
              2000              7,200
              2001              5,400
                              -------

        Total                 $19,800
                              =======
</TABLE>

Rent expense related to its facilities and equipment leases, for the years
ended August 31, 1998 and 1997, was $8,438 and $19,521, respectively.

The Company also leases corporate office space under an operating lease on a
month-to-month basis. Rent expense for its corporate leases was $15,432 for
each of the years ended August 31, 1998 and 1997.

In addition, the Company pays certain operating leases on behalf of the
physicians being managed by Doctors Practice Management, Inc. For the years
ended August 31, 1998 and 1997, total physicians' operating lease expenses were
$57,990 and $151,025, respectively.

Total rent expenses, including those physicians' operating leases paid by the
Company, for the years ended August 31, 1998 and 1997, was approximately
$81,860 and $186,000, respectively.

CONSTRUCTION

The Company has commitments for the construction of a fully licensed and
certified General Acute Hospital (the "Hospital") which will be adjacent to the
Vista facility in Pasadena, Texas. Total costs associated with the construction
and furnishing of the Hospital are expected to be approximately $3,650,000. The
Hospital is expected to be operational in February 1999.

LITIGATION

In March 1997, the Company filed a civil lawsuit against one of the Physicians
for which the Company provided management services, seeking repayment of
advances of $110,000 owed to the Company pursuant to a Revolving Credit
Agreement and Security Agreement executed between the parties in July of 1996.
In April 1997, the Physician filed a counterclaim against the Company and the
Company's president seeking alleged damages in excess of $500,000. In May 1997,
the Company and the Company's president filed a response denying allegations
made in the counterclaim. In November 1998, the matter was tried and resulted
in a $200,000 judgement favorable to the Company. All claims against the
Company were resolved and dismissed. In the opinion of management, the
Company's allowance for doubtful accounts, which was provided to cover any
potential loss in 1997, is still appropriate as collection of the judgement, if
any, is uncertain at this time.


                                      F-17

<PAGE>   38


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
-------------------------------------------------------------------------------

NOTE 10.  COMMITMENTS AND CONTINGENCIES (CONTINUED)

In October 1998, the Company filed a civil lawsuit claiming breach of contract
of the Asset Purchase Agreement dated October 22, 1997 (Note 9). On October 29,
1998, a Compromise, Settlement and Mutual Release Agreement was entered into
whereby the Company agreed to pay $118,000 in exchange for the return of 45,000
shares of restricted common stock, the cancellation of the option to acquire
37,500 restricted shares of common stock and the transfer of approximately
$57,849 of the original $63,300 of liabilities assumed. The settlement's effect
on the Company is the purchase, subsequent to August 31, 1998, of 45,000
treasury shares for approximately $60,200.

The Company is subject to legal proceedings and claims which arise in the
ordinary course of its business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not materially affect the
financial position of the Company.

OTHER RISKS

The Company maintains insurance for worker's compensation, automobile, general
liability, property loss, and medical malpractice claims. Management does not
believe the Company's exposure to medical malpractice is significant, and is
not aware of any pending or potential claims against the Company.

NOTE 11.  SUPPLEMENTARY INFORMATION

At August 31, 1998, the detail of certain balance sheet accounts was as
follows:

<TABLE>
<CAPTION>


         Accounts receivable:
<S>                                                             <C>        
            Trade                                               $ 6,070,615
            Other                                                   182,139
                                                                -----------
                                                                  6,252,754

         Less, allowance for doubtful accounts                   (4,587,405)
                                                                -----------
                                                                $ 1,665,349
                                                                ===========
         Other assets:
            Excess costs over net assets acquired,
               net of accumulated amortization of $66,191       $   164,526
            Note receivable, net of allowance
               of $616,922                                               --
            Other                                                    80,619
                                                                -----------

                                                                $   245,145
                                                                ===========
         Accrued liabilities:
            Compensation to Physicians                          $   128,050
            Interest expense                                         50,482
            Wages and payroll taxes                                  32,860
            Ad valorem taxes                                         42,113
            Other                                                    57,849
                                                                -----------

                                                                $   311,354
                                                                ===========
</TABLE>


                                     F-18
<PAGE>   39


                                                      DYNACQ INTERNATIONAL, INC.
                                      Notes to Consolidated Financial Statements
-------------------------------------------------------------------------------


NOTE 12.  CONCENTRATIONS OF CREDIT RISK AND FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company has financial instruments which are exposed to concentrations of
credit risk; they consist primarily of cash investments and trade accounts
receivable. The Company routinely maintains cash and temporary cash investments
at certain financial institutions in amounts substantially in excess of FDIC
insurance limits; however, management believes that these financial
institutions are of high quality and the risk of loss is minimal. As is
customary in the health care business, the Company has trade accounts
receivable from various private insurers, and the balance due from a particular
insurer at any point in time may be in excess of the allowance for doubtful
accounts. The Company does not request collateral from its customers and
continually monitors its exposure for credit losses and maintains allowances
for anticipated losses. The trade receivables from private insurers is normally
in excess of 90% of the total trade receivables at any point in time.

The carrying amounts of cash and cash equivalents, short-term investments,
receivables, notes payable and accounts payable approximate fair value due to
the short-term maturities of these instruments. The carrying amounts of the
Company's long-term borrowings, at August 31, 1998, approximate their fair
value.



                                     F-19
<PAGE>   40
                               INDEX TO EXHIBITS

All Exhibits listed below are incorporated by reference and are included
herewith unless otherwise noted by asterisk(s) next to the Exhibit No.

(2.1.)*      Stock Sale Agreement, dated July 21, 1992, pertaining to a change
             in control of Dynacq International, Inc. (the "Company") which was
             previously filed in and is incorporated herein by this reference
             to, the Company's Registration Statement on Form 10, No. 0-20554.

(2.2.)*      Exchange Agreement by and among the Company, Vista Healthcare,
             Inc. ("Vista") and certain Vista shareholders which was previously
             filed in, and is incorporated by this reference to, the Company's
             Current Report on Form 8-K, dated August 4, 1994.

(3.0)*       Articles of Incorporation, filed June 16, 1989, which were
             previously filed in, and are hereby incorporated by reference to
             the Company's Registration Statement on Form 10, No. 0-20554.

(3.1.)*      Amendment to Articles of Incorporation, filed February 12, 1992,
             which was previously filed in, and is hereby incorporated by
             reference to, the Company's Registration Statement on Form 10, No.
             0-20554.

(3.2.)*      Amendment to Articles of Incorporation, filed July 20, 1992, which
             was previously filed in, and is hereby incorporated by reference
             to, the Company's Registration Statement on Form 10, No. 0-20554.

(3.3.)       Amendment to Articles of Incorporation filed February 10, 1998.

(3.4.)*      Bylaws (amended August 1, 1995) which were previously filed in and
             are hereby incorporated by reference to the Company's Amended Form
             10-K for fiscal 1995 dated May 1, 1996, File No. 0-20554.

(10.1.)*     Pledge-Security Agreement between the Company and Capital Bank
             dated July 20, 1994, which was previously filed in and
             incorporated by this reference to, the Company's current Report on
             Form 8-K, dated August 4, 1994, No. 0-20554.

(10.2.)*     Guaranty Agreement between the Company and Metlife Capital
             Corporation dated July, 1994, which was previously filed in and is
             hereby incorporated by reference to, the Company's Annual Report
             on Form 10-K for the fiscal year ended August 31, 1993.

(10.3.)**    Security Agreement dated July 18, 1996, between Vista and Capital
             Bank.

(10.4.)**    1995 Incentive Stock Option Plan for Employees and Employee
             Directors

(10.5.)**    1995 Non-Qualified Stock Option Plan for Consultants and
             Non-Employee Directors.

(10.6.)**    1995 Stock Option Agreement between the Company and Philip S.
             Chan.


(10.7.)**    Full Service Facility and Management Agreement between DPMI and
             JCW Medical Associates, P.A. dated May 1, 1996.


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<PAGE>   41


(10.8.)**    Full Service Management Agreement between DPMI and Ping S. Chu,
             M.D., dated March 1, 1996.

(10.9.)**    Promissory Note dated November 15, 1996, from JCW Medical
             Associates, P.A. payable to the Company in the principal amount of
             $666,922.22, bearing interest at 8% per annum and payable in 180
             monthly installments.

(10.10.)**   Security Agreement dated May 1, 1996, by JCW Medical Associates,
             P.A. to DPMI.

(10.11.)**   Credit Agreement dated May 1, 1996, between JCW Medical
             Associates, P.A. and DPMI.

(10.12.)**   Revolving Credit Note from JCW Medical Associates, P.A. to DPMI
             dated April 1, 1996 for $675,000.

(10.13.)**   Credit Agreement dated April 1, 1996, between R.S. Arora, M.D., as
             Borrower, to DPMI as Lender, for advances up to $100,000.

(10.14.)**   Security Agreement dated April 1, 1996, by R.S. Arora M.D. as
             Grantor to DPMI as Lender.

(10.15.)**   Revolving Credit Note dated April 1, 1996, in the principal amount
             of $100,000 from R.S. Arora, M.D. to DPMI.

(10.16.)**   $100,000 Revolving Credit Note dated July 1, 1996, from Houston
             Physical Medicine Associates, M.D., P.A. to DPMI.

(10.17.)**   Credit Agreement dated July 1, 1996, between Houston Physical
             Medicine Associates, M.D., P.A. and DPMI

(10.18.)***  Full Service Facility and Management Agreement dated October 1,
             1996 by and between Milton Kirkwood, D.O. and DPMI.

(10.19.)***  Asset Purchase Agreement and Bill of Sale dated October 22, 1997
             by and between Medtek Management, Inc. and DPMI.

(10.20.)***  Asset Purchase Agreement dated November 13, 1997 by and among
             DPMI, Kirkwood Medical Associates, P.A., Milton E. Kirkwood, D.O.,
             Ron Kirkwood, D.O., and John Kirkwood, D.O.

(10.21.)***  Lease Agreement effective July 1, 1996 by and between DPMI as
             Tenant and the City of Pasadena as Landlord relating to 3,000
             square feet of office space in Pasadena, Texas.

(10.22.)***  Lease Agreement dated November 1, 1997 by and between DPMI as
             Landlord and Kirkwood Medical Associates as Tenant relating to
             approximately 9,200 square feet of office space located at 4301A
             Vista Road, Pasadena, Texas.

(10.23.)***  Amendment No. 1 effective September 1, 1996 to the Full Service
             Management Agreement between DPMI and Ping S. Chu, M.D. dated
             March 1, 1996.

(10.24.)***  Amendment No. 1 effective September 1, 1996 to Full Service
             Facility and Management Agreement between DPMI and JCW Medical
             Associates, P.A. dated May 1, 1996.


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<PAGE>   42


(10.25.)***  $60,000.00 Promissory Note dated November 30, 1996, of the
             Company, payable to JCW Medical Associates, P.A.

(10.26.)***  $190,000.00 Promissory Note dated January 31, 1997, of DPMI,
             payable to JCW Medical Associates, P.A.

(10.27.)     Stock Option Agreement for Philip Chan dated effective December
             18, 1997.

(10.28.)     Stock Option Agreement for Glenn Rodriguez dated effective
             December 18, 1997.

(10.29.)     Letter Agreement regarding pharmaceutical services between Vista
             and the Company dated effective September 1, 1998.

(10.30.)     Office/Surgical Care Center Lease Agreement dated September 1,
             1998, between the Company as Landlord and Vista as Tenant.

(10.31.)     Management Support and Marketing Agreement dated October 1, 1998,
             by and between DPMI and Ultramed, L.C.

(10.32.)     Full Service Management Agreement dated October 1, 1998, by and
             between DPMI and Vista

(10.33.)     Real Estate Lien Note dated September 1, 1998, in the principal
             amount of $1,400,000.00 from the Company to Vista.

(10.34.)     Warranty Deed with Vendor's Lien from Vista to the Company dated
             September 1, 1998, relating to 4.5799 acres of land in Pasadena,
             Texas.

(10.35.)     Deed of Trust dated September 1, 1998 from the Company regarding
             4.5799 acres of land in Pasadena, Texas.

(10.36.)     AIA Construction Contract dated April 13, 1998, by and between the
             Company and Beck Ford Construction, Inc. for construction of the
             Hospital for approximately $2,500,000.

(21.0)       Listing of subsidiaries of the Company

(27.)        Financial Data Schedule.

--------------------------

**       All Exhibits denoted with double asterisks were filed with the
         Company's Annual Report on Form 10-K for the fiscal year ended August
         31, 1996, Commission File No. 0-20554.

***      All Exhibits denoted with triple asterisks were filed with the
         Company's Annual Report on Form 10-K for the fiscal year ended August
         31, 1997, Commission File No. 0-20554.


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