**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


________________________





**FORM
      10-K**





**FOR
      ANNUAL AND TRANSITION REPORTS**


**PURSUANT
      TO SECTIONS 13 OR 15(d) OF THE**


**SECURITIES
      EXCHANGE ACT OF 1934**


(Mark
      One)





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





For
      the
      fiscal year ended June 30, 2006





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





For
      the
      transition period from ________ to
      ________





Commission
      file number 1-31943





Criticare
                Systems, Inc.(Exact
                Name of Registrant as Specified in Its
                Charter)





Delaware
            
            39-1501563(State
                or Other Jurisdiction of
              Incorporation
                or Organization)
            
            (I.R.S.
                Employer Identification No.)





20925 Crossroads
                Circle, Suite 100, Waukesha, Wisconsin
            
            53186(Address
                of Principal Executive Offices)
            
            (Zip
                Code)





Registrant's
      telephone number, including area code: 262-798-8282





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





Title
                of Each Class
            Name
                  of Each Exchange onWhich RegisteredVoting
                Common Stock, $.04 par value (together with
              associatedPreferred
                Stock Purchase Rights)
            American
                Stock Exchange






Securities
        registered pursuant to Section 12(g) of the Act:
 
 None







Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.


Yes
      [   ]    No [ X ]





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act.


Yes
      [   ]    No [ X ]





Indicate
      by check mark whether the registrant: (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.  Yes [ X ]    No [ 
 ]





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





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of "accelerated
      filer and large accelerated filer" in Exchange Act Rule 12b-2. (Check
      one)


Large
      accelerated filer [   ]  Accelerated
      filer [   ]  Non-accelerated
      filer [ X ]





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


Yes
      [   ]    No [ X ]





The
      aggregate market value of the voting common stock held by nonaffiliates of
      the
      registrant as of December 30, 2005 (the last business day of the registrant’s
      most recently completed second fiscal quarter) was $57,552,011. Shares of voting
      common stock held as of December 30, 2005 by any person who was an executive
      officer or director of the Registrant as of December 30, 2005 and any person
      who
      beneficially owned 10% or more of the outstanding voting common stock as of
      December 30, 2005 have been excluded from this computation because such persons
      may be deemed to be affiliates. This determination of affiliate status is not
      a
      conclusive determination for other purposes.





On
      August
      31, 2006, there were 12,293,668 shares of the registrant's $.04 par value voting
      common stock outstanding.





2


DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the Proxy Statement for the Annual Meeting of the Stockholders of the
      Registrant to be held November 30, 2006 are incorporated by reference into
      Part
      III of this report.





As
      used
      in this report, the terms "we," "us," "our," "Criticare" and the "Company"
      mean
      Criticare Systems, Inc. and its subsidiaries, unless the context indicates
      another meaning, and the term "common stock" means our common stock, par value
      $0.04 per share.





**Special
      Note Regarding Forward-Looking Statements**





A
      number
      of the matters and subject areas discussed in this report that are not
      historical or current facts deal with potential future circumstances and
      developments. These include anticipated product introductions, expected future
      financial results, liquidity needs, financing ability, management's or the
      Company's expectations and beliefs and similar matters discussed in this report.
      These statements may be identified by the use of forward-looking words or
      phrases such as "anticipate," "believe," "could," "expect," "intend," "may,"
      "hope," "plan," "potential," "should," "estimate," "predict," "continue,"
      "future," "will," "would" or the negative of these terms or other words of
      similar meaning. Such forward-looking statements are inherently subject to
      known
      and unknown risks and uncertainties. Our actual results and future developments
      could differ materially from the results or developments expressed in, or
      implied by, these forward-looking statements. Factors that may cause actual
      results to differ materially from those contemplated by such forward-looking
      statements include, but are not limited to, those described under the caption
      "Risk Factors" in Item 1A of this report. We undertake no obligation to make
      any
      revisions to the forward-looking statements contained in this filing or to
      update them to reflect events or circumstances occurring after the date of
      this
      filing.




3


PART
      I





Item
      1 . BUSINESS .





Criticare
      designs, manufactures and markets vital signs and gas monitoring instruments
      and
      related noninvasive sensors used to monitor patients in many healthcare
      environments. Since a patient's oxygen, anesthetic gas and carbon dioxide levels
      can change dramatically within minutes, causing severe side effects or death,
      continuous monitoring of these parameters is increasing. The Company's
      monitoring equipment improves patient safety by delivering accurate,
      comprehensive and instantaneous patient information to the clinician. The
      Company's products also allow hospitals to contain costs primarily by
      substituting cost-effective reusable pulse oximetry sensors for disposable
      sensors, controlling the use of costly anesthetics and increasing personnel
      productivity.




To
      meet the needs of end-users in a wide variety of
      patient environments, the Company has developed a broad line of patient monitors
      which combine one or more of its patented or other proprietary technologies,
      for
      monitoring oxygen saturation, carbon dioxide and anesthetic agents, with
      standard monitoring technologies that provide electrocardiogram ("ECG"),
      invasive and noninvasive blood pressures, temperature, heart rate and
      respiration rate. The Company's VitalView telemetry system allows one nurse
      to
      monitor up to sixteen patients simultaneously from a convenient central
      location. This allows hospitals to move out of the intensive care unit those
      patients that require continuous monitoring, but do not need all of an intensive
      care unit's extensive and costly personnel and equipment resources. In fiscal
      2006, the Company released a new, next generation portable cardiac monitor
      (VitalCareTM 506N3) and a new, next generation portable
      multi-parameter vital signs monitor (nGenuity 8100E).




Criticare
      is implementing several business initiatives as part of its strategy to develop
      products for highly technical, growth oriented niche markets. Management
      believes that in order to be successful, marketing and sales partnerships in
      these areas are required. That effort has resulted in the execution of a number
      of agreements with original equipment manufacturers ("OEMs"). To capitalize
      on
      these business initiatives, modules and stand-alone monitors were developed
      and
      marketed for specific OEM customers. The Company views OEM agreements as a
      complementary component to our strategy to develop products for highly technical
      niche markets, and the OEM business has been a significant driver of the
      Company’s growth.





The
      first
      of these initiatives involves monitoring products for anesthesia gases. In
      fiscal 2003, the Company introduced an anesthesia monitoring product line for
      sale both under the Criticare brand name and for sale to OEMs. A second
      initiative is the development of a highly specialized monitoring system for
      medical imaging applications in an MRI environment. In 2003, Criticare entered
      into an agreement with an OEM, Medrad, Inc. ("Medrad"), to jointly develop
      and
      exclusively sell a highly specialized medical monitoring product to Medrad.
      In
      July 2004, Criticare shipped the initial prototypes of this monitoring product
      to Medrad and production shipments began in January 2005. Sales to Medrad have
      grown quickly and Medrad has become the Company's largest customer in fiscal
      2006 and 2005. Following the acquisition, in July 2004, of Alaris Medical
      Systems, Inc. ("Alaris"), a long-time OEM customer, by Cardinal Health, Inc.,
      the third initiative was implemented to develop an Acute Care distribution
      network in the U.S. to sell to markets previously served through Alaris.
      Following such acquisition, Cardinal Health exited the vital signs monitor
      business and signed a transition agreement with the Company, which enabled
      our


4


new
      Acute
      Care distribution network the opportunity to sell to the former Alaris customer
      base. In conjunction with the transition agreement, in September 2005, we
      introduced a new portable cardiac monitor for the Acute Care market. Sales
      for
      the Acute Care market during the introduction year of fiscal 2006, approached
      the largest revenue year Criticare experienced under the Alaris OEM agreement
      and greatly exceeded our expectations.





According
      to the guidance set by Statement of Financial Accounting Standards No. 131,
      the Company operates in one business segment in the healthcare environment.
      The
      chief operating decision maker does not utilize segmented financial statements
      in making decisions about resource allocation because the business activities
      that generate revenue do not have expenses specifically associated with them.
      Therefore, no segment data is disclosed in the notes to the financial statements
      in Item 8. However, the Company's customer base is differentiated by region
      (see
      note 10 in the notes to the financial statements in Item 8 for an analysis
      of
      sales by geographic area).





The
      Company was incorporated under the laws of the State of Delaware in October
      1984.





Products0





Criticare
      markets a broad range of vital signs and gas monitoring products designed to
      address the needs of a variety of end-users in different patient environments.
      Criticare's monitors display information graphically and numerically. Many
      of
      the Company’s new products, as well as those in development, focus on anesthesia
      related monitoring, as management believes this is a high growth area with
      relatively few competitors. All Criticare monitors incorporate adjustable visual
      and audible alarms to provide reliable patient-specific warnings of critical
      conditions, and most of the Company's monitors record up to 60 hours of
      trend data. Criticare monitors are available with printer capability to provide
      permanent records of patient data.





VitalCareTM
      506N3 Portable Cardiac Monitors .
      The
      Portable Cardiac Monitor provides maximum versatility and cost effectiveness
      in
      a small, compact, portable, full-featured vital signs monitors configured to
      meet specific clinical needs. The unit is available in multiple configurations,
      with a choice of Criticare or Nellcor oximetry, ComfortCuffTM noninvasive blood
      pressure and temperature (either FILAC FasTempTM or Alaris TurboTemp). This unit
      is ideal for spot checking or continuously monitoring patients’ vital
      signs.





nGenuity
      8100E Multi Parameter Vital Signs Monitors .
      The
      full-featured Multi Parameter Vital Signs Monitor combines ECG, ComfortCuffTM
noninvasive blood pressure, DOXTM digital oximetry, heart rate, temperature,
      respiration rate, and nurse call interface for a complete vital signs monitor
      for physician offices, clinics, transport and hospital applications. Optional
      features include arrhythmia and ST analysis and an integrated
      printer.





PoetTM
      Plus 8100 Vital Signs Monitors .
      The
      full-featured CSI 8100 Vital Signs Monitor provides maximum flexibility for
      hospital, transport and outpatient care settings. The unit's custom
      configurations include ECG, ComfortCuffTM noninvasive blood pressure, DOXTM
digital oximetry, heart rate, temperature, respiration rate, and nurse call
      interface. Optional features include CO 2 ,
      CO 2 /O 2 and
      invasive blood pressure monitoring and an integrated printer. The 8100 is well
      suited for busy departments that require basic vital signs monitoring to
      conscious sedation.


5


PoetTM
      IQ 8500 and PoetTM IQ2 8500Q Anesthetic Gas Monitors. The
      PoetTM IQ 8500 gas monitor is used in conjunction with the PoetTM Plus 8100 Vital
      Signs Monitor to provide a unique combination of leading edge vital signs
      technology and anesthesia gas monitoring in a compact, modular system. The
      PoetTM
IQ2 8500Q Gas Monitor provides leading edge anesthesia gas monitoring in a
      compact stand alone monitor. The operating systems of both monitors consist
      of
      an integrated, solid state module based upon a proprietary infrared technology
      developed by Criticare. The operating systems automatically monitor up to five
      anesthetic agents plus nitrous oxide, oxygen, and carbon dioxide. The systems
      also utilize a unique, disposable water trap component that is also proprietary
      to the Company. These products were released in March 2003 and are being
      marketed as configurable systems for applications by OEMs and as Criticare
      branded products. The systems’ reliable performance, ease of use, flexible
      design, and affordable cost make them the ideal monitoring solutions for
      anesthesia applications in hospitals and surgical centers.





Model
      503DX and 504DX Pulse Oximeters .
      Criticare's complete line of pulse oximeters meets the needs of virtually all
      clinical environments, including: adult, pediatric and neonatal intensive care
      units, operating rooms, emergency rooms, nursing homes, physicians' offices
      and
      ambulances. The line is designed to provide accuracy and convenience at a
      competitive cost to the end-user.





VitalViewTM
      Central Monitoring Station .
      The
      VitalView central station makes it possible for one nurse or technician to
      monitor up to sixteen patients simultaneously. The VitalView can receive,
      display and store data from a wide variety of Criticare monitors and
      patient-borne multiple parameter telemetry devices for continuous, comprehensive
      vital signs monitoring. In addition, the VitalView can be used as a wireless
      device or hardwired and has ST and arrhythmia analysis
      capabilities.





Pulse
      Oximetry Sensors .
      Criticare has designed proprietary, noninvasive sensors that can be used on
      any
      patient, from a premature infant to a full-grown adult. Criticare's line of
      reusable pulse oximetry sensors offers users significant cost savings compared
      to disposables. Criticare's reusable sensors generally last longer than the
      one-year warranty period and are easily and inexpensively cleaned between uses.
      Criticare's reusable sensors include a finger sensor for routine applications
      and a multisite sensor for increased placement flexibility. The multisite sensor
      is fully immersible, allowing for sterilization between patients. The Company
      also sells a range of disposable sensors designed for single use in cases where
      the facility would prefer to use a patient charge disposable
      product.





WaterChekTM/Chek-Mate
      Filter System .
      The
      Company's patented, disposable WaterChek system separates a patient's
      respiratory secretions from a breath sample before it enters the gas monitor
      for
      analysis. The Company's proprietary, disposable Chek-Mate filter enhances the
      removal of moisture from the sample, while preventing cross-contamination.
      This
      system allows the monitor to operate effectively regardless of humidity or
      patient condition. The self-sealing feature also protects the healthcare
      provider from potential contamination.


6




Marketing
      and Sales





Domestic
      Sales .
      At
      August 31, 2006, the Company's domestic sales force consisted of three employees
      and 55 independent dealers. The Company's sales force and independent dealers
      market the Company's vital signs monitors and pulse oximeters primarily to
      surgery centers, dental and physician offices, and nursing homes.





The
      Company sells some of its higher-end monitors (anesthetic agent monitors and
      VitalView central stations) to domestic hospitals. With the development of
      an
      Acute Care distribution network, the Company is working to achieve a significant
      presence in U.S. hospitals that generally purchase medical equipment through
      large group purchasing organizations (GPOs). These GPOs contract large medical
      equipment suppliers who can provide not only medical monitors, but also the
      majority of the hospital’s other medical equipment and service needs (such as CT
      scanners and MRI equipment). In addition, Cardinal Health and Criticare signed
      a
      transition agreement which enabled Criticare’s new Acute Care distribution
      network the opportunity to sell to the former Alaris customer base. Alaris,
      formerly the Company’s largest customer, was acquired by Cardinal Health in
      2004, and Cardinal Health subsequently made the decision to exit from vital
      signs monitor sales activities, since those products no longer fit within its
      core business strategy.





Criticare
      is implementing several business initiatives as part of its strategy to develop
      products for highly technical, growth oriented niche markets. Management
      believes that in order to be successful, marketing and sales partnerships in
      these areas are required. That effort resulted in the execution of a number
      of
      OEM agreements.





To
      capitalize on these business initiatives, the Company began to focus on selling
      to OEMs with the hiring of a senior manager, in 1999, to lead this effort.
      Modules and stand-alone monitors were developed and marketed for specific OEM
      customers. The Company views OEM agreements as a critical component to our
      strategy to develop products for highly technical niche markets, and the OEM
      business has been a significant driver of the Company’s growth with 21.7% of
      total net sales in fiscal 2006 and 22.9% of total net sales in fiscal 2005.
      In
      particular, sales of the Company’s newly developed anesthesia products and a
      highly specialized monitoring system for medical imaging applications are
      expected to continue to be mainly for new OEM partners. In July 2004, Criticare
      shipped the initial prototypes of this monitoring product to Medrad. Medrad,
      the
      Company's OEM partner for medical imaging applications **,** was the
      Company's largest customer in fiscal 2006, accounting for net sales of
      approximately $5.2 million, which represented 17% of the Company's total
      net sales.





International
      Sales .
      One of
      the Company's principal marketing strategies has been to target international
      markets, particularly Europe, Latin America and the Pacific Rim countries.
      During fiscal 2006, Criticare sold its products, principally to hospitals,
      in
      over 83 **** countries
      through over 89 independent dealers.





Most
      of
      the Company's international order processing, invoicing, collection and customer
      service functions are handled directly from the Company's headquarters in
      Waukesha, Wisconsin. Criticare believes demand for the Company's products in
      international markets is primarily driven by cost containment concerns, and
      increased interest in using quality patient monitoring products for improved
      patient management.





7





In
      fiscal
      2006, 40% of Criticare's net sales, or $12.6 million, was attributable to
      international sales, of which approximately 59% was from sales in Europe and
      the
      Middle East, 13% was from sales to Pacific Rim countries and 28% was from sales
      to Canada and Central and South America. In fiscal 2005 and 2004, 62% and 41%,
      respectively, of Criticare's net sales were attributable to international sales.
      Other than inventory and accounts receivable for the Company’s branch office in
      India totaling approximately $0.7 million, there are no material identifiable
      assets of the Company located in foreign markets. The Company primarily sells
      its products in United States dollars and is therefore not subject to currency
      risks other than currency fluctuations from its operation in India; however,
      an
      increase in the value of the United States dollar relative to foreign currencies
      could make the Company's products less price competitive in those markets.
      In
      addition, significant devaluation of certain foreign currencies could adversely
      affect the collectibility of accounts receivable from international customers.
      The Company analyzes this risk before making shipments to countries it views
      as
      unstable.





Service,
      Support and Warranty .
      Criticare believes that customer service is a key element of its marketing
      program. At August 31, 2006, the Company had a customer service and
      technical support staff of 17 people at its Waukesha, Wisconsin facility.
      Customer service support is available 24 hours a day, seven days a week, with
      the majority of customers’ technical problems being resolved over the telephone.
      The customer service staff also provides periodic training and education of
      the
      direct sales force who in turn provide training to the dealers and end-users.





Criticare's
      monitors and sensors are generally warranted against defects for one year.
      If a
      problem develops with a Criticare product while under warranty, the Company
      typically provides a replacement unit until the product can be repaired at
      the
      Company's facility. The Company offers extended warranties and service contracts
      on all of its monitors.





Manufacturing





Historically,
      Criticare had manufactured and assembled its products internally, principally
      at
      the Company's facility in Waukesha, Wisconsin. Due mainly to pricing pressures
      on monitoring systems worldwide, in fiscal 2001 the Company entered into an
      agreement with two offshore contract manufacturing firms located in Taiwan
      and
      Ireland, respectively, that exclusively manufacture medical devices in a
      regulated environment. During fiscal 2005, the Company ended the supply
      agreement with the contract manufacturing firm in Ireland. The contract
      manufacturing firm in Taiwan also has manufacturing capabilities in China and
      the U.S. and a portion of Criticare’s production has been transitioned to China
      to continue to receive favorable pricing and a portion has been transitioned
      to
      the U.S. to satisfy the “made in U.S.A.” requirements of certain customers. The
      Company works closely with this firm to maintain product quality and
      reliability. This firm performs the same rigorous quality control testing at
      its
      facilities that Criticare had done in the past at its own facility. With the
      majority of the Company’s manufacturing outsourced as of the end of calendar
      2001, Criticare concentrates on product enhancements and new product
      development, customer service, and increased involvement with its OEM customers.
      The Company will manufacture and assemble all proprietary medical devices at
      the
      Company’s facility in Waukesha, Wisconsin. In addition, the Company will
      continue limited production of new products internally during the development
      phase and for a short period after commercial introduction until production
      can
      be effectively transitioned to offshore manufacturers.





8





Any
      inability of the offshore manufacturer to deliver products on a timely basis
      could have a material adverse effect on the Company. However, the manufacturer
      has the ability to produce the Company’s products in Taiwan, China, and the U.S.
      Therefore, the Company is not totally reliant on a single plant or single source
      to supply product. This factor, combined with the Company’s ability to continue
      to manufacture at its headquarters in Waukesha, Wisconsin, reduces the Company’s
      risk of supply interruption.





The
      Company has achieved certification under the International Organization for
      Standardization’s (ISO) standards 9001 and 9002. The offshore contract
      manufacturing firm has achieved certification under ISO's standard 9001. See
      "Regulation."





Research,
      Development and Engineering





Criticare
      has focused its research, development and engineering expenditures on products
      designed to meet identified market demands. The Company seeks to apply its
      expertise in gas monitoring, vital signs monitoring, and related sensor
      technology to develop new products and adapt existing products for new markets.
      At August 31, 2006, the Company had an in-house research, development and
      engineering staff of 19 people. The Company's research, development and
      engineering expenditures were $2.4 million in fiscal 2006, $2.6 million in
      fiscal 2005 and $2.5 million in fiscal 2004.





Research
      and development efforts for fiscal 2006 has focused on the development and
      release our next generation portable multi-parameter vital signs monitor
      (nGenuity 8100E), our next generation portable cardiac monitor (VitalCareTM
506N3), and an upgrade to the MRI monitor to provide a wireless option. Research
      and development efforts for fiscal 2005 has focused on the development and
      release of the Veris MRI compatible vital signs monitor. In addition, research
      and development efforts for fiscal 2004 and 2003 have focused on the development
      and release of the 8500 series monitors which feature automatic identification
      and quantification of all five approved anesthetic agents and the development
      of
      a highly specialized monitoring system for medical imaging applications.





Competition





The
      markets for the Company's products are highly competitive. Many of Criticare's
      competitors, including the principal ones described below, have greater
      financial resources, more established brand identities and reputations, longer
      histories in the medical equipment industry and larger direct and more
      experienced sales forces than Criticare. In these respects, such companies
      have
      a competitive advantage over Criticare. In addition, internationally there
      are
      many in-country manufacturers that supply duty and tariff-free low cost monitors
      that make it difficult for the Company to be price competitive in these
      countries.





The
      Company competes primarily on the basis of product features, the quality and
      value of its products ( i.e. ,
      their
      relative price compared to performance features provided), and the effectiveness
      of its sales and marketing efforts. The Company believes that its principal
      competitive advantages are provided by its focus on cost containment, provided
      in part by its outsourcing a large portion of its manufacturing, its patented
      and other proprietary technology and software for noninvasive, continuous
      monitoring of oxygen, anesthetic gases, carbon dioxide and noninvasive blood
      pressure, the efficiency and speed of its research and development efforts,
      and
      its established international presence.





9





The
      Company believes that the worldwide anesthetic agent and carbon dioxide monitor
      markets are comparatively fragmented, with Datex/Ohmeda, a subsidiary of General
      Electric Company, Andros Incorporated, and Dr’ger Medical as the principal
      competitors. The market for vital signs monitors includes competitors such
      as
      General Electric Company, Dr’ger Medical, Datascope Corp., Philips Electronics,
      Welch Allyn Inc., and Spacelabs Medical, Inc., a subsidiary of OSI Systems,
      Inc.
      Internationally, the market for vital signs monitors includes the competitors
      mentioned above, as well as in-country manufacturers that supply low cost
      monitors that are not required to comply with the rigorous regulations of the
      U.S. Food and Drug Administration ("FDA").





Regulation





As
      a
      manufacturer of medical diagnostic equipment, the Company is regulated by the
      FDA and similar foreign governmental agencies. In producing its products, the
      Company must comply with a variety of regulations, including the good
      manufacturing practices regulations of the FDA. In addition, it is subject
      to
      periodic inspections by the FDA. If the FDA believes that its legal requirements
      have not been fulfilled, it has extensive enforcement powers, including the
      ability to ban or recall products from the market and to prohibit the operation
      of manufacturing facilities. The Company believes its products comply with
      applicable FDA regulations in all material respects. In addition, the Company
      received ISO 9002 certification on April 29, 1993, ISO 9001 certification
      on July 8, 1994 and ISO 13485:2003 certification on January 16,
      2006.





Under
      the
      Federal Food, Drug and Cosmetic Act, all medical devices are classified as
      Class I, Class II or Class III, depending upon the level of
      regulatory control to which they will be subjected. Class III devices, which
      are
      the most highly controlled devices, are subject to premarket approval by the
      FDA
      prior to commercial distribution in the United States.





The
      Company's current products have not been subject to the FDA's comprehensive
      Class III premarket approval requirements, but are generally subject to
      premarket notification requirements. If a new device is substantially equivalent
      to a device that did not require premarket approval, premarket review is
      satisfied through a procedure known as a "510(k) submission," under which the
      applicant provides product information supporting its claim of substantial
      equivalence. The FDA may also require that it be provided with clinical trial
      results showing the device's safety and efficacy.





The
      Company believes that the products it is currently developing generally will
      be
      eligible for the 510(k) submission procedure and, therefore, will not be subject
      to lengthy premarket approval procedures. However, these products are still
      being developed and there can be no assurance that the FDA will determine that
      the products may be marketed without premarket approval.





Criticare
      seeks, where appropriate, to comply with the safety standards of Underwriters'
      Laboratories and the Canadian Standards Association and the standards of the
      European Union. To date, the Company has not experienced significant regulatory
      expense or delay in the foreign markets in which it sells its products. Industry
      and professional groups such as the American Society of Anesthesiologists,
      to
      the extent they have the power to mandate certain practices or procedures as
      part of their profession's standard of care, are also a source of indirect
      regulation of the Company's business.





10





Patents
      and Trademarks





The
      Company believes one of its principal competitive advantages is provided by
      its
      patented and other proprietary technology including its sensor technology,
      infrared specific anesthetic gas monitoring technology, UltraSync signal
      processing software and disposable respiratory secretion filter system. The
      Company has 20 **** issued
      U.S. patents. The Company's U.S. patents expire between 2006 and 2022. Criticare
      also has 14 issued foreign patents and 9 foreign patent applications pending.
      There is no assurance that any patents held or secured by the Company will
      provide any protection or commercial or competitive benefit to the Company.
      There is also no assurance that the Company's products will not infringe upon
      patents held by others. The Company is the owner of United States trademark
      registrations for "POET," "POET IQ," "MPT," "REMOTEVIEW," "MICROVIEW,"
      "VITALVIEW," "SCHOLAR," and "WATERCHEK."





The
      Company also relies upon trade secret protection for certain of its proprietary
      technology. Although the Company requires all employees to sign confidentiality
      agreements, no assurance can be given that such agreements can be effectively
      enforced or that others will not independently develop substantially equivalent
      proprietary information and techniques or otherwise gain access to or disclose
      the Company's trade secrets.





Employees





At
      August
      31, 2006 Criticare, had 93 employees in the U.S., including 19 in research,
      development and engineering, 17 in customer service and support, 27 in
      manufacturing and operations, 14 in administration, 8 in sales and marketing,
      and 8 in quality control. Criticare also utilizes four international country
      managers that work as independent contractors to support its international
      sales
      efforts. The Company also has an operation in India with 15
      employees.





Many
      of
      the Company's technical employees are highly skilled. The Company believes
      that
      its continued success depends in part on its ability to continue to attract
      qualified management, marketing and technical personnel. None of the Company's
      employees are subject to a collective bargaining agreement. The Company believes
      that its relations with its employees are good.





Backlog





Criticare's
      backlog on June 30, 2006 and 2005 was $5,260,197 and $9,788,662, respectively.
      The backlog is driven by the extended delivery schedule from Medrad, which
      totaled $4,100,984 as of June 30, 2006 and $8,052,614 as of June 30, 2005.
      Criticare generally delivers its products out of inventory when specified by
      the
      customer. The Company does not believe that its backlog at any date is
      indicative of its future sales.





Item
      1A . RISK
      FACTORS .





An
      investment in our common stock is subject to risks inherent in our business,
      including the risks described below. The risks described below are not the
      only
      risks we face. Additional risks that we do not yet know of or that we currently
      think are immaterial may also impair our business operations. If any of the
      events or circumstances described in the following risks actually occur, our
      business, financial condition or results of operations could be materially
      adversely affected. In such cases, the trading price of our common stock could
      decline.





11





**Risks
      Related to Our Business**





**Our
      net sales and profitability depend on our ability to conceive, design and market
      new products.**





The
      introduction of new products is critical to our growth strategy. Our future
      success will depend in large part upon our ability to conceive, design, and
      market new products and upon market acceptance of our existing and future
      products. Any significant delays in the introduction of, or the failure to
      introduce, new products or additions to our existing product lines or the
      failure of our existing or future products to maintain or receive market
      acceptance could have a material adverse effect on our net sales and
      profitability.





**Our
      future success will depend on our ability to compete effectively in our
      industry.**





The
      medical equipment industry is highly competitive. Many of our competitors have
      greater financial and other resources, more established brand identities and
      reputations, greater development capabilities, more experience in testing
      products and obtaining regulatory approvals, and larger and more experienced
      sales forces than us. In these respects, such companies have a competitive
      advantage over us. In addition, internationally there are many in-country
      manufacturers that supply duty and tariff-free low cost monitors that make
      it
      difficult for us to be price competitive in these countries. The medical
      equipment market is also experiencing increasing customer concentration, due
      to
      the emergence of large purchasing groups, which can increase the barriers for
      a
      small company such as Criticare. If we cannot compete successfully in the
      future, our net sales and profitability will likely decline.





**We
      have a history of significant losses and may not be able to sustain
      profitability.**





Although
      we achieved net income of $212,118 in fiscal 2006, we have historically suffered
      net losses, including a net loss of $(422,245) for fiscal 2005 and
      $(2,100,573) for fiscal 2004. We achieved positive net income in fiscal 2006
      with net sales of $31.4 million, the second highest level of net sales in our
      history. If our net sales decline, or if we are not able to control expenses,
      we
      may not be able to sustain or improve profitability.





**Our
      business may be adversely affected by the highly regulated environment in which
      we operate.**





Our
      products are subject to regulation by the United States Food and Drug
      Administration and comparable foreign governmental authorities. These
      regulations can be burdensome and may:





l
            substantially
                delay or prevent the introduction of new products;


l
            materially
                increase the costs of any new product introductions;


l
            interfere
                with or require cessation of product manufacturing and marketing;
                and


l
            result
                in product recalls.





Additionally,
      adoption of new regulations or modifications to applicable regulations could
      harm our business. Some of the legislative and regulatory changes may benefit
      us
      and our competitors; other changes, however, could have a material adverse
      effect on our business, financial condition and results of operation and/or
      provide an advantage to certain of our competitors.





12





**Since
      we sell product in foreign markets, we are subject to foreign currency and
      other
      international business risks that could adversely affect our operating
      results.**





International
      sales account for a significant portion of our total net sales each fiscal
      year.
      We expect that international sales will continue to constitute a significant
      portion of our business. Although our net sales are primarily denominated in
      United States dollars and are not subject to significant currency risks, an
      increase in the value of the United States dollar relative to foreign currencies
      in our international markets could make our products less price competitive
      in
      such markets. Our international sales are subject to the risks inherent in
      doing
      business abroad, including:





l
            complications
                in complying with the laws and policies of the United States and
                foreign
                governments affecting foreign trade, including duties, quotas, taxes
                and
                export controls;


l
            unexpected changes in international regulatory
              requirements and tariffs; l
            difficulties
                in staffing and managing foreign
                operations;


l
            political
                or economic changes, especially in developing nations;
                and


l
            price
                controls and other restrictive actions by foreign
                governments.




Any of these risks might disrupt sales of our products, increase our expenses
      or
      decrease our revenues.





**Our
      reliance on offshore contract manufacturing makes our business susceptible
      to
      numerous risks that could affect our profitability.**





In
      response to pricing pressure, in fiscal 2001 we entered into agreements for
      offshore contract manufacturing. We completed the transition of the offshore
      production of substantially all of our established product lines at the end
      of
      calendar 2001. Currently, our offshore manufacturing is handled by a contract
      manufacturing firm in Taiwan that also has manufacturing capabilities in China
      and the U.S. Any inability of the offshore manufacturer to deliver products
      on a
      timely basis could have a material adverse effect on us.





Our
      reliance on offshore contract manufacturing will subject us to numerous risks,
      including the following:




l economic
      and political instability in the countries where the contract manufacturing
      firms are located;


l restrictive
      actions by foreign governments;


l the
      laws
      and policies of the United States affecting the importation of goods (including
      duties, quotas and taxes);


l production
      delays and cost overruns;


l quality
      control; and


l foreign
      trade and tax laws.





**We
      depend on a major customer for a significant portion of our
      sales.**





In
      fiscal
      2006, our largest customer accounted for net sales of approximately $5.2
      million, which represented approximately 17% of our total net sales. We also
      had
      a receivable balance with this customer of approximately $0.9 million as of
      June
      30, 2006, which represented approximately 15% of our total receivables as of
      that date. An adverse change in our relationship with or the financial viability
      of our largest customer could have a material adverse effect on our net sales
      and profitability.





13





**As
      a manufacturer and marketer of medical equipment, we could experience product
      liability claims.**





The
      nature of our products may expose us to significant product liability risks.
      Although, we maintain product liability insurance, we can make no assurance
      that
      we will be able to maintain this insurance on acceptable terms or that the
      insurance will provide adequate coverage against product liability claims.
      A
      successful product liability claim against us in excess of our insurance
      coverage could be extremely damaging to us. Even if a product liability claim
      is
      without merit, the claim could harm our reputation and divert management's
      attention and resources from our business.





**Our
      success depends on our ability to protect our intellectual
      property.**





We
      rely
      on our patented and other proprietary technology including:





l
            our
                sensor technology;


l
            infrared
                specific anesthetic gas monitoring
                technology;


l
            UltraSync
                signal processing software; and


l
            disposable
                respiratory secretion filter system.





The
      actions taken by us to protect our proprietary rights may not be adequate to
      prevent imitation of our products, processes or technology. We can not assure
      you that:





l
            our
                proprietary information will not become known to competitors;


l
            others
                will not independently develop substantially equivalent or better
                products
                that do not infringe on our intellectual property rights; or


l
            others
                will not challenge or assert rights in, and ownership of, our patents
                and
                other proprietary rights.





**Health
      care cost containment programs could adversely affect our domestic
      sales.**





The
      cost
      of a significant portion of medical care in the United States and in
      international markets is funded by government or other insurance programs.
      Additional limits imposed by such programs on health care cost reimbursements
      may further impair the ability of hospitals and other health care providers
      to
      purchase equipment such as our products and could reduce our domestic
      sales.





**Our
      controls and procedures may be ineffective**





Our
      management regularly reviews and updates our internal control over financial
      reporting, disclosure controls and procedures, and corporate governance policies
      and procedures. Any system of controls, no matter how well designed and
      operated, is based partly on certain assumptions and can provide only
      reasonable, not absolute, assurances that the objectives of the system are
      met.
      Any failure or circumvention of our controls and procedures or failure to comply
      with regulations related to controls and procedures could have a material
      adverse effect on our business, results of operations, and financial condition.





14





**Risks
      Related to an Investment in our Common Stock**





**The
      trading price of our common stock has been volatile and investors in our common
      stock may experience substantial losses.**





The
      market price of our common stock has experienced significant volatility from
      time to time. There may be volatility in the market price of our common stock
      due to factors that may or may not relate to our performance. The trading price
      of our common stock could decline or fluctuate in response to a variety of
      such
      factors, including:





l
            announcements and developments relating to the consent
              solicitation to replace a majority of our Board of Directors started
              by
              BlueLine Partners; l
            the
                timing of announcements by us or our competitors concerning significant
                acquisitions, financial performance or the introduction of new innovative
                products or services;


l
            fluctuations
                in our quarterly operating results;


l
            fluctuations
                in demand for our products;


l
            fluctuations
                in interest rates;


l
            substantial
                sales of our common stock; or


l
            general
                stock market or other economic
                conditions.





You may be unable to sell your stock at or above your purchase
      price.





**Various
      restrictions in our certificate of incorporation and by-laws, our rights plan
      and Delaware law could prevent or delay a change in control of us which is
      not
      supported by our board of directors.**





Provisions
      of our certificate of incorporation and by-laws may make it more difficult
      for a
      third party to gain control or acquire us without the consent of our board
      of
      directors, even if such a transaction may be perceived as beneficial to our
      stockholders. These provisions include a board of directors divided into three
      classes of directors serving staggered terms of three years each.





Each
      currently outstanding share of our common stock includes, and each newly issued
      share of our common stock will include, one preferred share purchase right.
      The
      rights are attached to and trade with the shares of common stock and generally
      are not exercisable. The rights will become exercisable the tenth business
      day
      after a person or group acquires 20% or more of our common stock or makes an
      offer to acquire 30% or more of our common stock. When exercisable, each right
      entitles the holder to purchase for $25, subject to adjustment,
      1/100 th of a
      share of preferred stock for each share of common stock owned. The rights have
      anti-takeover effects and generally will cause substantial dilution to a person
      or group that attempts to acquire control of us without conditioning the offer
      on either redemption of the rights or amendment of the rights to prevent this
      dilution. The rights could have the effect of delaying or preventing a change
      of
      control. The rights are scheduled to expire on April 1,
      2007.





15





We
      are
      also subject to Section 203 of the Delaware General Corporation Law which
      prohibits a merger, consolidation, asset sale or other similar business
      combination between Criticare and any stockholder of 15% or more of our common
      stock for a period of three years after the stockholder acquires 15% or more
      of
      our common stock, unless (1) the transaction is approved by our board of
      directors before the stockholder acquires 15% or more of our common stock,
      (2)
      upon completing the transaction the stockholder owns at least 85% of our common
      stock outstanding at the commencement of the transaction, or (3) the transaction
      is approved by our board of directors and the holders of 66 2/3% of our common
      stock excluding shares of our common stock owned by the
      stockholder.





Item
      1B.UNRESOLVED
      STAFF COMMENTS.





Not
      applicable.





Item
      2 . PROPERTIES .





In
      August
      2002, the Company sold its 60,000 square foot building in Waukesha, Wisconsin
      for $4,000,000 and leased back approximately 37,000 square feet of this building
      to serve as the Company’s headquarters, warehouse, manufacturing, research and
      development and service facility. The proceeds from the sale were used to retire
      the mortgage note on the facility. The lease expires on August 30, 2007, with
      an
      option for the Company to extend for an additional three years, with rent
      totaling $22,423 per month for the first year of the lease and annual increases
      approximating 3% in years two, three and five of the lease.





Item
      3 . LEGAL
      PROCEEDINGS .





In
      the
      normal course of business Criticare may be involved in various legal proceedings
      from time to time. Criticare does not believe it is currently involved in any
      claim or action the ultimate disposition of which would have a material adverse
      effect on the Company.





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





No
      matters were submitted to a vote of security holders during the fourth quarter
      of the fiscal year ended June 30, 2006.





16





PART
      II





Item
      5 . MARKET
      FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
      OF EQUITY SECURITIES .





The
      Company's common stock trades on the American Stock Exchange under the symbol
      “CMD." As of June 30, 2006, there were approximately 199 holders of record
      of the common stock. The Company has never paid dividends on its common stock
      and has no plans to pay cash dividends in the foreseeable future.








Years
                Ended June 30,2006
            
            2005Quarter
                Ended:
            
            
            High
            
            
            Low
            
            
            High
            
            
            LowSeptember
                30
            
            $
            5.34
            
            $
            4.14
            
            $
            2.95
            
            $
            1.74December
                31
            
            $
            5.15
            
            $
            4.62
            
            $
            3.71
            
            $
            1.97March
                31
            
            $
            5.30
            
            $
            4.55
            
            $
            3.72
            
            $
            3.00June
                30
            
            $
            5.09
            
            $
            3.58
            
            $
            5.16
            
            $
            2.90





Item
      6 . SELECTED
      FINANCIAL DATA .





The
      following table sets forth selected financial data with respect to the Company
      for each of the periods indicated, which should be read along with our
      consolidated financial statements and the notes to those statements and with
      “Management’s Discussion and Analysis of Financial Condition and Results of
      Operations.”




Years
                Ended June 30,2006
            
            2005
            
            2004
            
            2003
            
            2002Net
                sales
            
            $
            31,350,919
            
            $
            26,781,627
            
            $
            28,591,481
            
            $
            28,562,943
            
            $
            26,219,618Net
                income (loss)
            
            
            212,118
            
            
            (422,245
            )
            
            (2,100,573
            )
            
            (938,596
            )
            
            (1,425,181
            )Net
                income (loss) per common share--basic
                and diluted
            
            $
            0.02
            
            $
            (0.04
            )
            $
            (0.19
            )
            $
            (0.08
            )
            $
            (0.13
            )


Average
                shares outstanding--basic
            
            
            12,069,060
            
            
            11,514,786
            
            
            11,240,685
            
            
            11,071,735
            
            
            10,876,818diluted
            
            
            12,256,431
            
            
            11,514,786
            
            
            11,240,685
            
            
            11,071,735
            
            
            10,876,818Stockholders'
                equity
            
            $
            15,853,086
            
            $
            14,209,140
            
            $
            13,789,300
            
            $
            15,034,208
            
            $
            18,387,067Long-term
                obligations
            
            
            134,485
            
            
            210,592
            
            
            286,417
            
            
            38,662
            
            
            3,151,879Working
                capital
            
            
            13,322,276
            
            
            12,339,332
            
            
            11,756,441
            
            
            12,895,476
            
            
            15,464,899Total
                assets
            
            
            22,979,078
            
            
            19,060,473
            
            
            19,542,341
            
            
            18,762,327
            
            
            25,474,256








17





Item
      7 . MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS .




The
      following discussion is intended to provide an analysis of our financial
      condition and results of operations and should be read in conjunction with
      our
      financial statements and the notes to our financial statements included in
      Item
      8 of this report. The discussion also includes forward-looking statements.
      As
      indicated on the cover page of this report under "Special Note Regarding
      Forward-Looking Statements," undue reliance should not be placed on
      forward-looking statements.





**Overview**





Criticare
      designs, manufactures and markets vital signs and gas monitoring instruments
      and
      related noninvasive sensors used to monitor patients in many healthcare
      environments. The Company sells its products both in the U.S. and in
      international markets to customers such as hospitals, surgery centers, dental
      and physicians offices, and nursing homes. Criticare is implementing several
      business initiatives as part of its strategy to develop products for highly
      technical, growth oriented niche markets. Management believes that in order
      to
      be successful, marketing and sales partnerships in these areas are required.
      That effort resulted in the execution of a number of OEM agreements.





Criticare
      is implementing several new business initiatives as part of its strategy to
      develop products for highly technicals growth oriented niche markets. To
      capitalize on these business initiatives, modules and stand-alone monitors
      were
      developed and marketed for specific OEM customers. The Company views OEM
      agreements as a critical component to our strategy to develop products for
      highly technical niche markets, and the OEM business has been a significant
      driver of the Company’s growth with 21.7% of total net sales in fiscal 2006 and
      22.9% of total net sales in fiscal 2005.





The
      first
      of these initiatives involves monitoring products for anesthesia gases. In
      fiscal 2003, the Company introduced an anesthesia monitoring product line for
      sale both under the Criticare brand name and for sale to OEMs. A second
      initiative is the development of a highly specialized monitoring system for
      medical imaging applications in an MRI environment. In 2003, Criticare entered
      into an agreement with Medrad to jointly develop and exclusively sell a highly
      specialized medical monitoring product to Medrad. In July 2004, Criticare
      shipped the initial prototypes of this monitoring product to Medrad and
      production shipments began in January 2005. Medrad was the Company's largest
      customer in fiscal 2006 and 2005, accounting for 16.5% and 11.6%, respectively,
      of the Company's net sales in those fiscal years. Following the acquisition,
      in
      July 2004, of Alaris Medical Systems, Inc., a long-time OEM customer, by
      Cardinal Health, Inc., the third initiative was implemented to develop an Acute
      Care distribution network in the U.S. to sell to markets previously served
      through Alaris. Following such acquisition, Cardinal Health exited the vital
      signs monitor business and signed a transition agreement with the Company,
      which
      enabled our new Acute Care distribution network the opportunity to sell to
      the
      former Alaris customer base. In conjunction with the transition agreement,
      in
      September 2005, we introduced a new portable cardiac monitor for the Acute
      Care
      market. Sales for the Acute Care market totaled approximately $3.49 million
      during the introduction year of fiscal 2006, approaching the largest revenue
      year Criticare experienced under the Alaris OEM agreement.





18





Fourth
      quarter net sales for fiscal 2006 of $7,095,962 were 11.5% lower than the
      $8,020,894 in net sales for the same period of fiscal 2005, principally due
      to
      the strong OEM sales in fiscal 2005. The Company had a net loss of $(524,220)
      for the fourth quarter for fiscal 2006 as compared to net income of $371,271
      for
      the fourth quarter of fiscal 2005. The fourth quarter of fiscal 2006 included
      a
      change of $529,700 to reserve a portion of a receivable from a distributor
      in
      Mexico. For the full year, the Company had net sales of $31,350,919 in fiscal
      2006 and net income of $212,118 compared to net sales $26,781,627 and a net
      loss
      $(422,245) in fiscal 2005.





**Results
      of Operations**





The
      following table sets forth, for the periods indicated, certain items from the
      Company's Consolidated Statements of Operations expressed as percentages of
      net
      sales.




**Percentage
                of Net
                Sales****Years
                Ended June
                30,****2006**
            
            **2005**
            
            **2004**Net
                sales
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Cost
                of goods sold
            
            
            61.6
            
            
            60.9
            
            
            58.8Gross
                profit
            
            
            38.4
            
            
            39.1
            
            
            41.2Operating
                expenses:Sales
                and marketing
            
            
            22.2
            
            
            21.2
            
            
            25.0Research,
                development and engineering
            
            
            7.5
            
            
            9.8
            
            
            8.9Administrative
            
            
            10.1
            
            
            10.8
            
            
            12.8Total
            
            
            39.8
            
            
            41.8
            
            
            46.7Loss
                from operations
            
            
            (1.4
            )
            
            (2.7
            )
            
            (5.5
            )Interest
                expense
            
            
            (0.1
            )
            
            (0.1
            )
            
            --Interest
                income
            
            
            0.3
            
            
            0.2
            
            
            0.1Foreign
                currency exchange gain (loss)
            
            
            (0.3
            )
            
            0.5
            
            
            --Other
                income
            
            
            2.2
            
            
            0.5
            
            
            (1.9
            )Income
                (loss) before income taxes
            
            
            0.7
            
            
            (1.6
            )
            
            (7.3
            )Income
                tax provision
            
            
            --
            
            
            --
            
            
            --Net
                income (loss)
            
            
            0.7
            %
            
            (1.6
            )%
            
            (7.3
            )%





**Fiscal
      Year Ended June 30, 2006 Compared to June 30, 2005**





Net
      sales
      increased $4,569,292 to $31,350,919 for fiscal 2006 compared to $26,781,627
      for
      fiscal 2005. The increase resulted from a 3.5% increase in the number of units
      shipped, a 11.7% increase in the average sales price per unit and a 6.5%
      increase in accessory sales in the current year. The increased sales were in
      part the result of $3,492,754 in acute care sales, which are a successful result
      of Criticare’s business initiative to develop an acute care distribution network
      in the U.S. to sell to markets previously served through Alaris.





19





Additionally,
      the increased sales were driven by a $827,941 increase in international sales
      and a $682,501 increase in OEM sales, which were partially offset by a
      $1,025,778 decrease in domestic sales during fiscal 2006. The international
      sales increased despite a $357,972 reduction of sales in India during fiscal
      2006. The OEM sales of $5,179,879 to Medrad, for medical imaging applications,
      was partially offset by reduced sales of $2,034,468 to Alaris, formerly our
      largest OEM customer, during fiscal 2006. The decrease in domestic sales was
      due
      to a number of factors, including Criticare’s movement to exit the defibrillator
      market due to the continued trend of direct sales by defibrillator manufacturers
      rather than through an establish distribution network, the postponed sales
      of
      patient monitors awaiting the release of our next generation portable
      multi-parameter vital signs monitor and the overall maturation of the oral
      surgery market. OEM sales in fiscal 2006 were $6,815,000 and represented 21.7%
      of total net sales, compared to $6,132,000 (22.9% of total net sales) in fiscal
      2005.




The
      gross
      profit percentage of 38.4% realized in fiscal 2006 decreased from the 39.1%
      generated in the prior year. The margins decreased in the current period as
      the
      positive effect of a slight change in product mix was offset by the adverse
      effect of increased overhead costs associated with the manufacturing start-up
      costs related to our new portable cardiac monitor and the portable
      multi-parameter vital signs monitor, the replacement of a key supplier and
      with
      an upward shift in the fixed overhead costs to meet the increased quality and
      production demands of our OEM customers.





Charges
      to cost of goods sold for potentially obsolete inventory totaled $56,622 in
      fiscal 2006 compared to $281,003 for fiscal 2005. This inventory is considered
      obsolete and will be disposed of and removed from Criticare’s warehouse during
      fiscal 2007.





Operating
      expenses for the year ended June 30, 2006 increased $1,293,377 from the same
      period in fiscal 2005 as an increase of $1,279,806 in sales and marketing and
      $271,193 in administrative expenses was partially offset by a $257,622 reduction
      in research, development and engineering expenses. The increase of $1,279,806
      in
      sales and marketing expenses was due mainly to a $354,918 increase in the
      commissions earned due to increased sales and a $148,113 increase in India
      operation expenses, combined with a $98,277 increase in advertising, trade
      shows
      and sales promotion and a $19,154 increase in license fees spending for the
      year
      ended June 30, 2006. In addition, due to the political climate currently in
      Mexico and the age of the receivable, we are concerned that our distributor
      will
      be unable to complete a previously discussed tender with the Mexican government,
      and as a result, we have reserved a portion of the receivable in the amount
      of
      $529,700, which has significantly increased our sales and marketing expenses.
      Administrative expenses increased by $271,193 mainly due to $316,096 in
      compensation expenses of which $172,988 was recognized in conjunction with
      stock
      options under SFAS 123(R), an increase of $38,406 in license fees and an
      increase of $37,500 in board of director fees, which was partially offset by
      a
      $99,211 reduction in legal fees and a $26,506 reduction in recruiting fees.
      The
      increase in operating expenses was partially offset by a decrease of $257,622
      in
      research, development and engineering expenses. In the first quarter of fiscal
      2005, Criticare received funding of $125,000 from our largest OEM customer
      to
      jointly develop a highly specialized monitoring system for medical imaging
      applications, which reduced the research, development and engineering expenses
      for the year ended June 30, 2005 as compared to the year ended June 30, 2006.





20





Total
      other income for the fiscal year ended June 30, 2006 increased $355,657 from
      the
      same period in fiscal 2005. This increase was mainly due to the $300,000
      received pursuant to a patent license agreement, an increase of $136,297 in
      royalty income and an increase of $36,120 in interest income. The increase
      in
      other income was offset in part due to a foreign currency exchange loss of
      $108,225 related to the Company’s operation in India, which had a foreign
      currency exchange gain of $131,885 in fiscal 2005.





The
      $1,572,083 and $355,657 increase in gross profit and total other income,
      respectively, partially offset by the increased operating expenses of
      $1,293,377, resulted in net income of $212,118 for the year ended June 30,
      2006
      as compared to a net loss of $(422,245) for the same period in fiscal
      2005.





**Fiscal
      Year Ended June 30, 2005 Compared to June 30, 2004**





Net
      sales
      decreased $1,809,854 to $26,781,627 for fiscal 2005 compared to $28,591,481
      for
      fiscal 2004. The decrease resulted from a 30.4% decrease in the number of units
      shipped that was partially offset by a 25.0% increase in the average sales
      price
      per unit and a 26.6% increase in accessory sales in the current year. The
      reduced sales were also the result of a $1,451,260 decrease in sales to Alaris,
      formerly our largest OEM customer, a $2,054,985 decrease in domestic sales
      and a
      $534,322 decrease in international sales during fiscal 2005. The international
      sales decrease was the result of a $1,130,250 order shipped in December 2003,
      which increased international sales for the year ended June 30, 2004, without
      a
      comparable sale in fiscal 2005. The Alaris OEM sales decrease was offset by
      $3,100,199 of sales to Medrad, our newest OEM customer for medical imaging
      applications, in fiscal 2005. The decrease in domestic sales was due to a number
      of factors, including $366,140 of orders that were unable to ship by year end;
      the growing trend in the defibrillator market of direct sales rather than
      through an established distribution network; the postponed sales of patient
      monitors awaiting the release of our next generation portable patient monitor;
      the overall maturation of the oral surgery market; and to lost sales following
      the cancellation of three oral surgery shows, two oral surgery shows in Florida
      and one oral surgery show in Louisiana, as a result of the hurricanes during
      the
      first quarter of fiscal 2005. The lower unit sales and higher average sales
      price per unit were driven, in part, by a large shipment of pulse oximeters
      to
      supply a government tender in Mexico in fiscal 2004. These units monitor pulse
      oximetry only and therefore carried a much lower average selling price than
      the
      Company’s equipment that monitors multiple vital signs parameters. OEM sales in
      fiscal 2005 were $6,132,000 and represented 22.9% of total sales, compared
      to
      $4,634,000 (16.5% of total sales) in fiscal 2004.





The
      gross
      profit percentage of 39.1% realized in fiscal 2005 decreased from the 41.2%
      generated in the prior year. The reduced margins in the current period were
      mainly a result of the decreased manufacturing overhead absorption due to the
      decrease in the number of units shipped against relatively fixed overhead costs.





Charges
      to cost of goods sold for potentially obsolete inventory totaled $281,003 in
      fiscal 2005 which compared to $509,001 for fiscal 2004. This inventory is
      considered obsolete and was disposed of and removed from Criticare’s warehouse
      during fiscal 2006.





21





Total
      operating expenses in fiscal 2005 decreased by $2,147,534 from the prior year
      as
      a $88,005 increase in research, development and engineering expenses partially
      offset a $1,480,362 reduction in sales and marketing expenses and a $755,177
      reduction in administrative expenses. The decrease in sales and marketing
      expenses was primarily due to a $471,065 decrease in the commissions earned
      by
      dealers and employees, a decrease of $339,647 in advertising, trade shows and
      sales promotion spending, a $405,953 decrease in operating supplies and a
      $434,864 decrease in payroll and related benefit expenses. Administrative
      expenses decreased by $755,177 mainly due to the cost containment efforts,
      including a reduction in consulting expenses of $117,311, a reduction in
      investor expenses of $66,676 and a reduction in business insurance premium
      expense of $17,483. In addition, bad debt expense of $421,340 was incurred
      in
      the prior year to write off the receivable due from an international distributor
      as compared to the current year.





Total
      other income was $303,950 for the fiscal year ended June 30, 2005 which compared
      to total other expense of $(526,060) for fiscal 2004. The increase in other
      income was due in part to a foreign currency exchange gain of $131,885 related
      to the Company’s operation in India. Moreover, other expense in the prior year
      included a $200,000 charge to settle a dispute with a customer, over a 1999
      product installation, to avoid litigation. The Company elected to settle this
      issue rather than incur the significant legal and administrative costs deemed
      necessary to successfully defend its position. Other expenses in fiscal 2004
      also included a $400,000 charge for the potential call of a standby letter
      of
      credit used to guarantee fund borrowings by an international distributor and
      a
      $90,000 charge to satisfy a claim for duties and Value Added Tax associated
      with
      importation of products into a foreign country on behalf of the international
      distributor.





**Critical
      Accounting Policies**





The
      Company’s discussion and analysis of its financial condition and results of
      operations are based upon the Company’s consolidated financial statements, which
      have been prepared in accordance with accounting principles generally accepted
      in the United States. The preparation of these financial statements requires
      the
      Company to make estimates and judgments that affect the reported amounts of
      assets, liabilities, revenues and expenses, and related disclosure of contingent
      assets and liabilities. On an on-going basis, the Company evaluates its
      estimates, including those related to bad debts, sales returns, inventories,
      and
      warranty obligations. The Company bases its estimates on historical experience
      and on various other assumptions that are believed to be reasonable under the
      circumstances, the results of which form the basis for making judgments about
      the carrying values of assets and liabilities that are not readily apparent
      from
      other sources. Actual results may differ from these estimates. The Company
      believes the following accounting policies require its more significant
      judgments and estimates used in the preparation of its financial
      statements.





**Revenue
      Recognition**





Revenues
      and the costs of products sold are recognized as the related products are
      shipped or installed, if there are significant installation costs. This revenue
      recognition policy is utilized for shipment of product to customers including
      both distributors and end-users.





Revenues
      derived from patent and intellectual property license agreements are recognized
      when both the delivery of the technology has occurred and all parties have
      signed the agreement.





22





**Estimating
      Allowances for Doubtful Accounts and Sales Returns**





The
      Company maintains allowances for doubtful accounts for estimated losses
      resulting from the inability of its customers to make required payments.
      Management analyzes specific accounts receivable as well as historical bad
      debts, customer concentrations, customer credit-worthiness, current economic
      trends, foreign currency movements, and changes in its customer payment terms
      when evaluating the allowance for doubtful accounts. If the financial condition
      of any of the Company’s customers were to deteriorate, resulting in impairment
      of their ability to make payments, additional allowances may be
      required.





The
      Company also maintains a sales returns reserve in order to estimate potential
      future product returns related to current period revenue. Management analyzes
      historical returns, current economic trends, changes in customer demand, and
      acceptances of the Company’s products when evaluating the adequacy of the sales
      returns reserve. Significant management judgments and estimates must be made
      and
      used in connection with establishing the sales returns reserve in any accounting
      period. Material differences may result in the timing of the Company’s revenue
      if management made different judgments or utilized different
      estimates.





**Valuation
      of Inventories**





Inventories
      are stated at the lower of cost or market, with cost determined on the first-in,
      first-out method. The Company maintains a reserve for obsolete inventory that
      it
      utilizes to write down inventories for estimated obsolescence or unmarketable
      inventory equal to the difference between the carrying value of the inventory
      and the estimated market value. The Company determines the adequacy of the
      obsolescence reserve by considering historical annual usage of component parts
      and finished goods as well as assumptions about market conditions and forecasted
      demand. When items are physically disposed of the amounts are written off
      against the reserve. If future product demand is lower than expected or if
      market conditions are less favorable than those projected by the Company,
      additional charges to increase the obsolescence reserve may be
      required.





During
      fiscal 2006, the reserve for obsolete inventory was decreased $78,300 to
      $360,000 at June 30, 2006 due mainly to the disposal of obsolete inventory
      that
      had been reserved for in prior years. During fiscal 2005, the reserve for
      obsolete inventory was decreased $171,700 to $438,300 at June 30, 2005 due
      mainly to the disposal of obsolete inventory that had been reserved for in
      prior
      years.




**Product
      Warranty**





The
      Company provides for the estimated cost of product warranties at the time
      products are shipped based upon its historical experience providing warranty
      coverage. The Company’s warranty obligations are affected by product failure
      rates, material usage and service delivery costs incurred in correcting a
      product failure. If actual product failure rates, material usage or service
      delivery costs differ from current projections, revisions to the estimated
      warranty reserve would be required.





23





**Liquidity
      and Capital Resources**





As
      of
      June 30, 2006, the Company had a cash balance of $3,793,781 as compared with
      its
      fiscal 2005 year-end cash balance of $3,680,965. The Company has continued
      to
      maintain a bank debt free balance sheet.





The
      Company has been able to increase its cash position by an aggregate of $77,335
      over the last three fiscal years despite generating aggregate net losses of
      $(2,310,700) during this period. Non-cash expenses consisting primarily of
      depreciation expense, provisions for obsolete inventory and provision from
      doubtful accounts decreased the Company’s profitability by an aggregate of
      $3,955,301 during the last three fiscal years, but did not impact the Company’s
      cash flows. Over the last three fiscal years the Company has been able to fund
      $1,543,472 of cash used in operations and capital spending of $1,198,505
      primarily with $2,940,201 of cash provided by the exercise of stock
      options.





In
      fiscal
      2006, $1,213,677 of cash was generated from the issuance of 473,045 shares
      of
      common stock upon the exercise of stock options, most of which were scheduled
      to
      expire in less than one year. This cash partially offset the $581,532 of cash
      used in operations and the $669,275 of capital spending in fiscal 2006. 
Cash used in operations in fiscal 2006 was primarily driven by the inventory
      investment in the new, next generation portable multi-parameter vital signs
      monitor.  In fiscal 2005, $688,724 of cash was generated from the issuance
      of 280,337 shares of common stock upon the exercise of stock options and an
      additional $131,250 of cash was generated from the issuance of 70,000 shares
      of
      common stock upon the exercise of stock warrants, most of which were scheduled
      to expire in less than one year. This cash partially offset the $726,064 of
      cash
      used in operations and the $116,167 of capital spending in fiscal 2005. In
      fiscal 2004, $855,664 of cash provided from the issuance of 470,725 shares
      of
      common stock upon the exercise of stock options, most of which were scheduled
      to
      expire in less than one year, more than offset $413,063 of capital spending
      and
      $408,864 of cash used in operations.





The
      Company believes all future capital and liquidity requirements will be satisfied
      by cash generated from operations, proceeds received from the issuance of common
      stock related to the exercise of stock options, and its current cash balances.
      No major capital equipment expenditures are expected in the Company’s next
      fiscal year ending June 30, 2007. The Company also has a $2,000,000 line of
      credit currently in place that could be utilized, if necessary. At June 30,
      2006, there were no borrowings outstanding under this line of credit. The credit
      facility has covenants which require minimum income or liquidity levels. The
      Company was in compliance with the covenants at June 30, 2006. This line expires
      in June 2007.





The
      following table summarizes the Company’s contractual cash obligations at June
      30, 2006 in the categories set forth below, and the effect such obligations
      are
      expected to have on its liquidity and cash flow in future fiscal
      periods:




Total
            
            2007
            
            2008
            
            2009
            
            2010
            
            2011
                andThereafterOperating
                leases
            
            $
            455,239
            
            $
            334,427
            
            $
            86,479
            
            $
            31,664
            
            $
            2,669
            
            
            --Capital
                leases
            
            
            227,760
            
            
            82,560
            
            
            82,560
            
            
            52,140
            
            
            10,500
            
            
            --Contract
                manufacturing obligations
            
            
            555,000
            
            
            555,000
            
            
            --
            
            
            --
            
            
            --
            
            
            --Other
                long-term obligations
            
            
            8,561
            
            
            7,902
            
            
            659
            
            
            --
            
            
            --
            
            
            --Total
                contractual obligations
            
            $
            1,246,560
            
            $
            979,889
            
            $
            169,698
            
            $
            83,804
            
            $
            13,169
            
            
            --




24





Item
      7A . QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK .





The
      Company has a demand line of credit facility with a commercial bank with
      interest payable monthly at 25 basis points below the bank's reference rate.
      The
      Company had no borrowings outstanding under this bank facility at June 30,
      2006, 2005, and 2004. Due historically to the lack of need to borrow from this
      credit facility and due to the Company’s current cash position, the Company is
      not subject to financial risk on this obligation if interest rates in the market
      change significantly.





The
      Company’s net sales are primarily denominated in United States dollars, except
      for a small amount of net sales from the Company’s operations in India which are
      denominated in Indian rupees. As a result, part of the Company’s accounts
      receivable are denominated in rupees and translated into U.S. dollars for
      financial reporting purposes. A 10% change in the exchange rate of the U.S.
      dollar with respect to the Indian rupee would not have a material adverse effect
      on the Company’s financial condition or results of operations for the fiscal
      year ended June 30, 2006. The Company does not use any hedges or other
      derivative financial instruments to manage or reduce exchange rate
      risk.





25




Item
      8 . FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA .





FINANCIAL
      STATEMENTS





**CRITICARE
      SYSTEMS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**


**JUNE
      30, 2006 AND 2005**





ASSETS
                (Note 6)
            
            2006
            
            2005CURRENT
                ASSETS:Cash
                and cash equivalents (Notes 1 and 10)
            
            $
            3,793,781
            
            $
            3,680,965Accounts
                  receivable, less allowance for doubtful accounts
                of
                  $829,700 and $300,000, respectively (Note 1)
            
            
            6,187,351
            
            
            6,847,432Other
                receivables (Note 1)
            
            
            591,008
            
            
            645,479Short-term
                note receivable (Note 1)
            
            
            50,000
            
            
            --Inventories
                (Notes 1 and 2)
            
            
            9,464,037
            
            
            5,551,093Prepaid
                expenses
            
            
            227,606
            
            
            255,104Total
                current assets
            
            
            20,313,783
            
            
            16,980,073PROPERTY,
                PLANT AND EQUIPMENT (Note 1):Machinery
                and equipment
            
            
            3,157,328
            
            
            2,800,269Furniture
                and fixtures
            
            
            952,193
            
            
            947,726Leasehold
                improvements
            
            
            243,604
            
            
            220,407Demonstration
                and loaner monitors
            
            
            1,997,844
            
            
            1,352,267Production
                tooling
            
            
            2,294,360
            
            
            2,009,809Property,
                plant and equipment - cost
            
            
            8,645,329
            
            
            7,330,478Less
                accumulated depreciation
            
            
            6,193,015
            
            
            5,320,061Property,
                plant and equipment - net
            
            
            2,452,314
            
            
            2,010,417OTHER
                ASSETS:License
                rights and patents - net (Notes 1 and 3)
            
            
            62,981
            
            
            69,983Long-term
                note receivable (Note 1)
            
            
            150,000
            
            
            --Total
                other assets
            
            
            212,981
            
            
            69,983TOTAL
                ASSETS
            
            $
            22,979,078
            
            $
            19,060,473





See
      notes
      to consolidated financial statements.





26





LIABILITIES
                AND STOCKHOLDERS' EQUITY
            
            2006
            
            2005CURRENT
                LIABILITIES:Accounts
                payable
            
            $
            5,408,746
            
            $
            3,033,559Accrued
                liabilities:Compensation
                and commissions
            
            
            914,889
            
            
            900,636Product
                warranties (Notes 1 and 4)
            
            
            425,000
            
            
            452,000Obligations
                under capital lease (Note 12)
            
            
            68,205
            
            
            62,739Other
            
            
            174,667
            
            
            191,807Total
                current liabilities
            
            
            6,991,507
            
            
            4,640,741LONG-TERM
                LIABILITIES:Obligations
                under capital lease (Note 12)
            
            
            133,826
            
            
            202,031Other
                long-term obligations
            
            
            659
            
            
            8,561Total
                long-term liabilities
            
            
            134,485
            
            
            210,592COMMITMENTS
                AND CONTINGENCIES (Notes 7, 9 and 12)TOTAL
                LIABILITIES
            
            
            7,125,992
            
            
            4,851,333STOCKHOLDERS'
                EQUITY (Notes 1 and 8):Preferred
                  stock - $.04 par value, 500,000 shares authorized,
                no
                  shares issued or outstanding
            
            
            --
            
            
            --Common
                  stock - $.04 par value, 15,000,000 shares authorized, 12,398,131
                  and
                11,925,086
                  shares issued, and 12,291,454 and 11,812,493 outstanding,
                  respectively
            
            
            495,925
            
            
            477,003Additional
                paid-in capital
            
            
            26,156,864
            
            
            24,775,995Common
                stock held in treasury (106,677 and 112,593 shares, respectively)
            
            
            (375,813
            )
            
            (386,834
            )Retained
                earnings (accumulated deficit)
            
            
            (10,436,794
            )
            
            (10,648,912
            )Cumulative
                translation adjustment
            
            
            12,904
            
            
            (8,112
            )Total
                stockholders' equity
            
            
            15,853,086
            
            
            14,209,140TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY
            
            $
            22,979,078
            
            $
            19,060,473





See
      notes
      to consolidated financial statements.





27





**CRITICARE
      SYSTEMS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**YEARS
      ENDED JUNE 30, 2006, 2005 AND 2004**





**2006**
            
            **2005**
            
            **2004****NET
                SALES (**Notes
                10 and 11**)**
            
            $
            31,350,919
            
            $
            26,781,627
            
            $
            28,591,481**COST
                OF GOODS SOLD**
            
            
            19,308,353
            
            
            16,311,144
            
            
            16,821,782**GROSS
                PROFIT**
            
            
            12,042,566
            
            
            10,470,483
            
            
            11,769,699**OPERATING
                EXPENSES:**Sales
                and marketing (Note 1)
            
            
            6,950,311
            
            
            5,670,505
            
            
            7,150,867Research,
                development and engineering (Note 1)
            
            
            2,362,512
            
            
            2,620,134
            
            
            2,532,129Administrative
                (Note 9)
            
            
            3,177,232
            
            
            2,906,039
            
            
            3,661,216Total
            
            
            12,490,055
            
            
            11,196,678
            
            
            13,344,212**LOSS
                FROM OPERATIONS**
            
            
            (447,489
            )
            
            (726,195
            )
            
            (1,574,513
            )**OTHER
                (EXPENSE) INCOME:**Interest
                expense (Note 12)
            
            
            (19,820
            )
            
            (28,848
            )
            
            (9,282
            )Interest
                income
            
            
            94,830
            
            
            58,710
            
            
            37,176Foreign
                currency exchange gain (loss) (Note 1)
            
            
            (108,225
            )
            
            131,885
            
            
            --Other
                income (expense) (Note 14)
            
            
            692,822
            
            
            142,203
            
            
            (553,954
            )Total
            
            
            659,607
            
            
            303,950
            
            
            (526,060
            )**INCOME
                (LOSS) BEFORE INCOME TAXES**
            
            
            212,118
            
            
            (422,245
            )
            
            (2,100,573
            )**INCOME
                TAX PROVISION (**Notes
                1 and 5**)**
            
            
            --
            
            
            --
            
            
            --**NET
                INCOME (LOSS)**
            
            $
            212,118
            
            $
            (422,245
            )
            $
            (2,100,573
            )**NET
                INCOME (LOSS) PER COMMON SHARE (**Note
                1**):**Basic
                and diluted
            
            $
            0.02
            
            $
            (0.04
            )
            $
            (0.19
            )**WEIGHTED
                  AVERAGE NUMBER OF COMMON**
                **SHARES
                  OUTSTANDING (Note 1):**Basic
            
            
            12,069,060
            
            
            11,514,786
            
            
            11,240,685Diluted
            
            
            12,256,431
            
            
            11,514,786
            
            
            11,240,685





See
      notes
      to consolidated financial statements.





28




**CRITICARE
      SYSTEMS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' EQUITY**


**YEARS
      ENDED JUNE 30, 2006, 2005 AND 2004**




RetainedAdditional
            
            Common
                Stock
            
            
            
            Earnings
            
            Cumulative
            
            TotalCommon
                Stock
            
            Paid-In
            
            Treasury
            
            Subscriptions
            
            (Accumulated
            
            Translation
            
            Stockholders’Shares
            
            Amount
            
            Capital
            
            Shares
            
            Cost
            
            Receivable
            
            Deficit)
            
            Adjustment
            
            Equity**Balance,
                June 30, 2003**
            
            
            11,204,024
            
            $
            448,161
            
            $
            23,360,244
            
            
            130,192
            
            $
            (419,618
            )
            $
            (225,000
            )
            $
            (8,126,097
            )
            $
            (3,482
            )
            $
            15,034,208Net
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,100,573
            )
            
            
            
            
            (2,100,573
            )Comprehensive
                income/(loss)Exercise
                of options
            
            
            370,725
            
            
            14,829
            
            
            600,455
            
            
            
            
            
            
            
            
            225,000
            
            
            
            
            
            
            
            
            840,284Employee
                  common stock
                purchased
                  from treasury
            
            
            
            
            
            
            
            
            5,201
            
            
            (5,464
            )
            
            10,179
            
            
            
            
            
            
            
            
            
            
            
            15,380**Balance,
                June 30, 2004**
            
            
            11,574,749
            
            $
            462,990
            
            $
            23,965,900
            
            
            124,728
            
            $
            (409,439
            )
            $
            0
            
            $
            (10,226,670
            )
            $
            (3,482
            )
            $
            13,789,299Net
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (422,242
            )
            
            
            
            
            (422,242
            )Cumulative
                translation adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,630
            )
            
            (4,630
            )Comprehensive
                income/(loss)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (426,872
            )Exercise
                of options
            
            
            280,337
            
            
            11,213
            
            
            677,511
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            688,724Exercise
                of warrants
            
            
            70,000
            
            
            2,800
            
            
            128,450
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            131,250Employee
                  common stock
                purchased
                  from treasury
            
            
            
            
            
            
            
            
            4,134
            
            
            (12,135
            )
            
            22,605
            
            
            
            
            
            
            
            
            
            
            
            26,739**Balance,
                June 30, 2005**
            
            
            11,925,086
            
            $
            477,003
            
            $
            24,775,995
            
            
            112,593
            
            $
            (386,834
            )
            $
            0
            
            $
            (10,648,912
            )
            $
            (8,112
            )
            $
            14,209,140Net
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            212,118
            
            
            
            
            
            212,118Cumulative
                translation adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            21,016
            
            
            21,016Comprehensive
                income/(loss)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            233,134Exercise
                of options
            
            
            473,045
            
            
            18,922
            
            
            1,194,755
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,213,677Stock-based
                employee compensation
            
            
            
            
            
            
            
            
            172,988
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            172,988Employee
                  common stock
                purchased
                  from treasury
            
            
            
            
            
            
            
            
            13,126
            
            
            (5,916
            )
            
            11,021
            
            
            
            
            
            
            
            
            
            
            
            24,147**Balance,
                June 30, 2006**
            
            
            12,398,131
            
            $
            495,925
            
            $
            26,156,864
            
            
            106,677
            
            $
            (375,813
            )
            $
            0
            
            $
            (10,436,794
            )
            $
            12,904
            
            $
            15,853,086





See
      notes
      to consolidated financial statements.





29





**CRITICARE
      SYSTEMS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**YEARS
      ENDED JUNE 30, 2006, 2005 AND 2004**





**2006**
            
            **2005**
            
            **2004****OPERATING
                ACTIVITIES:**Net
                income (loss)
            
            $
            212,118
            
            $
            (422,245
            )
            $
            (2,100,573
            )Adjustments
                  to reconcile net income (loss) to
                net
                  cash used in operating activities:Depreciation
            
            
            650,142
            
            
            588,559
            
            
            635,322Amortization
            
            
            7,002
            
            
            7,002
            
            
            7,001Share
                based compensation
            
            
            172,988
            
            
            --
            
            
            --Provision
                for doubtful accounts
            
            
            559,206
            
            
            87,695
            
            
            393,758Provision
                for obsolete inventory
            
            
            56,622
            
            
            281,003
            
            
            509,001Note
                receivable
            
            
            (200,000
            )
            
            --
            
            
            --Changes
                in assets and liabilities:Accounts
                receivable
            
            
            100,875
            
            
            (445,243
            )
            
            (1,256,444
            )Other
                receivables
            
            
            54,471
            
            
            (285,673
            )
            
            193,341Inventories
            
            
            (4,392,330
            )
            
            197,563
            
            
            (469,269
            )Prepaid
                expenses
            
            
            27,498
            
            
            109,271
            
            
            (23,441
            )Accounts
                payable
            
            
            2,375,187
            
            
            (203,846
            )
            
            964,452Accrued
                liabilities
            
            
            (32,323
            )
            
            (640,150
            )
            
            737,988Net
                cash used in operating activities
            
            
            (408,544
            )
            
            (726,064
            )
            
            (408,864
            )**INVESTING
                ACTIVITIES:**Purchases
                of property, plant and equipment, net
            
            
            (669,275
            )
            
            (116,167
            )
            
            (413,063
            )Net
                cash used in investing activities
            
            
            (669,275
            )
            
            (116,167
            )
            
            (413,063
            )**FINANCING
                ACTIVITIES:**Retirement
                of obligation under capital lease
            
            
            (68,205
            )
            
            (57,712
            )
            
            (11,358
            )Proceeds
                from issuance of common stock
            
            
            1,237,824
            
            
            846,713
            
            
            855,664Net
                cash provided by financing activities
            
            
            1,169,619
            
            
            789,001
            
            
            844,306**EFFECT
                OF EXCHANGE RATE CHANGES ON CASH**
            
            
            21,016
            
            
            (4,630
            )
            
            --**NET
                INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**
            
            
            112,816
            
            
            (57,860
            )
            
            22,379**CASH
                AND CASH EQUIVALENTS, BEGINNING OF YEAR**
            
            
            3,680,965
            
            
            3,738,825
            
            
            3,716,446**CASH
                AND CASH EQUIVALENTS, END OF YEAR**
            
            $
            3,793,781
            
            $
            3,680,965
            
            $
            3,738,825**SUPPLEMENTAL
                CASH FLOW INFORMATION:**Cash
                paid for:Income
                taxes paid—net
            
            $
            3,910
            
            $
            2,506
            
            $
            3,053Interest
            
            
            19,820
            
            
            26,596
            
            
            11,535Noncash
                investing and financing activities:Cost
                of fixed asset disposals
            
            
            --
            
            
            61,522
            
            
            1,898,210Property,
                plant, and equipment acquired under capital lease
            
            
            --
            
            
            --
            
            
            333,840





See
      notes
      to consolidated financial statements.





30




**NOTES
      TO FINANCIAL STATEMENTS**





**CRITICARE
      SYSTEMS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**YEARS
      ENDED JUNE 30, 2006, 2005 AND 2004**





**1.** **SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES**





**Nature
      of Business** --
      Criticare Systems, Inc. designs, manufactures and markets patient monitoring
      equipment and related accessories to the health care community worldwide and
      is
      headquartered in Waukesha, Wisconsin. The Company sells domestically primarily
      to oral and stand-alone general surgery centers and hospitals through regional
      sales managers and a dealer network. Internationally, the Company sells mainly
      to hospitals through country managers and a worldwide dealer network. In
      addition, the Company sells modules and stand-alone monitors worldwide to
      original equipment manufacturers (“OEMs”).





**Principles
      of Consolidation** -- The
      consolidated financial statements include the accounts of Criticare Systems,
      Inc. (the "Company") and its wholly owned subsidiaries: Criticare International
      GmbH Marketing Services ("Criticare International"), CSI Trading, Inc. ("CSI
      Trading"), Criticare Service GmbH ("Criticare Service"), Criticare Biomedical,
      Inc. ("Criticare Biomedical"), Sleep Care, Inc. ("Sleep Care"), Criticare
      Systems Limited ("Criticare Limited"), and Criticare Integration, Inc.
      ("Criticare Integration"). CSI Trading was incorporated in November 1996 to
      assist with European marketing activities and includes an operation in India.
      All significant intercompany accounts and transactions have been
      eliminated.





**Cash
      Equivalents** -- The
      Company considers all investments with purchased maturities of less than three
      months to be cash equivalents.





**Accounts
      Receivable and Allowance for Doubtful Accounts --** Accounts
      receivable are customer obligations due under normal trade terms. The Company
      sells its products to distributors, OEMs, and end users in medical facilities
      such as hospitals, surgery centers, nursing homes, and physician offices. The
      Company performs continuing credit evaluations of its customers’ financial
      condition, and although it generally does not require collateral, letters of
      credit may be required from customers in certain circumstances.





Management
      reviews accounts receivable on a monthly basis to determine if any receivables
      will potentially be uncollectible. The Company includes any accounts receivable
      balances that are determined to be uncollectible, along with a general reserve,
      in its overall allowance for doubtful accounts. The general reserve in the
      allowance for doubtful accounts is a calculation based upon the accounts
      receivable balance and the historical effectiveness of Criticare's collection
      of
      those receivables. The general reserve as of June 30, 2006 and 2005 is $100,000
      and $89,602, respectively. After all attempts to collect a receivable have
      failed, the receivable is written off against the allowance. Based on the
      information available, the Company believes its allowance for doubtful accounts
      as of June 30, 2006 and 2005 is adequate. However, actual write-offs might
      exceed the recorded allowance.





31





**Inventories** --
      Inventories are stated at the lower of cost or market, with cost determined
      on
      the first-in, first-out method.





**Other
      Receivables** -- **** Other
      receivables as of June 30, 2006 and 2005 consist mainly of tender deposits
      in
      the amount of $130,880 and $145,090, respectively, bank guarantees in the amount
      of $28,917 and $27,574, respectively, and receivables to be paid via letters
      of
      credit amounting to $259,286 and $256,627, respectively.





**Note
      Receivable** -- **** Note
      receivable as of June 30, 2006 consisted of a non-exclusive license agreement
      with quarterly royalty payments ending January 1, 2010. This license agreement
      is treated, for accounting purposes, as a non-interest bearing note which is
      segregated into a $50,000 short-term note and a $150,000 long-term note,
      respectively. The future maturities of the note receivable is $50,000 in each
      of
      the fiscal years, 2006, 2007, 2008 and 2009, respectively.





**Property,
      Plant and Equipment** --
      Property, plant and equipment is recorded at cost. Each member of the Company's
      sales force is provided with demonstration monitors to assist them in their
      sales efforts. The Company also has loaner monitors which are used to
      temporarily replace a customer's unit when it is being repaired or upgraded.
      Depreciation is provided over the estimated useful lives of the assets. The
      estimated useful lives of other property and equipment are as follows:


****EstimatedClassification
              
              Useful
                  LivesMachinery
                  and equipment
              
              5-7
                  yearsFurniture
                  and fixtures
              
              5
                  yearsLeasehold
                  improvements
              
              4-5
                  yearsDemonstration
                  and loaner monitors
              
              4
                  yearsProduction
                  tooling
              
              5-7
                  years
 The
        Company periodically assesses the recoverability of long-lived assets, including
        property and equipment and intangibles, in accordance with the Statement
        of
        Financial Accounting Standards No. 144, “Accounting for the Impairment of
        Long-Lived Assets and for Long-Lived Assets to be Disposed Of” (“SFAS No. 144”),
        when indications of potential impairment exist. The amount of any impairment
        is
        calculated by comparing the estimated fair market value with the carrying
        value
        of the related asset. Management considers such factors as current operating
        results, trends, and future prospects, in addition to other economic factors
        in
        performing this analysis. No such impairments exist at June 30, 2006 and
        2005.
        As of July 1, 2005, in accordance with the Statement of Financial Accounting
        Standards No. 86, Accounting for the Costs of Computer Software to be Sold,
        Leased or Otherwise Marketed” (“SFAS No. 86”), the Company will accumulate and
        amortize the software costs on a product-by product basis once the technological
        feasibility of the product has been established. Amortization of the costs
        will
        be equal to the straight-line amortization of the costs over the estimated
        economic life of the product.





32





**License
      Rights and Patents** -- The Company adopted SFAS 142, “Goodwill and Other
      Intangible Assets,” during the period ended June 30, 2003 to account for its
      license rights and patents. License rights and patents are carried at cost
      and
      are amortized using the straight-line method over their estimated useful life
      as
      follows:




****EstimatedClassification
              
              Useful
                  LivesLicense
                  rights and patents
              
              17
                  years


License
      rights and patents are evaluated for impairment when events or changes in
      circumstances indicate that the carrying amounts of the assets may not be
      recoverable through the estimated undiscounted future cash flows resulting
      from
      the use of these assets. When any such impairment exists, the related assets
      will be written down to fair value.





**Revenue
      Recognition** --
      Revenues and the costs of products sold are recognized as the related products
      are shipped or installed, if there are significant installation costs. This
      revenue recognition policy is utilized for shipment of product to customers,
      including both distributors and end-users. Revenue for the non-exclusive license
      agreement is recognized, in accordance with SAB No. 104, when all four elements
      for revenue recognition have been met.





**Shipping
      Costs** -- **** Any
      shipping costs that are billable to the customer are included in revenue and
      all **** shipping
      costs are included in cost of goods sold in the accompanying consolidated
      statements of operations.





**Product
      Warranties** --
      Estimated costs for product warranties are accrued for and charged to operations
      as the related products are shipped and installed.





**Marketing
      Expenses** --
      Marketing expenses include all of the Company's sales related costs. Bad debt
      expense totaled $559,206, $87,695 and $393,758 in fiscal 2006, 2005 and 2004,
      respectively.





**Advertising
      Costs** --
      Advertising costs are expensed as incurred. Advertising costs totaled $97,460,
      $68,120 and $101,174 for the years ended June 30, 2006, 2005 and 2004,
      respectively.





**Research
      and Development Expenses** --
      Research and development costs are charged to operations as incurred. Such
      expenses totaled $2,304,226, $2,561,386 and $2,271,476 in fiscal 2006, 2005
      and
      2004, respectively.





**Income
      Taxes** -- The
      Company accounts for income taxes using an asset and liability approach.
      Deferred income tax assets and liabilities are computed annually for differences
      between the financial statements and tax bases of assets and liabilities that
      will result in taxable or deductible amounts in the future based on enacted
      tax
      laws and rates applicable to the periods in which the differences are expected
      to affect taxable income. The Company pays income taxes in certain states that
      require an annual minimum tax. These taxes are included in administrative
      expenses in the consolidated statements of operations.





33





**Translation
      of Foreign Currency** --
      The
      Company follows the translation policy as provided by Financial Accounting
      Standards No. 52, “Foreign Currency Translation” in translating the financial
      statements of its operation in India from Indian rupees to U.S. dollars.
      Accordingly, assets and liabilities are translated at the rate of exchange
      at
      the balance sheet date. Income and expense items are translated at the average
      exchange rate prevailing throughout the year.





**Net
      Income (Loss) Per Common Share** -- Basic
      income (loss) per share is computed using the weighted average number of common
      shares outstanding during the periods. Diluted income (loss) per share is
      computed using the weighted average number of common and dilutive common
      equivalent shares outstanding during the periods. The basic and diluted weighted
      average number of common shares outstanding in the financial statements are
      the
      same in fiscal years 2005 and 2004 because including a diluted calculation
      in a
      loss position would produce an anti-dilutive per share amount. The number of
      diluted weighted average common shares outstanding would be higher by 131,230
      shares in 2005 and 335,215 shares in 2004 without this anti-dilutive
      impact.





**Stock
      Options** --
      The
      Company grants options to purchase Criticare Systems, Inc. common shares under
      stock option plans that are described more fully in Note 8. Prior to fiscal
      2006, the Company had adopted the disclosure-only provisions of SFAS No. 123,
      “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for
      Stock-Based Compensation—Transition and Disclosure." Effective July 1, 2005, the
      Company adopted the fair value recognition provisions of SFAS No. 123 (R),
      “Share-Based Payment." Under the modified prospective method of adoption
      selected by the Company, compensation cost recognized in fiscal 2006 is the
      same
      as that which would have been recognized had the recognition provisions of
      SFAS
      No. 123 been applied from its original effective date. Results for the prior
      year have not been restated. If the Company had elected to recognize
      compensation cost for the options granted during the years ended June 30, 2005
      and 2004, consistent with the method prescribed by SFAS No. 123, net loss
      and net loss per share would have been changed to the pro forma amounts
      indicated below:





**Years
                Ended June 30,****2005**
            
            
            **2004**Net
                loss - as reported
            
            $
            (422,245
            )
            $
            (2,100,573
            )Deduct:
                Total stock-based employee compensation
              expensedetermined
                under fair value based
              method
                for all awards
            
            
            (211,498
            )
            
            (285,566
            )Net
                loss - pro forma
            
            $
            (633,743
            )
            $
            (2,386,139
            )Basic
                net loss per share - as reported
            
            $
            (0.04
            )
            $
            (0.19
            )Diluted
                net loss per share - as reported
            
            $
            (0.04
            )
            $
            (0.19
            )Basic
                net loss per share - pro forma
            
            $
            (0.06
            )
            $
            (0.21
            )Diluted
                net loss per share - pro forma
            
            $
            (0.06
            )
            $
            (0.21
            )








34





**Fair
      Value of Financial Instruments** -- The
      Company's financial instruments under SFAS No. 107 "Disclosure About Fair
      Value of Financial Instruments," includes cash, accounts receivable, accounts
      payable, borrowings under line of credit facility and long-term debt. The
      Company believes that the carrying amounts of these accounts are a reasonable
      estimate of their fair value because of the short-term nature of such
      instruments or, in the case of long-term debt because of interest rates
      available to the Company for similar obligations.





**Comprehensive
      Income** --
      Comprehensive income consists of net income and foreign currency translation
      adjustments, and is presented in the consolidated statements of stockholders'
      equity.





**Use
      of Estimates** -- The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities and disclosure of
      contingent assets and liabilities at the date of the financial statements and
      the reported amounts of revenues and expenses during the reporting period.
      Actual results could differ from those estimates.





**Reclassifications
      -** -
      Certain
      amounts for fiscal 2004 and fiscal 2005 have been reclassified to conform to
      the
      fiscal 2006 presentation.





**2.**
            **INVENTORIES**





Inventories
                consist of the following as of June
                30:





**2006**
            
            **2005**Component
                parts
            
            $
            2,605,751
            
            $
            3,573,396Work
                in process
            
            
            1,470,893
            
            
            1,085,172Finished
                units
            
            
            5,747,393
            
            
            1,330,825Total
                inventories
            
            
            9,824,037
            
            
            5,989,393Less:
                reserve for obsolescence
            
            
            360,000
            
            
            438,300Net
                inventory
            
            $
            9,464,037
            
            $
            5,551,093




**3.    
      LICENSE RIGHTS AND PATENTS**





The
      components of and changes in the carrying amount of license rights and patents
      are as follows:





**2006**
            
            **2005**License
                rights and patents
            
            $
            196,777
            
            $
            196,777Accumulated
                amortization
            
            
            (133,796
            )
            
            (126,794
            )Net
                license rights and patents
            
            $
            62,981
            
            $
            69,983








35





Future
      amortization of license and patents is as follows at June 30, 2006:





Year ended June 30,2007
            $
                7,0012008
            7,0012009
            7,0012010
            7,0012011
            7,001Thereafter
            27,976Total
            $62,981





Approximately
      $7,000 of amortization was charged to operations in each of the fiscal years
      ended June 30, 2006, 2005 and 2004.





**4.    
      PRODUCT WARRANTY**





The
      Company’s products are subject to warranties, and therefore reserves are
      established for the estimated future costs of repair or replacement and included
      in cost of sales at the time the related sale is recognized. These reserves
      are
      adjusted based on management’s best estimates of future warranty costs after
      considering historical and projected product failure rates and product repair
      costs. In the event that actual experience differs from these best estimates,
      changes in the Company’s warranty reserves might become necessary.





Changes
      in the Company’s warranty reserve for fiscal years 2006 and 2005 are as
      follows:





**2006**
            
            ******2005**Balance,
                beginning of year
            
            $
            452,000
            
            $
            444,000Warranties
                issued
            
            
            244,093
            
            
            297,955Settlements
            
            
            (271,093
            )
            
            (289,955
            )Changes
                in estimated pre-existing warranties
            
            
            --
            
            
            --Balance,
                end of year
            
            $
            425,000
            
            $
            452,000





The
                Company’s warranty settlements for fiscal 2004 totaled
                $321,212.





**5.**
            **INCOME
                TAXES**





The
      Company accounts for income taxes using an asset and liability approach, which
      generally requires the recognition of deferred income tax assets and liabilities
      based upon the expected future income tax consequences of events that have
      previously been recognized in the Company's financial statements or tax returns.
      In addition, a valuation allowance is recognized if it is more likely than
      not
      that some or all of the deferred income tax asset will not be realized. A
      valuation allowance is used to offset the related net deferred income tax assets
      due to uncertainties of realizing the benefits of certain net operating loss
      and
      tax credit carryforwards.





The
      valuation allowance was increased $260,000 in 2006 and $360,000 in
      2005.





36





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




**June
                30,**
            
            **June
                30,**
            
            **June
                30,****2006**
            
            **2005**
            
            **2004**Deferred
                income tax assets:Accounts
                receivable and sales allowances
            
            $
            341,000
            
            $
            148,000
            
            $
            133,000Inventory
                allowances
            
            
            183,000
            
            
            196,000
            
            
            269,000Product
                warranties
            
            
            167,000
            
            
            177,000
            
            
            174,000Other
                accrued liabilities
            
            
            139,000
            
            
            146,000
            
            
            135,000Severance
                pay accrual
            
            
            3,000
            
            
            9,000
            
            
            14,000Federal
                net operating loss carryforwards
            
            
            6,020,000
            
            
            6,004,000
            
            
            5,772,000State
                net operating loss carryforwards
            
            
            597,000
            
            
            601,000
            
            
            574,000Federal
                tax credit carryforwards
            
            
            143,000
            
            
            198,000
            
            
            198,000Excess
                of book over tax depreciation and amortization
            
            
            258,000
            
            
            116,000
            
            
            0Investment
                losses not deducted
            
            
            118,000
            
            
            118,000
            
            
            118,000Total
                deferred income tax assets
            
            
            7,969,000
            
            
            7,713,000
            
            
            7,387,000




Deferred
                income tax liabilities:Excess
                of tax over book depreciation and amortization
            
            
            0
            
            
            0
            
            
            (22,000
            )Prepaid
                expenses
            
            
            (38,000
            )
            
            (42,000
            )
            
            (54,000
            )Total
                deferred income tax liabilities
            
            
            (38,000
            )
            
            (42,000
            )
            
            (76,000
            )Valuation
                allowance
            
            
            (7,931,000
            )
            
            (7,671,000
            )
            
            (7,311,000
            )Net
                deferred income taxes recognized in the
              consolidated
                balance sheets
            
            $
            0
            
            $
            0
            
            $
            0




At
      June
      30, 2006, the Company had federal net operating loss carryforwards of
      approximately $17,706,000 which expire in 2008 through 2026. At June 30, 2006,
      the Company had available for federal income tax purposes approximately $87,000
      of alternative minimum tax credit carryforwards which carry forward indefinitely
      and approximately $56,000 of tax credit carryforwards which expire in the years
      2007 through 2009. The Company also has approximately $11,930,000 of state
      net
      operating loss carryforwards, which expire in 2007 through 2021, available
      to
      offset certain future state taxable income.





The
                income tax provision consists of the
                following:





**2006**
            
            **2005**
            
            **2004**CurrentFederal
            
            $
            0
            
            $
            0
            
            $
            0State
            
            
            0
            
            
            0
            
            
            0Total
                income tax provision
            
            $
            0
            
            $
            0
            
            $
            0





A
                reconciliation of the provision for income taxes (benefit) at the
                federal
                statutory income tax rate to the effective income tax rate
                follows:





**2006**
            
            **2005**
            
            **2004**Federal
                statutory income tax rate
            
            
            34.0
            %
            
            (34.0
            )%
            
            (34.0
            )%Losses
                and change in other deferrred assets
              for
                which no benefit was provided
            
            
            141.5
            
            
            77.2
            
            
            49.1Stock
                options and warrants
            
            
            (181.6
            )
            
            (46.0
            )
            
            15.5Other—net
            
            
            6.1
            
            
            2.8
            
            
            0.4Effective
                income tax rate
            
            
            0
            %
            
            0
            %
            
            0
            %




37





**6.**
            **LINE
                OF CREDIT FACILITY**





At
                June 30, 2006, the Company had a $2,000,000 demand line of credit
                facility
                with a commercial bank to meet its short-term borrowing needs. Borrowings
                against the line were payable on demand with interest payable monthly
                at
                the bank's reference rate, less 0.25% (8.00% as of June 30, 2006).
                As of
                June 30, 2006, 2005, and 2004 there were no borrowings against the
                line. Borrowings under the line of credit facility are collateralized
                by
                substantially all assets of the Company. The credit facility has
                covenants
                which require minimum income or liquidity levels. The Company was
                in
                compliance with the covenants at June 30,
                2006.





**7.**
            **CONTINGENCIES**





From
      time
      to time, various lawsuits arise out of the normal course of business. These
      proceedings are handled by outside counsel. Currently management is not aware
      of
      any claim or action pending against the Company that would have a material
      adverse effect on the Company.





**8.**
            **STOCKHOLDERS'
                EQUITY**





**Stock
      Options** -- At
      the
      December 1, 2005 annual meeting of the stockholders of the Company, the
      stockholders approved an amendment of the Criticare Systems, Inc. 2003 Stock
      Option Plan (the “2003 Plan”) to increase the number of shares of common stock
      available for future grants by 500,000 shares to 930,000 shares and to authorize
      grants of restricted stock and stock appreciation rights under the plan. During
      the annual stockholders meeting held on November 14, 2003, the Company’s
      stockholders approved the original 2003 Plan. This 2003 Plan replaced the 1992
      Employee Stock Option Plan and the 1992 Non-Employee Stock Option Plan
      (collectively, the “1992 Plans”) and 179,380 reserved shares of common stock
      available under the 1992 Plans were moved to the 2003 Plan. The stockholders
      also approved 250,620 shares being available for future grants in addition
      to
      the 179,380 shares currently available, for a total of 430,000 shares authorized
      for issuance under the 2003 Plan. The Company also has options outstanding
      under
      two plans which existed prior to the approval of the 1992 Plans, the 1987
      Employee Stock Option Plan and the 1987 Non-Employee Stock Option Plan
      (collectively with the 1992 Plans, the "Old Plans"). As a result of the approval
      of the 2003 Plan, no new stock options can be granted under the Old Plans,
      although the Company can regrant existing stock options under the Old Plans
      to
      extend the terms of such options.The
      Board
      of Directors has authorized in connection with these stock option plans the
      issuance of 3,210,620 reserved shares of common stock, of which495,875reserved
      shares remain available for future issuance at June 30, 2006.The
      Board
      of Directors increased the number of reserved shares for issuance under the
      Plans from 1,720,000 to 2,220,000 during 2001, from 2,220,000 to 2,460,000
      during 2002, from 2,460,000 to 2,710,620 during 2003, and from 2,710,620 to
      3,210,620 during 2005. The compensation cost that has been charged against
      income for the 2003 Plan and the Old Plans was $172,988 for the year ended
      June
      30, 2006. No income tax benefit was recognized in the income statement for
      share-based compensation arrangements due to the valuation allowance. The
      activity during 2004, 2005 and 2006 for the above plans is summarized as
      follows:




38




**Number
                  of**
              
              **Stock
                  Options**
              
              **Weighted
                  Avg.****Shares**
              
              **Price
                  Range**
              
              **Exercise
                  Price**Outstanding
                  at June 30, 2003
              
              
              1,426,370
              
              
              1.50-4.40
              
              
              2.35Granted
              
              
              414,000
              
              
              3.05-4.37
              
              
              3.19Cancelled
              
              
              (39,750
              )
              
              1.63-4.30
              
              
              3.21Exercised
              
              
              (370,725
              )
              
              1.50-2.97
              
              
              1.66Outstanding
                  at June 30, 2004
              
              
              1,429,895
              
              
              1.88-4.40
              
              
              2.75Granted
              
              
              96,000
              
              
              2.25-5.13
              
              
              2.97Cancelled
              
              
              (189,200
              )
              
              2.88-3.75
              
              
              3.16Exercised
              
              
              (280,337
              )
              
              1.88-4.30
              
              
              2.46Outstanding
                  at June 30, 2005
              
              
              1,056,358
              
              
              1.88-5.13
              
              
              2.77Granted
              
              
              45,000
              
              
              4.60-5.19
              
              
              4.90Cancelled
              
              
              (84,625
              )
              
              1.88-3.42
              
              
              2.51Exercised
              
              
              (473,045
              )
              
              1.88-4.40
              
              
              2.57Outstanding
                  at June 30, 2006
              
              
              543,688
              
              
              2.25-5.19
              
              
              3.17
 
 The
        following table summarizes the option activity as of June 30, 2006:
 
 Weighted
                  AverageSharesOutstanding
              
              Remaining
                  Contractual
              
              WeightedAverage
                  Exercise
              
              AggregateIntrinsic
                  ValueAt
                  June 30, 2006
              
              Life-Years
              
              Price
              
              at
                  June 30, 2006Options
                  Outstanding
              
              
              543,688
              
              
              6.70
              
              $
              3.17
              
              $
              491,729Options
                  Exercisable
              
              
              242,989
              
              
              5.81
              
              $
              3.01
              
              $
              239,789
 
 Option
        awards are granted with an exercise price equal to the market price of the
        Company’s stock at the date of the grant; those option awards generally vest
        based upon 4 years of continuous service and have 5 and 10 year contractual
        terms for the Old Plans and 2003 Plan, respectively, as determined by the
        Compensation Committee of the Company's Board of Directors. Certain option
        awards provide for accelerated vesting if there is a change in
        control.
 
 The
        Company has adopted the  fair
        value recognition provisions of SFAS No. 123 (R), “Share-Based Payment”. Under
        the modified prospective method of adoption selected by the Company,
        compensation cost recognized in fiscal 2006 is the same as that which would
        have
        been recognized had the recognition provisions of SFAS No. 123 been applied
        from
        its original effective date. The fair value of stock options is the estimated
        fair value at the grant date using the Black-Scholes option-pricing model.
        The
        fair value of each option award is estimated on the date of the grant using
        the Black-Scholes option-pricing model that uses the assumptions noted in
        the
        following table. Expected volatilities are based on implied volatilities
        from
        traded options on the Company’s stock, historical volatility of the Company’s
        stock, and other factors. The Company uses historical data to estimate option
        exercise and employee termination within the valuation model. The expected
        term
        of options granted is derived from the output of the option valuation model
        and
        represents the period of time that options granted are expected to be
        outstanding. The risk-free rate for periods within the contractual life of
        the
        option is based on the U.S. Treasury yield curve in effect at the time of
        the
        grant. The weighted average fair market value of the options granted during
        fiscal 2006, 2005 and 2004, along with the assumptions used, follows
        below:
  39
  **Years
                  Ended June 30,****2006**
              
              **2005**
              
              **2004**Weighted
                  average fair market value of options
                granted
                  during the fiscal year ended June 30
              
              $
              2.90
              
              $
              1.62
              
              $
              0.95
   Assumptions
                  used:Expected
                  volatility
              
              
              45.0
              %
              
              55.0
              %
              
              80.0
              %Risk-free
                  interest rate
              
              
              4.29
              %
              
              3.74
              %
              
              4.39
              %Expected
                  option life (in years)
              
              
              8.88
              
              
              6.25
              
              
              9.40
 
 The
        total
        intrinsic value of the options exercised during the years ended June 30,
        2006,
        2005 and 2004 was $1,132,994, $377,138 and $960,387,
        respectively.
 
 The
        following table summarizes the status of the Company’s nonvested shares as of
        June 30, 2006, and changes during the year ended June 30, 2006:
 
 **Number
                  of**
              
              **Weighted-Average
                  Grant****Nonvested
                  Shares**
              
              **Shares**
              
              **Date
                  Fair Value**Nonvested
                  at June 30, 2005
              
              
              398,005
              
              
              $3.02Granted
              
              
              45,000
              
              
              4.90Cancelled
              
              
              (3,188
              )
              
              3.04Vested
              
              
              (139,118
              )
              
              3.02Nonvested
                  at June 30, 2006
              
              
              300,699
              
              
              $3.30
 
 As
        of
        June 30, 2006 there was $184,717 of total unrecognized compensation cost
        related
        to nonvested share-based compensation arrangements granted under the 2003
        Plan
        and Old Plans. That cost is expected to be recognized over a weighted-average
        period of 1.48 years. The total fair value of the shares vested during the
        year
        ended June 30, 2006 was $139,392.
 
 **Stock
        Warrants** -- In
        February 1998, the Company executed a warrant agreement with a consultant.
        The
        warrant agreement provided for the issuance of warrants to purchase up to
        150,000 shares of common stock at a price of $3.00 per share. The warrant
        was
        exercisable as to 30,000 shares upon execution of the agreement and the warrants
        to purchase the remaining 120,000 shares were to be exercisable if certain
        performance parameters were achieved by February 1999. No such parameters
        were
        achieved. These warrants expired in February 2003, but were amended. The
        30,000
        warrants were extended for an additional five years with an exercise price
        of
        $2.88 per share which represents the closing price of the Company’s stock on the
        date the warrants were amended. The fair value of the extended warrants,
        based
        on the estimated fair value using the Black-Scholes pricing model, totaled
        $24,990 and was expensed during the year in which they were extended, fiscal
        2003.
 
 In
        December 2000, the Company executed another warrant agreement with the
        consultant. The warrant agreement provided for the issuance of warrants to
        purchase up to 70,000 shares of common stock at a price of $1.875 per share.
        The
        warrant vested over a four year period in four equal increments each year
        on the
        anniversary date of the warrant. The warrant was to terminate as to any shares
        that were unvested at the time the consultant ceased to provide consulting
        services to the Company. As of December 21, 2004, the warrant had fully vested.
        During fiscal 2005, this warrant was exercised in full to purchase 70,000
        shares. The fair value of this warrant is the estimated fair value using
        the
        Black-Scholes pricing model. The fair value is expensed over the vesting
        period
        of the grants.
 40
  **Preferred
        Stock** -- The
        Company's Board of Directors has the authority to determine the relative
        rights
        and preferences of any series it may establish with respect to the 500,000
        shares of $.04 par value authorized preferred shares. As of June 30, 2006,
        no
        preferred stock was issued or outstanding.
 
 On
        March
        27, 1997, the Board of Directors of the Company declared a dividend of one
        preferred share purchase right (a "Right") for each outstanding share of
        common
        stock of the Company. The dividend was made on April 24, 1997 to the
        stockholders of record on that date to purchase Preferred Stock ("Preferred")
        upon the occurrence of certain events. The Rights will be exercisable the
        tenth
        business day after a person or group acquires 20% of the Company's common
        stock,
        or makes an offer to acquire 30% or more of the Company's common stock. When
        exercisable, each right entitles the holder to purchase for $25, subject
        to
        adjustment, one-hundredth of a share of Preferred for each share of common
        stock
        owned. Each share of Preferred will be entitled to a minimum preferential
        quarterly dividend of $25 per share, but not less than an aggregate dividend
        of
        100 times the common stock dividend. Each share will have 100 votes, voting
        together with the common stock. In the event of any merger, each share of
        Preferred will be entitled to receive 100 times the amount received per share
        of
        common stock. The Rights expire on April 1, 2007.
 
 **Common
        Stock Held in Treasury --** At
        June
        30, 2006 and 2005, the Company held in Treasury 106,677 and 112,593 shares
        of
        common stock, respectively. On February 28, 2002, the Criticare Board of
        Directors approved the purchase in the open market of up to 500,000 shares
        of
        Criticare common stock. At June 30, 2006 and 2005, the Company held in Treasury
        76,223 shares of common stock purchased  in
        accordance with this stock buyback program.
 
 **Employee
        Stock Purchase Plan --** The
        Company has an Employee Stock Purchase Plan to provide employees of the Company
        with an opportunity to purchase common stock of the Company through accumulated
        payroll deductions. The plan allows eligible employees to purchase shares
        of the
        Company’s common stock through monthly offering periods. The option price for
        each share of common stock purchased equals 85% of the last quoted sales
        price
        of a share of the Company’s common stock as reported by the American Stock
        Exchange on the first day of the monthly offering period or the last day
        of the
        monthly offering period, whichever is lower. The Company is authorized to
        issue
        500,000 shares of common stock under the plan. As of June 30, 2006, the
        Company had issued a total of 73,643 shares of common stock under the plan,
        and
        had 426,357 shares of common stock authorized for future issuance under the
        plan. The plan will terminate on July 1, 2009, unless sooner terminated by
        the
        Board of Directors.




**9.** **EMPLOYEE
      BENEFIT PLAN**





The
      Company has a 401(k) plan which covers substantially all employees. Company
      contributions to the plan are discretionary and determined annually by the
      Company's Board of Directors. The Company's contributions were approximately
      $104,000, $97,000 and $96,000 in 2006, 2005 and 2004, respectively.





**10.** **BUSINESS
      AND CREDIT CONCENTRATIONS**





Financial
      instruments which potentially subject the Company to concentrations of credit
      risk consist of cash, certificates of deposit, and accounts receivable. These
      financial instruments are carried at approximate fair value, less appropriate
      allowance, due to their short maturities.





41





The
      Company maintains cash balances which at times may exceed federally insured
      limits. As of June 30, 2006 and 2005, the Company held $3,764,888 and
      $3,401,743, respectively, in excess of federally insured limits. The Company’s
      management evaluates the creditworthiness of the financial institutions in
      which
      it places its cash. The Company has not experienced any losses in such accounts
      and does not believe it is exposed to any significant credit risk for cash
      accounts.





The
      Company is a manufacturer of medical monitors and telemetry products whose
      customers include hospitals and alternative health care sites throughout the
      world. Although the Company's products are sold primarily to health care
      providers, concentrations of credit risk with respect to trade accounts
      receivable are limited due to the Company's large number of customers, their
      geographic dispersion, and the Company’s credit evaluation process. The Company
      currently coordinates substantially all international sales and distribution
      activities through its headquarters in Waukesha, Wisconsin. Other than
      inventory, other receivables and accounts receivable for the Company’s operation
      in India totaling approximately $1.2 million, identifiable assets located
      outside of the United States are insignificant in relation to the Company's
      total assets. Net export sales by geographic area are as follows:





**2006**
            
            **2005**
            
            **2004**Europe
                and Middle East
            
            $
            7,355,000
            
            $
            7,182,000
            
            $
            7,164,000Pacific
                Rim
            
            
            1,692,000
            
            
            1,787,000
            
            
            1,389,000Canada
                and Central and South America
            
            
            3,516,000
            
            
            2,689,000
            
            
            3,246,000Export
                net sales
            
            $
            12,563,000
            
            $
            11,658,000
            
            $
            11,799,000U.S.
                net sales
            
            
            18,788,000
            
            
            15,124,000
            
            
            16,792,000Total
                net sales
            
            $
            31,351,000
            
            $
            26,782,000
            
            $
            28,591,000




Note:  Sales
      in Europe and the Middle East have been combined above due to joint sales
      responsibility in these areas. No foreign country made up more than 10% of
      the
      Company’s total net sales.





**11.** **OTHER
      BUSINESS CONCENTRATIONS**





During
      2003, the Company entered into an OEM agreement with a customer to jointly
      develop and exclusively sell a highly specialized medical monitoring product
      to
      the OEM. In July 2004, Criticare shipped the initial prototypes of this
      monitoring product to this OEM and in January 2005 production shipments began.
      Sales to this customer approximated $5,177,000 in fiscal 2006 and $3,100,000
      in
      fiscal 2005, which represented approximately 17% and 12%, respectively, of
      the
      Company's total net sales. The Company had a receivable balance from this
      customer of $939,270 on June 30, 2006 and $1,373,836 on June 30, 2005, which
      represented 15% and 20%, respectively, of the Company's total receivables as
      of
      this date.





During
      1999, the Company entered into an OEM agreement with a customer. This agreement
      ended on June 30, 2005 with transition sales continuing through August 31,
      2005.
      Sales to this customer approximated $95,000, $2,129,000 and $3,580,000 in fiscal
      2006, 2005 and 2004, respectively, which represented approximately 0.3%, 8%
      and
      13% of the Company's total net sales in each of these fiscal years. The Company
      had a receivable balance from this customer of $1,366 and $218,891 on June
      30,
      2006 and 2005, respectively, which represented 0% and 3% of the Company's total
      receivables as of these dates.





42




In
      fiscal
      2001, the Company entered into agreements with two offshore contract
      manufacturing firms to supply finished products. During fiscal 2005, the Company
      ended the supply partnership agreement with one of the contract manufacturing
      firms. A summary of the purchases and outstanding payables to these two
      companies for the years ended June 30, 2006, 2005 and 2004 follows
      below:





**2006**
            
            **2005**
            
            **2004**Supplier
                I - Purchases
            
            $
            9,324,825
            
            $
            6,193,106
            
            $
            6,756,279%
                of total purchases
            
            
            32.3%
            
            
            29.5%
            
            
            30.0%Accounts
                payable balance
            
            $
            973,625
            
            $
            610,479
            
            $
            1,227,116%
                of total payables
            
            
            18.0%
            
            
            20.1%
            
            
            37.9%Supplier
                II - Purchases
            
            $
            63,000
            
            $
            270,058
            
            $
            1,115,484%
                of total purchases
            
            
            0.2%
            
            
            1.3%
            
            
            5.0%Accounts
                payable balance
            
            $
            0
            
            $
            0
            
            $
            200,978%
                of total payables
            
            
            0.0%
            
            
            0.0%
            
            
            6.2%




**12.**  **COMMITMENTS**




The
        Company leases various equipment under both operating leases and a capital
        lease, which expire at various dates through fiscal 2010.
 
 On
        January 19, 2004 the Company entered into a lease agreement for the hardware
        and
        software for a new business system. This lease has been accounted for as
        a
        capital lease in accordance with SFAS No. 13, “Accounting for Leases.”  The
        following is an analysis of this capital lease:


June
                30, 2006
            
            June
                30, 2005Machinery
                and equipment
            
            $
            333,840
            
            $
            333,840Less
                accumulated depreciation
            
            
            (119,228
            )
            
            (71,537
            )Net
            
            $
            214,612
            
            $
            262,303





Depreciation
      expense was $47,691 and $47,691, respectively, in fiscal 2006 and
      2005.




In
        August
        2002 the Company sold its facility headquartered in Waukesha, Wisconsin and
        leased back approximately 62% of the building’s square footage through August
        2007. Rent expense was $339,024 in 2006
        and $ 337,281 in 2005
        for the five year building lease and all other lease commitments.


43





The
        following is a schedule by years of the future minimum lease payments under
        this
        capital lease and future minimum rental payments required under operating
        leases, together with the present value of the net minimum lease payments
        at
        June 30, 2006:


Capital
            
            OperatingFiscal
                year ending June 30
            
            Lease
            
            Leases2007
            
            $
            82,560
            
            $
            334,4272008
            
            
            82,560
            
            
            86,4792009
            
            
            52,140
            
            
            31,6642010
            
            
            10,500
            
            
            2,6692011
                and thereafter
            
            
            --
            
            
            --Total
                minimum lease payments
            
            $
            227,760
            
            $
            455,239Less
                amount representing interest
            
            
            (25,729
            )Present
                value of net minimum lease payments
            
            $
            202,031Less
                current portion at June 30, 2006
            
            
            68,205Long-term
                portion at June 30, 2006
            
            $
            133,826





During
        fiscal 2001, the Company entered into supply partnership agreements with
        two
        offshore contract manufacturing firms that exclusively manufacture medical
        devices in a regulated environment. These two firms manufacture specific
        products designated by the Company in accordance with formal purchase orders.
        The initial term of the agreements is for a period of three years and is
        automatically extended for additional periods of two years each, unless either
        party gives written notice at least sixty days prior to the end of the initial
        term or the then current extension term. During fiscal 2005, the Company
        ended
        the supply partnership agreement with one of the contract manufacturing firms.
        To ensure an adequate supply of products manufactured by the remaining contract
        manufacturer is maintained, the remaining agreement, with this manufacturer,
        requires that this firm keeps on hand in its finished goods inventories one
        full
        month of supply of all products under current purchase orders. At June 30,
        2006
        and 2005, a one month supply of product maintained at the firm would total
        approximately $555,000. In the event the Company would cancel a purchase
        order
        under the agreement, the Company would be required to purchase at cost all
        raw
        materials, work-in-progress and finished goods inventories for that purchase
        order. The total work-in-process and raw material inventories for the agreement
        is approximately $555,000. In addition, any property or equipment that this
        firm
        purchased specifically for the production of the Company's products would
        be
        purchased at mutually agreed upon prices. There have not been any purchase
        order
        cancellations under this agreement.





44





**13.** **QUARTERLY
      RESULTS** -
      Unaudited





The
      following table contains quarterly information, which includes all adjustments,
      consisting only of normal recurring adjustments, that the Company considers
      necessary for a fair presentation.





**Quarters
                Ended (Unaudited)****June
                30,**
            
            **March
                31,**
            
            **Dec.
                31,**
            
            **Sept.
                30,**
            
            **June
                30,**
            
            **March
                31,**
            
            **Dec.
                31,**
            
            **Sept.
                30,****2006**
            
            **2006**
            
            **2005**
            
            **2005**
            
            **2005**
            
            **2005**
            
            **2004**
            
            **2004****(in
                thousands, except per share data)**Net
                sales
            
            $
            7,096
            
            $
            7,812
            
            $
            8,771
            
            $
            7,672
            
            $
            8,021
            
            $
            6,055
            
            $
            7,375
            
            $
            5,331Gross
                profit
            
            
            2,442
            
            
            3,089
            
            
            3,576
            
            
            2,935
            
            
            3,068
            
            
            2,430
            
            
            3,101
            
            
            1,871Net
                income (loss)
            
            
            (524
            )
            
            (8
            )
            
            607
            
            
            137
            
            
            371
            
            
            (245
            )
            
            152
            
            
            (700
            )Net
                income (loss) percommon
                share:—Basic
                and diluted
            
            
            (0.04
            )
            
            (0.00
            )
            
            0.05
            
            
            0.01
            
            
            0.03
            
            
            (0.02
            )
            
            0.01
            
            
            (0.06
            )





The
      Company typically receives a substantial volume of its quarterly sales orders
      at
      or near the end of each quarter. In anticipation of meeting this expected
      demand, the Company usually builds a significant inventory of finished products
      throughout each quarter. If the expected volume of sales orders is not received
      during the quarter, or is received too late to allow the Company to ship the
      products ordered during the quarter, the Company's quarterly results and stock
      of finished inventory can be significantly affected. During the fourth quarter
      of fiscal 2006, the Company reevaluated the allowance for doubtful accounts
      and
      increased the allowance by $529,700.





**14.** **OTHER
      INCOME**





The
      Company recognized $300,000 pursuant to a patent license agreement
      and royalty income of $313,500 for the year ended June 30, 2006. 
Royalty income of $177,203 and $77,875 for fiscal 2005 and fiscal 2004,
      respectively.





45





**Report
      of Independent Registered Public Accounting Firm**







To
      the
      Board of Directors and Stockholders of Criticare Systems, Inc.


Waukesha,
      Wisconsin





We
      have
      audited the accompanying consolidated balance sheets of Criticare Systems,
      Inc.
      as of June 30, 2006 and 2005, and the related consolidated statements of
      operations, stockholders' equity, and cash flows for each of the three years
      in
      the period ended June 30, 2006. These financial statements are the
      responsibility of the Company's management. Our responsibility is to express
      an
      opinion on these financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. The Company is not required to
      have, nor were we engaged to perform, an audit of its internal control over
      financial reporting. Our audits included consideration of internal control
      over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purpose of expressing an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting. Accordingly, we express no such opinion. An audit includes examining,
      on a test basis, evidence supporting the amounts and disclosures in the
      financial statements. An audit also includes assessing the accounting principles
      used and significant estimates made by management, as well as evaluating the
      overall financial statement presentation. We believe that our 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 Criticare Systems, Inc.
      at
      June 30, 2006 and 2005, and the results of its operations and its cash flows
      for
      each of the three years in the period ended June 30, 2006, in conformity with
      accounting principles generally accepted in the United States of
      America.





/s/
      BDO
      Seidman, LLP


Milwaukee,
      Wisconsin


August
      11, 2006




46





Item
      9 . CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE .




Not
      applicable.








Item
      9A . CONTROLS
      AND PROCEDURES .





As
      of the
      end of the period covered by this report, the Company carried out an evaluation,
      under the supervision and with the participation of the Company’s management,
      including the Company’s Chief Executive Officer and the Company’s Vice President
      - Finance, of the Company’s disclosure controls and procedures (as defined in
      Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
      amended). Based upon this evaluation, the Company’s Chief Executive Officer and
      Vice President - Finance concluded that, as of the end of such period, the
      Company’s disclosure controls and procedures were effective in recording,
      processing, summarizing and reporting, on a timely basis, information required
      to be disclosed by the Company in reports that the Company files with or submits
      to the Securities and Exchange Commission. It should be noted that in designing
      and evaluating the disclosure controls and procedures, management recognized
      that any controls and procedures, no matter how well designed and operated,
      can
      provide only reasonable assurance of achieving the desired control objectives,
      and management necessarily was required to apply its judgment in evaluating
      the
      cost-benefit relationship of possible controls and procedures. The Company
      has
      designed its disclosure controls and procedures to reach a level of reasonable
      assurance of achieving the desired control objectives and based upon the
      evaluation described above, the Company’s Chief Executive Officer and Vice
      President - Finance concluded that the Company’s disclosure controls and
      procedures were effective at reaching that level of reasonable
      assurance.





There
      was
      no change in the Company’s internal control over financial reporting (as defined
      in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934,
      as
      amended) during the Company’s most recently completed fiscal quarter that has
      materially affected, or is reasonably likely to materially affect, the Company’s
      internal control over financial reporting.





Item
      9B . OTHER
      INFORMATION .




Effective
        September 28, 2006, the Company entered into an amendment to the employment
        agreement of each of Emil H. Soika, President, Chief Executive Officer and
        Director, Drew M. Diaz, Vice President-Worldwide Sales, Joseph P. Lester,
        Vice President and General Manager, Deborah A. Zane, Vice
        President-Marketing and Business Development, Joel D. Knudson, Vice
        President-Finance and Secretary, and Michael T. Larsen, Vice
        President-Quality and Regulatory Affairs. Each amendment replaces the prior
        definition of a "change in control" with a new, more complete definition
        which
        includes the following changes:
 
 l
            a
                change in control will now include a change in the composition of
                a
                majority of the Board of Directors of the Company (except with the
                approval of at least a majority of the incumbent directors);
                and l
            a
                change in control will occur upon a change in the ownership of 50%
                or more
                (in place of the prior threshold of 51% or more) of the outstanding
                stock
                or voting power of the Company. 
 The
        employment agreements provide that if the Company experiences a change in
        control, and Mr. Soika or Mr. Diaz voluntarily terminates his employment
        for any reason after the change in control, or Mr. Lester, Ms. Zane,
        Mr. Knudson or Mr. Larsen voluntarily terminates his or her employment for
        any reason after completing three months of employment after the change in
        control, Mr. Soika is entitled to receive payment of his base salary and
        other employee benefits for 30 months after the date of termination, Mr.
        Diaz is entitled to receive payment of his total compensation for 24 months
        after the date of termination, Mr. Lester is entitled to receive payment of
        his total compensation for 18 months after the date of termination, and
        each of Ms. Zane, Mr. Knudson and Mr. Larsen is entitled to
        receive payment of his or her base salary and other employee benefits for
        12 months after the date of termination, or until Mr. Soika,
        Mr. Diaz, Mr. Lester, Ms. Zane, Mr. Knudson or
        Mr. Larsen secures alternative employment, whichever period is shorter.
 
 The
        amendment to Mr. Diaz's employment agreement also increases his severance
        period
        from 12 months to 24 months following a voluntary termination of employment
        by
        Mr. Diaz after a change in control or a termination of employment by the
        Company
        without cause at any time either before or after a change in
        control.
 
 The
        amendments were unanimously approved by the Board of Directors (including
        all of
        the independent directors) after the Board received the advice of counsel
        that
        the new definition of a change in control is customary for similarly-situated
        executives of public companies and concluded that the Board desired to diminish
        the inevitable distraction of the Company's executive officers by virtue
        of the
        personal uncertainties created by a pending or threatened change in control,
        including one involving a change in a majority of the Board not approved
        by the
        existing Board, and to encourage each such executive officers' full attention
        and dedication to the Company in the event of a threatened or pending change
        in
        control.
 
 The
        amendments, including the complete text of the new definition of a change
        in
        control, have been filed as exhibits to this report and are incorporated
        herein
        by reference





47





PART
      III





Item
      10 . DIRECTORS
      AND EXECUTIVE OFFICERS OF THE REGISTRANT .





Information
      regarding the executive officers and directors of the Company is incorporated
      herein by reference to the discussions under "Election of Directors," "Section
      16(a) Beneficial Ownership Reporting Compliance," "Executive Officers," "Audit
      Committee Matters—Audit Committee Financial Expert" and "Corporate Governance
      Matters—Code of Business Ethics" in the Company's Proxy Statement for the 2006
      Annual Meeting of Stockholders which will be filed on or before October 30,
      2006
      (the "Criticare Proxy Statement").





The
      Audit
      Committee of the Company's Board of Directors is an "audit committee" for
      purposes of Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The
      members of the Audit Committee are Dr. Higgins D. Bailey, Dr. N.C. Joseph Lai
      and Stephen K. Tannenbaum (Chairman).





Item
      11 . EXECUTIVE
      COMPENSATION .





Information
      regarding executive compensation is incorporated herein by reference to the
      discussion under "Executive Compensation" and "Compensation of Directors" in
      the
      Criticare Proxy Statement.




Item
      12. 
      SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
      MATTERS.




Information
      regarding security ownership of certain beneficial owners and management is
      incorporated herein by reference to the discussion under "Security Ownership"
      in
      the Criticare Proxy Statement.





The
      following table summarizes share information for the Company’s equity
      compensation plans as of June 30, 2006, including the 2003 Stock Option Plan,
      the 1992 Employee Stock Option Plan, the 1992 Non-Employee Stock Option Plan,
      the 1987 Employee Stock Option Plan, the 1987 Non-Employee Stock Option Plan
      and
      the Company’s Employee Stock Purchase Plan.





48





**Equity
      Compensation Plan Information**





Number
                of securitiesremaining
                available forNumber
                of securities to be
            Weighted
                average
            future
                issuance underissued
                upon exercise of
            exercise
                price of
            equity
                compensationoutstanding
                options,
            outstanding
                options,
            plans
                (excluding securitiesPlan
                category
            warrants
                and rights
            warrants
                and rights
            in
                first column)Equity
                compensation plansapproved
                by security holders
            543,688
                shares
            $3.17
                per share
            922,232
                sharesEquity
                compensation plansnot
                approved by security holders
            30,000 shares
            $2.88
                per share
            0
                sharesTotal
            573,688 shares
            $3.15 per share
            922,232
                shares





As
      noted
      in the table above, the Company has issued warrants to a consultant which have
      not been approved by the Company’s stockholders. The Company extended warrants
      for the purchase of 30,000 shares of Common Stock issued to the consultant
      expiring in February 2003 for an additional five years with an exercise price
      of
      $2.88 per share.




Item
        13 . 
        CERTAIN
        RELATIONSHIPS AND RELATED TRANSACTIONS.


Information
      regarding certain relationships and related party transactions is incorporated
      herein by reference to the discussion under "Executive Compensation—Employment
      Agreements” in the Criticare Proxy Statement.





Item
      14 . PRINCIPAL
      ACCOUNTANT FEES AND SERVICES .





Information
      regarding the fees and services of the independent registered public accounting
      firm is incorporated herein by reference to the discussion under “Audit
      Committee Matters—Fees of Independent Registered Public Accounting Firm” in the
      Criticare Proxy Statement.





49





PART
      IV




Item
      15.   EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES.




(a) The
      following documents are filed as part of this report:





1. Financial
      Statements . 
      The following consolidated financial statements of the Company are included
      in
      Item 8 of this report.





Consolidated
      Balance Sheets - as of June 30, 2006 and 2005.





Consolidated
      Statements of Operations - for the years ended June 30, 2006, 2005 and
      2004.





Consolidated
      Statements of Stockholders' Equity - for the years ended June 30, 2006,
      2005 and 2004.





Consolidated
      Statements of Cash Flows - for the years ended June 30, 2006, 2005 and
      2004.





Notes
      to
      consolidated financial statements.





Report
      of
      Independent Registered Public Accounting Firm.





2. Financial
      Statement Schedules :





Report
      of
      Independent Registered Public Accounting Firm.





Financial
      Statement Schedule for the years ending June 30, 2006, 2005 and
      2004:


Schedule
                Number
              
              Description
              
              PageII
              
              Valuation
                  and Qualifying
              
              57Accounts
                  and Reserves





All
      other
      schedules for which provision is made in the applicable accounting regulations
      of the Securities and Exchange Commission are not required under the related
      instructions, are inapplicable or the required information is shown in the
      financial statements or notes thereto, and therefore have been
      omitted.




50





3. Exhibits :





3.1 Restated
      Certificate of Incorporation of the Company (incorporated by reference to the
      Registration Statement on Form S-1, Registration
      No. 33-13050).





3.2 Restated
      By-Laws of the Company (incorporated by reference to the Company's Current
      Report on Form 8-K filed on March 17, 2006).





4.1 Specimen
      Common Stock certificate (incorporated by reference to the Registration
      Statement filed on Form S-1, Registration No. 33-13050).





4.2 Rights
      Agreement (incorporated by reference to the Company's Current Report on Form
      8-K
      filed on April 18, 1997).





10.1* 2003
      Stock Option Plan, as amended (and form of stock option grant agreement, stock
      appreciation right grant agreement and restricted stock grant agreement)
      (incorporated by reference to the Company's Current Report on Form 8-K
      filed on December 7, 2005).





10.2* 1999
      Employee Stock Purchase Plan (incorporated by reference to the Company's Annual
      Report on Form 10-K for the year ended June 30, 1999).





10.3* 1992
      Employee Stock Option Plan (incorporated by reference to the Company's
      Registration Statement on Form S-8, Registration
      No. 33-60644).





10.4* 1992
      Nonemployee Stock Option Plan (incorporated by reference to the Company's
      Registration Statement on Form S-8, Registration
      No. 33-60214).





10.5* 1987
      Employee Stock Option Plan (incorporated by reference to the Company's
      Registration Statement on Form S-8, Registration
      No. 33-33497).





10.6* 1987
      Nonemployee Stock Option Plan (incorporated by reference to the Company's
      Registration Statement on Form S-8, Registration
      No. 33-40038).




10.7* Form
        of
        Executive Officer and Director Indemnity Agreement (incorporated by reference
        to
        the Company's Registration Statement on Form S-1, Registration
        No. 33-13050).
 
 10.8* Employment
        Agreement of Emil H. Soika (incorporated by reference to the Company's Current
        Report on Form 8-K filed on September 8, 2005).


51




10.9* Employment
      Agreement of Drew M. Diaz.





10.10 Supply
      Partnership Agreement, dated as of August 1, 2000, between the Company and
      BioCare Corporation (incorporated by reference to the Company’s Annual Report on
      Form 10-K for the year ended June 30, 2001).




10.11* Employment
      Agreement of Joseph P. Lester (incorporated by reference to the Company’s
      Quarterly Report on Form 10-Q for the quarter ended September 30,
      2002).





10.12* Employment
      Agreement of Deborah A. Zane (incorporated by reference to the Company's Annual
      Report on Form 10-K for the year ended June 30, 2005).





10.13* Employment
      Agreement of Joel D. Knudson (incorporated by reference to the Company's Annual
      Report on Form 10-K for the year ended June 30, 2005).





10.14* Employment
      Agreement of Michael Larsen (incorporated by reference to the Company's Annual
      Report on Form 10-K for the year ended June 30, 2005).




10.15* Amendment
        to Employment Agreement of Emil H. Soika effective September 28,
        2006.
 
 10.16* Amendment
        to Employment Agreement of Joseph P. Lester effective September 28,
        2006.
 
 10.17* Amendment
        to Employment Agreement of Deborah A. Zane effective September 28,
        2006.
 
 10.18* Amendment
        to Employment Agreement of Joel D. Knudson effective September 28,
        2006.
 
 10.19* Amendment
        to Employment Agreement of Michael T. Larsen effective September 28,
        2006.
 
 21        Sub sidiaries.





23.1 Consent
      of BDO Seidman, LLP.




24         P ower
      of
      Attorney (incorporated by reference to the signature page hereof).




31.1 Certification
      of Emil H. Soika, President and Chief Executive Officer (Principal Executive
      Officer) pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.




52


31.2 Certification
        of Joel D. Knudson, Vice President - Finance and Secretary (Principal Financial
        Officer) pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 32** Certification
        of Principal Executive Officer and Principal Financial Officer pursuant to
        18
        U.S.C. Section 1350.





__________________


*
      Management contract or compensatory plan or arrangement.





**
      This
      Certification is not “filed” for purposes of Section 18 of the Securities
      Exchange Act of 1934, as amended, or incorporated by reference into any filing
      under the Securities Act of 1933, as amended, or the Securities Exchange Act
      of
      1934, as amended.





(b) Exhibits.





The
      response to this portion of Item 15 is submitted as a separate section of this
      report.





(c) Financial
      Statement Schedules.





The
      response to this portion of Item 15 is submitted as a separate section of this
      report.





53




SIGNATURES





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





CRITICARE SYSTEMS, INC.





By   /s/
      Emil H.
      Soika


Emil
      H.
      Soika, President


and
      Chief
      Executive Officer





Date: September 28, 2006








POWER
      OF
      ATTORNEY





KNOW
      ALL
      MEN BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints Emil H. Soika and Joel D. Knudson, and each of them,
      as
      his true and lawful attorneys-in-fact and agents, with full power of
      substitution and resubstitution, for him and in his name, place and stead,
      in
      any and all capacities, to sign any and all amendments to this Annual Report
      on
      Form 10-K and to file the same, with all exhibits thereto and other
      documents in connection therewith, with the Securities and Exchange Commission,
      granting unto said attorneys-in-fact and agents, and each of them full power
      and
      authority to do and perform each and every act and thing requisite and necessary
      to be done in connection therewith, as fully to all intents and purposes as
      he
      might or could do in person, hereby ratifying and confirming all that said
      attorneys-in-fact and agents, or any of them, or their or his substitute or
      substitutes, may lawfully do or cause to be done by virtue hereof.




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





Signature
            Title
            Date/s/
                Emil H. Soika
            President,
                Chief Executive Officer
            September
                28, 2006Emil
                H. Soika
            and
                Director (Principal ExecutiveOfficer)




54
 
 
 /s/
                  Joel D. Knudson
              Vice
                  President-Finance and Secretary
              September
                  28, 2006Joel
                  D. Knudson
              (Principal
                  Financial and AccountingOfficer)/s/
                  Dr. Higgins Bailey
              Chairman
                  of the Board and Director
              September
                  28, 2006Dr.
                  Higgins Bailey/s/
                  N.C. Joseph Lai, Ph.D.
              Director
              September
                  28, 2006N.C.
                  Joseph Lai, Ph.D./s/
                  Jeffrey T. Barnes
              Director
              September
                  28, 2006Jeffrey
                  T. Barnes/s/
                  Stephen K. Tannenbaum
              Director
              September
                  28, 2006Stephen
                  K. Tannenbaum/s/
                  Sam B. Humphries
              Director
              September
                  28, 2006Sam
                  B. Humphries
 
  55
 
 **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
  To
        the
        Board of Directors and Stockholders of Criticare
        Systems, Inc.
 Waukesha,
        Wisconsin
 
 The
        audits referred to in our report dated August 11, 2006 relating to the
        consolidated financial statements of Criticare Systems, Inc., which is contained
        in Item 8 of this Form 10-K included the audit of the financial statement
        schedule listed in Item 15. This financial statement schedule is the
        responsibility of the Company's management. Our responsibility is to express
        an
        opinion on this financial statement schedule based upon our audits.
 
 In
        our
        opinion such financial statement schedule presents fairly, in all material
        respects, the information set forth therein.
 
 
 
 /s/
        BDO
        Seidman, LLP
 Milwaukee,
        Wisconsin
 August
        11, 2006
 
 56
 
 SCHEDULE II
 
 CRITICARE
        SYSTEMS, INC.
 
 VALUATION
        AND QUALIFYING ACCOUNTS
 FOR
        THE
        YEARS ENDED JUNE 30, 2006, 2005 AND 2004
  Column
                  A
              
              Column
                  B
              
              Column
                  C
              
              Column
                  D
              
              Column
                  EDescription
              
              Balance
                  at
                Beginning
                of
                  Period
              
              Charged
                  to
                Costs
                  and
                Expenses
              
              Deductions
              
              Balance
                  at
                End
                  of
                PeriodYEAR
                  ENDED JUNE 30, 2004:Allowance
                  for doubtful accounts
              
              $
              300,000
              
              $
              393,758
              
              $
              433,758
              
              $
              260,000Reserve
                  for sales returns and
                allowances
              
              $
              77,945
              
              $
              --
              
              $
              --
              
              $
              77,945Reserve
                  for obsolete inventory
              
              $
              1,400,000
              
              $
              509,001
              
              $
              1,299,001
              
              $
              610,000YEAR
                  ENDED JUNE 30, 2005:Allowance
                  for doubtful accounts
              
              $
              260,000
              
              $
              87,695
              
              $
              47,695
              
              $
              300,000Reserve
                  for sales returns and
                allowances
              
              $
              77,945
              
              $
              --
              
              $
              --
              
              $
              77,945Reserve
                  for obsolete inventory
              
              $
              610,000
              
              $
              281,003
              
              $
              452,703
              
              $
              438,300YEAR
                  ENDED JUNE 30, 2006:Allowance
                  for doubtful accounts
              
              $
              300,000
              
              $
              559,206
              
              $
              29,506
              
              $
              829,700Reserve
                  for sales returns and
                allowances
              
              $
              77,945
              
              $
              --
              
              $
              37,945
              
              $
              40,000Reserve
                  for obsolete inventory
              
              $
              438,300
              
              $
              56,622
              
              $
              134,922
              
              $
              360,000
     57