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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                  FORM 10-K405

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

For the fiscal year ended December 31, 1997

                                       or

[ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

Commission file number 1-10515


                              JMAR Industries, Inc.
--------------------------------------------------------------------------------
             (Exact name of registrant as specified in its charter)


          Delaware                                     68-0131180
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(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

3956 Sorrento Valley Blvd., San Diego, CA                    92121
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(Address of principal executive offices)               (Zip code)

Registrant's telephone number, including area code:          (619) 535-1706
                                                             --------------

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

       Title of each class                     Name of each exchange on which
                                                        registered

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

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

Common Stock, $.01 par value; Warrant; Unit to purchase Common Stock and Warrant
--------------------------------------------------------------------------------

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

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



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        The aggregate market value of the common stock held by non-affiliates of
the Registrant as of March 3, 1998 was approximately $51,461,454. The aggregate
market value was based on the closing price on March 3, 1998 for the common
stock as quoted on the NASDAQ National Market System.

        Number of shares outstanding of common stock: Common Stock, $.01 Par
Value - 17,968,504 shares as of March 3, 1998.



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                                     PART I

ITEM 1.  BUSINESS

GENERAL

        Founded in 1987, San Diego, California based JMAR Industries, Inc. (the
"Company" or "JMAR") develops, manufactures and markets precision measurement,
process control and manufacturing systems and laser and semiconductor products
for the microelectronics and medical industries and is a leading developer of
advanced lithography sources for production of higher performance
semiconductors. JMAR primarily operates through three divisions located in
Southern California:

             PACIFIC PRECISION LABORATORIES ("PPL"), the Company's equipment
manufacturing division is located in Chatsworth, California, northwest of Los
Angeles where JMAR's core product lines are produced. These currently include:
Measurement and Inspection Systems - non-contact systems to measure and inspect
microelectronics (primarily semiconductors and disk drives) parts for both
process control and quality assurance purposes; Positioning and Motion Control
Systems - to improve the precision of microelectronics manufacturing; and Laser
Processing Systems - which perform the highly precise welding and cutting
required by the microelectronics industry.

        JMAR TECHNOLOGY CO. ("JTC"), the Company's research and development
center in San Diego where JMAR's Emerging Products are developed, including:
advanced X-ray and other lithography sources for manufacturing tomorrow's
high-performance semiconductors; ultra-precision laser machining systems; a
family of high powered handheld all solid state lasers for a variety of medical
and dental applications, including blood sampling; and other leading-edge
products based on its patented laser technology.

        CALIFORNIA ASIC ("CAL ASIC"), the Company's semiconductor design and
production facility located south of Los Angeles in Irvine. Using advanced
design tools and established foundry relationships with semiconductor producers,
this "fab-less" supplier of semiconductors focuses on the development and
delivery of high performance custom microcircuits for a wide range of
commercial, medical and military electronics uses.

BUSINESS SUMMARY

        JMAR's business involves the utilization of specialized forms of light
energy such as lasers or precision regulated light sources. These business
operations fall into two categories: Current Products and Emerging Products.

CURRENT PRODUCTS

        CURRENT PRODUCTS which are manufactured and sold today by JMAR's PPL
division, include:

        MEASUREMENT AND INSPECTION EQUIPMENT - MEASUREMENT, INSPECTION AND
ALIGNMENT. During 1997, JMAR's non-contact video and laser-based Test and
Measurement and Inspection Equipment product line accounted for approximately 66
percent of the Company's revenues. JMAR's measurement and inspection systems are
sold primarily to manufacturers of semiconductors and computer disk drives. This
line utilizes state-of-the-art machine vision and laser position sensors
integrated with programmable optics and lighting control, precision X-Y-Z motion
control and other computer controlled functions. Vision, laser and other sensors
are used to check changes in variations in geometries. Proprietary algorithms
are then written by PPL for edge sensing, height sensing and point taking and
fed into mathematical formulas to determine straightness of lines, dimensional
data, height measurements, angles and radii of curvature of microscopic devices.



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        In late 1995, JMAR introduced its new compact Mirage tabletop,
non-contact, high-resolution video/laser measurement system to complement the
larger series 3000 and 4000 systems, all of which are targeted towards the
microelectronics industry. The Mirage can be used for a variety of applications
including incoming and outgoing inspection, off-line process control for
equipment, process verification and many laboratory functions. The Mirage has
proven to be a large success for the product group, contributing over 12 percent
of the Company's sales in 1997. The Company's standard Series 3000 systems
incorporate video-based measurement and offer several different sizes of X-Y
stages while the larger Series 4000 combines video and laser height probes to
provide high accuracy X-Y-Z measurements.

        LASER SYSTEMS. The Company manufactures laser processing systems,
precision laser welding centers and laser machining centers. While the Company
produces laser welding systems based on current commercially-available laser
technology, it is currently focusing its new laser system development programs
on the micromachining market, which will make use of the Company's emerging new
Britelight(TM) laser technology, expected to become available in 1998.

        Laser Processing Systems. JMAR's laser processing systems utilize
state-of-the-art lasers for microelectronics manufacturing and repair. There is
a growing need for higher precision instruments to probe, inspect and repair
semiconductor assemblies such as Multi-Chip Modules ("MCM"). The Company's
optical inspection stations are used to locate open and short circuits while its
Laser Processing Stations are designed to meet today's demanding requirements
for MCM repair.

        Current system models use either excimer lasers to repair short circuits
by removing excess material or Nd: YAG lasers for welding applications. Both
lasers are capable of delivering a broad combination of power levels, material
removal, spot sizes and energy uniformity.

        Systems which incorporate JMAR's newly patented short pulse solid state
laser ("Britelight(TM)") technology are currently in the prototype development
phase and are expected to be available in the second half of 1998.

        Laser Machining and Welding Centers. JMAR also produces Laser Machining
and Welding Centers for targeted marketplaces in the microelectronics industry.
These products include high accuracy small component welding systems which
utilize vision controlled alignment and sub-micron position repeatability. The
Company also produces processing stations for welding of microelectronic
feed-throughs and medical implantables and systems for welding critical computer
disk drive components. JMAR's precision micro-positioning and vision processing
technologies are incorporated into its Laser Machining and Welding Centers to
provide customers with single source, full turnkey manufacturing systems which
often include laser beam delivery systems, parts handling and barcode readers.

        Laser Micromachining Centers. As the emerging Britelight(TM) laser
technology with high-powered picosecond* pulse capability becomes available for
integration with a laser machining center, the Company plans to utilize this new
laser source as the heart of its systems. Market research performed by Laser
Focus World, a major laser trade magazine, indicates that the market for laser
micromachining is in excess of $300 million. This is the target market for the
Company's laser processing systems in 1998.




* Laser pulse widths (measured in time) which are shorter than one billionth of
a second.


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        POSITIONING AND MOTION CONTROL. During 1997, the Positioning and Motion
Control product line accounted for approximately 20 percent of the Company's
revenues. JMAR manufactures a wide range of precision customized positioning
stages and motion control devices for the microelectronics industry, including a
standard product line of stages capable of being integrated into customer
turnkey systems. These stages which are the fundamental building blocks of many
microelectronic manufacturing systems, are often integrated into comprehensive
custom products and systems. In addition, the Company provides positioning
components and systems for original equipment manufacturers ("OEM") as well as
for its own test and measurement equipment and laser processing products.

        CUSTOM PRODUCTS. In addition to its standard products, JMAR's PPL
division designs, engineers and manufactures customized systems based on its
motion control, measurement and/or laser system capabilities to meet specified
requirements of customers. Frequently, the design of a particular custom product
may lead to additional sales of that product to the customer.

        CONTRACT RESEARCH AND DEVELOPMENT. The Company performs profitable
research and development contract work at JTC for third party customers,
including the U.S. government and a large medical equipment company. The goals
of these efforts are to develop commercially significant products based on the
Company's proprietary laser and advanced optical technology. During 1997
contract R&D contributed approximately 10 percent of JMAR's revenues.

EMERGING PRODUCTS

        JMAR's contract and company-funded R&D programs, collectively, have
created a broad world-class technology base that provides the foundation for an
array of important new commercial product lines and business areas, which the
Company refers to as its "Emerging Products". JMAR's Emerging Products,
described in the following sections, include: advanced X-ray and other
lithography sources for semiconductor manufacturing, ultra-precision laser
machining systems and a family of high powered handheld all solid state lasers
for a variety of medical and dental applications, including blood sampling.

        ADVANCED LITHOGRAPHY FOR SEMICONDUCTOR MANUFACTURING. Lithography is one
of the most critical steps in the production of semiconductors. It is a
photographic process which uses precision light sources to copy intricate
computer-generated electronic circuit designs onto the semiconductor chips. A
typical lithography system consists of an illumination source integrated into an
apparatus known as a "stepper" or an "aligner". The combined system is installed
in the semiconductor fabrication line.

        Semiconductors are the engines that drive the technology industry.
Whereas the economics of most industries are driven by consumption or
deterioration, the economics of the semiconductor industry are driven by
continuous innovation because semiconductors rarely wear out. To continue to
grow, the semiconductor industry must develop ever more powerful computer chips
at a rapid pace. That requires continuing advances in the ability of the
industry to produce ever-smaller circuit feature sizes which make it possible to
produce higher circuit densities. Advanced lithography systems, employing
shorter wavelength illumination sources, are required to make smaller feature
sizes. JMAR is one of the leading developers of compact high-intensity
short-wavelength X-ray lithography sources.

        The total size of the lithography market is substantial. The
semiconductor industry purchases between 1,500 to 2,000 new lithography systems
per year at prices ranging from approximately $700,000 to $7 million. As the
circuit feature sizes get smaller the prices of the lithography systems increase
rapidly.

        In X-ray lithography, the illumination is provided by the X-ray source.
JMAR's point source X-ray lithography ("XRL") technology utilizes the Company's
patented Britelight(TM) high-power, picosecond-class, diode-pumped solid state
laser technology to generate the X-rays required to print



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microscopic circuits finer than the 0.25 micron (one micron is about one-one
hundredth of the thickness of a human hair) feature size of today's
state-of-the-art optical lithography processes. As the semiconductor industry
moves toward squeezing more and more circuits onto each chip, considerable
uncertainty exists as to whether current optical lithography technology will
remain either feasible or economically viable. Major issues include the need for
new light sources that can deliver the shorter wave lengths required and the
availability and cost of appropriate optical materials.

        XRL systems, which generate light wave lengths 200 times shorter than
current optical lithography systems, do not require the use of advanced optical
materials. Furthermore, extensive process development work at several leading
centers around the world have demonstrated the viability of the process using
large immobile X-ray sources known as "synchrotrons". The Company believes that
most of the industry considers these sources to be overly cumbersome, too
expensive and extremely inflexible.

        JMAR's XRL program, aimed at providing an acceptable alternative to the
synchrotron, is developing a proprietary compact point source that, when
completed, is expected to be economically competitive with and no larger than
conventional optical lithography sources. The Company believes that once these
much smaller and more cost effective X-ray lithography systems become
commercially available, they will be well received. Semiconductor industry
sources have made it clear that for the industry to stay on schedule to support
future market needs, the upcoming 0.18 micron technology must be available to
enter production by 1999, followed by 0.15 micron and 0.13 micron technology on
two year intervals thereafter. JMAR believes its X-ray lithography source
technology is a leading candidate to fulfill these demanding semiconductor
industry requirements. See "Market-Advanced Lithography" below and "Factors That
May Affect Future Results".

        In January, 1994, after working on smaller government funded X-ray
lithography R&D contracts in prior years, JMAR received a $6.9 million
multi-year contract to develop its laser-plasma Picosecond X-ray Source ("PXS")
for use in a point source X-ray stepper system. The revenues from this contract
constitute 8 percent of the Company's 1997 sales. The contract was issued by the
U.S. Army Research Laboratory and is sponsored by the Defense Advanced Research
Projects Agency (DARPA) of the Department of Defense. Since 1991, the cumulative
amount of U.S. government contract funding for JMAR's X-ray lithography point
source development program totaled approximately $9,000,000. In December, 1997,
the Company was awarded $1.3 million in new funding from DARPA to procure long
lead-time items necessary to initiate the construction of an X-ray lithography
point source demonstration system in 1998. The award is the first installment of
a new, larger contract that JMAR expects to receive in early 1998.

        ULTRA-PRECISION LASER MANUFACTURING SYSTEMS FOR INDUSTRIAL
MANUFACTURERS. JMAR's ultra-precision laser manufacturing systems are being
developed to manufacture microelectronics products to unprecedented tolerances
at high rates. The new proprietary Microlight all-solid state high performance
laser systems provide the bases for a wide range of ultra-precision
manufacturing operations on a variety of materials, including semiconductors,
ceramics, highly conductive materials and thin films. JMAR has demonstrated its
prototype Microlight 1000 system to several initial potential customers and is
now upgrading the system to perform actual micromachining tasks identified
during these initial demonstrations. JMAR expects to introduce its initial
Britelight precision manufacturing laser systems into the commercial marketplace
during 1998. See "Factors That May Affect Future Results".

        LIGHT KNIFE(TM) PRODUCTS. During 1996, the Company entered into a
product development agreement with a major medical equipment company to finalize
the configuration and obtain clearance from the U.S. Food and Drug
Administration to market its pocket size, solid state Light Knife(TM) laser
system (hereinafter, for brevity referred to as "Light Knife") as a bladeless
blood sampling device. The final configurations of the devices and the schedule
for their introduction



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into the marketplace will be determined by the Company's medical equipment
partner. See "Factors That May Affect Future Results".

        MANUFACTURE OF CUSTOM SEMICONDUCTORS. In May 1996, JMAR acquired
approximately 94 percent of the outstanding shares of Cal ASIC in exchange for
1,427,526 shares of JMAR valued at approximately $1,722,000. Cal ASIC is a
supplier of low volume application specific integrated circuits ("ASIC's"), an
important class of semiconductors. ASIC's are compact logic devices that can
process and integrate a series of functions within a single semiconductor chip.
They are commonly used to enhance the performance of a broad range of electronic
devices, including computers, telephones, fax machines, modems, televisions and
medical products.

        In connection with the acquisition, JMAR agreed to loan $1,500,000 to
Cal ASIC to upgrade its 1.0 micron CMOS gate array semiconductor fabrication and
engineering capabilities. Cal ASIC's semiconductor design and engineering
support capabilities were established by the first quarter of 1997 and continued
to grow throughout the year. Its proprietary software and state of the art
design tools combine to create a design capability that can produce designs with
densities up to 250,000 gates in gate array and standard cell technologies.

        In the second half of 1997, the Company conducted an extensive, in-depth
evaluation (the "Evaluation") of Cal ASIC's assets and capabilities which
revealed a wealth of semiconductor design and foundry management expertise that
was not being adequately utilized. Under its original business plan Cal ASIC's
markets were to be restricted to only those semiconductor products that could be
manufactured in the Company's own facilities. However, actual facility operating
experience in the first half of 1997 disclosed that the production throughput
capability of Cal ASIC's fabrication facility was far below the representations
made by the Sellers at the time of the acquisition in 1996. That formed the
basis for both an extensive reorganization of Cal ASIC and a warranty claim
which led to the payment of a settlement to JMAR by the former owners of Cal
ASIC.

        Pursuant to the reorganization, Mr. Marvin Sepe was elected President of
Cal ASIC. Under his direction, Cal ASIC negotiated a series of foundry
arrangements with other semiconductor manufacturers that gave it the means for
production without the volume constraints posed by reliance on its existing
fabrication facilities. Today, in its new role as a "fab-less" supplier of
custom semiconductors and a provider of foundry management services for other
organizations, Cal ASIC has the ability to address a much broader segment of the
semiconductor market and offer a far wider range of high-performance chips
without those volume constraints.

        Since its reorganization, Cal ASIC has continued to focus on
establishing additional cost-effective manufacturing arrangements with major
semiconductor producers. By so doing it has been able to increase its product
offerings which allow it to now supply its customers with a much wider selection
of higher performance semiconductor products. This increase in capability
substantially expands the available market for Cal ASIC services and products to
include microchips with feature sizes as small as 0.35 micron. The Company
believes that opportunities will also emerge for cooperative developments with
other semiconductor producers, including its current wafer fabrication partners.

MARKET

        The Company's technology base has applications in several market areas:

        LASER PROCESSING SYSTEMS. The worldwide market for laser based material
processing equipment is generally viewed as being divided into two major
application categories. The first category is the cutting or joining of parts
having large sections or geometries that are over three feet in length (one
meter). In general, manufacturers of high power CO2 and Yag lasers dominate this
market. The Company chooses to compete in the second application category which
involves the manufacture of systems to handle objects that require a
manufacturing travel



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distance of less than 2 feet in any direction, and which normally have a high
value added component. Such applications for the microelectronics industry
require small parts handling systems, vision-aided alignment, use of sub-micron
positioning and laser pointing. Examples of applications of such systems include
spot welding of flexures used in the disk drive industry. Examples of small
microelectronic parts that require sub-micron positioning and alignment are the
repair of multichip modules (both open circuits and shorts repair) and the
repair or process of high density interconnects.

        The selling cycle of the above products is relatively lengthy and ranges
between three months and one year. This cycle corresponds with the customers'
capital budgets. The normal marketing process starts with a preliminary
feasibility study funded by either the Company or by the customer, followed by
process qualification, the obtaining of budgetary information, final contract
negotiations, manufacturing and delivery.

        MEASUREMENT AND INSPECTION POSITIONING SYSTEMS. In this market, the
Company concentrates on providing manufacturing equipment for the electronics
industry, medical industry, aerospace and defense industries. The mass storage
industry (hard disk drives and tape backup systems), microelectronics and
semiconductor segments of such industries constitute the targeted marketing
focus of the Company. The Company believes that the total annual sales in the
niches within this market in which it currently competes are approximately $100
million.

        The Company provides equipment needed to improve manufacturing process
yields in environments where precision sub-micron accuracy and repeatability for
parts measurement or inspection are required and contact with the products could
result in damage or contamination. The Company uses non-contact technologies
such as laser interferometry and laser distant probes. By combining its
expertise in non-contact technologies with strong systems integration skills,
JMAR believes it is able to provide the solutions required by these targeted
market segments. The Company also believes that the trend toward small and more
intricate electronic devices will continue to increase the demand for
non-contact technologies, parts handling and full integration for a turnkey
solution in which it specializes.

        R&D efforts in 1998 are expected to provide new products and systems
into the market that the Company believes will answer the needs of key customers
in its primary markets. The Company further believes that its R&D efforts will
produce new products that are estimated to increase the markets in which its
measurement and inspection product line currently competes by about $200
million. See "Factors That May Affect Future Results".

        ULTRA-PRECISION LASER MANUFACTURING SYSTEMS. The Company believes that a
large potential market demand exists for high performance systems which
manufacture a broad range of ever-smaller microdevices from materials which
cannot be machined by currently available fabrication tools. In December 1996
the Company contracted with an established high technology market research firm
to evaluate the current and expected markets for its new laser-based
micromachining systems including various alternative configurations of its
Microlight systems using JMAR's patented Britelight lasers.

        The results of this study directed the Company toward ultra-precision
machining of microelectronic components such as multi-chip-modules, ceramic
substrates, polyimide layered substrates, silicon wafers and printed circuit
boards. The Company expects to commence sales and marketing efforts in 1998 to
support its expected release of the Britelight(TM) laser and the upgraded
Microlight 1000(TM) manufacturing system for customer demonstrations.

        ADVANCED LITHOGRAPHY. Semiconductor manufacturers purchase lithography
tools from established stepper suppliers. The principal suppliers of steppers
for high volume semiconductor production are Nikon, Canon, ASML, Silicon Valley
Group Lithography (SVGL) and Ultratech Systems.



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        The Company understands that Canon and SVGL have X-ray lithography
stepper development and prototype programs underway. However, the primary
business focus of these companies is on the current multi-billion dollar optical
lithography stepper market. On the other hand, Suss Advanced Lithography (SAL),
a privately-owned venture headquartered in Vermont, was established several
years ago to focus on the X-ray lithography ("XRL") market. According to SAL, as
of the end of 1997 a total of 15 X-ray steppers have been sold worldwide for
X-ray lithography process development. SAL has informed JMAR that 12 of those
steppers were manufactured and sold by SAL. It is the Company's understanding
that one of those X-ray steppers was designed to interface with a point source
and that the remainder were designed to interface with various synchrotron X-ray
source facilities currently being utilized worldwide for X-ray lithography
process development.

        JMAR believes that it is currently the leading developer of X-ray
lithography "point sources". The Company further believes that point source XRL
systems, once their X-ray outputs reach levels adequate for commercially viable
chip production rates, will provide the semiconductor industry with a lower
cost, much more compact and flexible alternative to synchrotron facilities for
X-ray lithography process development and production.

        The Company understands that the semiconductor industry is currently
transitioning its highest performance fab lines to the initial production of
circuitry having feature sizes as small as 0.25 microns (critical dimension).
The Company also understands that, with the exception of SAL, the primary focus
of the stepper manufacturers for the next few years will continue to be on the
marketing of optical lithography steppers.

        At the present time, the market for point source X-ray lithography
systems is believed to be limited to the sale of a few systems per year to
support the 0.13 micron process development programs of the major semiconductor
manufacturers and government supported research laboratories. That market is
expected to expand as the new 0.13 micron technology moves into the pilot plant
phase at leading semiconductor manufacturers and then onto full scale
production. The selling price for each JMAR point source is expected to be
approximately two million dollars. Pursuant to the Technology Roadmap prepared
by SIA, the subsequent generation 0.13 micron technology will start moving into
its pilot phase as the 0.18 micron processes move into production in 1999.

        The Company believes that, as a result of the X-ray lithography process
development conducted during the past decade, or more, by other organizations
using synchrotron X-ray sources, XRL is closer to commercial reality for the
0.13 micron generation, and beyond, than any of the other alternatives. In
Japan, Mitsubishi has announced plans to manufacture 0.20 micron DRAM devices
using X-ray lithography while LG Semicon in Korea recently announced that it
"has developed" a 0.13 micron process technology using X-ray lithography. In the
U.S., IBM recently announced it will invest $700 million to build an advanced
microchip development facility which will have access to IBM's advanced X-ray
lithography technology and will be equipped to manufacture the latest generation
chips on 12 inch wafers.

        The Company believes that all of the technology advances in XRL process
technology throughout the world help bring the market for application of its
XRL point source technology closer to reality.

        The principal roadblocks often cited by critics of XRL are the size,
cost, complexity and radiation hazards of synchrotron X-ray sources and the lack
of availability of a commercially financed e-beam X-ray mask writer and mask
supplier. Whereas, the principal roadblocks often cited by critics for the
extension of deep UV lithography technology to 0.13 micron feature sizes is the
lack of demonstrated optical component technology and the projected higher costs
of the new stepper systems.

        The Company's XRL program is focused on the development of the PXS as a
commercially-viable X-ray source for low-volume production, process development
for synchrotron production systems, and ultimately as an alternative to the
synchrotron for high volume production. Unlike synchrotrons, the PXS source is
not a hazardous radiation source. Furthermore, commercial PXS source/stepper
systems for XRL are expected to cost less and be of comparable, or smaller, size
than projected DUV stepper systems for the 0.18 micron generation and beyond.
The PXS architecture includes both pulse generating and amplifier lasers



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based on JMAR's high performance proprietary solid state Britelight(TM) laser
technology to produce 30 to 90 watts of the type of X-rays required for optimum
lithographic exposures. JMAR is currently expecting the award of a large new
DARPA contract to continue the scale-up of its PXS source technology to higher
power levels and to initiate integration of this source with an aligner being
developed under other DARPA programs to create a complete X-ray lithography
workstation no larger than current optical lithography systems.

        LIGHT KNIFE(TM) PRODUCTS. JMAR has a light knife blood sampler product
development agreement with a large medical products manufacturer and currently
expects its products to be marketed by that customer. That customer has informed
JMAR that the current total U.S. market for disposable capillary access devices
is approximately $60 million per year. JMAR's Light Knife(TM) blood collection
system aims to compete for a portion of that market. JMAR further believes that
this market could increase once healthcare practitioners become aware of the
convenience and safety advantages of Light Knife(TM) relative to current sharp
edged products. JMAR is also pursuing other applications of Light Knife(TM) in
fields such as dentistry and ophthalmology.

        SPECIALTY SEMICONDUCTORS. The Cal ASIC specialty semiconductor business
is focused on the currently under-served low and mid-volume gate array and
standard cell segments of the rapidly expanding $19 billion worldwide market for
application specific integrated circuits (ASIC's). Gate arrays and cell based
ASIC's, which constitute over 40% of the entire ASIC market are a series of
customizable semiconductor building blocks for a variety of critical digital
electronic components, such as computers.

        The low and mid-volume gate array and cell based ASIC market is believed
to be several hundred million dollars in size and to be growing at a rate of
approximately 13% per year. This market demand comes from chip developers who
never need more than a few thousand chips of a given design due to the limited
number of products they build at one time. This is a viable market for Cal ASIC
due to the inability of large semiconductor factories, which are set up for high
volume production, to handle short run orders in a cost effective manner. Since
large producers cannot serve the market, potential customers must look to
smaller suppliers, like Cal ASIC for support. Cal ASIC's flexible design and
engineering capabilities coupled with its alliances with various semiconductor
foundries give it the ability to provide multiple technologies at any volume.


MANUFACTURING

        The Company believes that alternative suppliers are readily available
for most of its critical components that it requires to manufacture its
products. During 1997 the Company expanded the internal machine shop
capabilities at its PPL manufacturing division to enable it to fabricate many
components previously purchased from outside suppliers. Once this expansion is
completed, JMAR expects to realize improved costs, quality, and lead times that
will significantly improve overall competitiveness in the marketplace. Due to
the complex nature of the capital equipment that the Company manufactures, it
purchases a substantial amount of "off-the-shelf" components from outside
vendors for integration into its final systems. These items include computers,
optics, television cameras and motors. The Company has not encountered
difficulties procuring these items and does not rely on exclusive sole source
suppliers.

        JMAR has installed and integrated at PPL an internal information system
which includes a management information system that supports a fully integrated
material requirements planning



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system that is run on an internal local area network. This system which enables
the Company to control its material requirements and production planning, as
well as all phases of production, was expanded last year to improve the quality
assurance program. Those improvements contributed to the Company's receipt of
its ISO 9001 certification. Improvements were also made in PPL's communication
network to speed responses to its customers.

        Due to the complexity of the equipment that the Company manufactures,
delivery times after receipt of an order typically range from 30 to 90 days for
standard products and from 90 days to one year for customized and special
products.

        During its reorganization in 1997 Cal ASIC was transformed from a small
volume semiconductor manufacturer to a "fab-less" supplier of products based on
Cal ASIC's existing semiconductor design and engineering capabilities. To do so,
it established manufacturing supply arrangements with multiple semiconductor
manufacturers for semiconductor wafers, technology, design, and manufacturing
support. Accordingly, it no longer utilizes its own wafer fabrication facility,
with its attendant costs. Its flexible manufacturing agreements with multiple
sources give Cal ASIC the ability to offer a much broader variety of higher
performance products than could be economically produced in its own fabrication
facilities.

RESEARCH AND DEVELOPMENT

        Company-funded expenditures for research, development and engineering
were $1,699,010, $1,304,119, $881,800, $995,520 and $853,828 for the years ended
December 31, 1997, 1996, 1995, 1994 and 1993, respectively. Total expenditures
for RD&E including funding provided by third party contracts from the U.S.
government and other companies were $3,186,149, $2,441,184, $2,118,550,
$2,292,635 and $1,419,851 for the years ended December 31, 1997, 1996, 1995,
1994 and 1993, respectively.

        JMAR's JTC division is performing R&D contract work based on its
advanced solid state laser technology. That work is funded by the Defense
Advanced Research Projects Agency (DARPA) of the Department of Defense and other
customers. Its work for DARPA relates to: (1) X-ray lithography source
development, and (2) other advanced military system technology. During the past
five years, JTC has been awarded several contracts from the government relating
to the development of advanced manufacturing and military system prototypes
utilizing the Company's leading edge laser technology base. JMAR's PPL division
is responsible for the engineering and manufacturing of commercial products
based on these prototypes. Government funding of these dual use technologies,
however, is very vulnerable to changes in the political atmosphere. For this
reason, the Company is pursuing strategic alliances with commercial
microelectronics manufacturers as additional sources of development funding.

        Some of the more significant research and development projects the
Company has worked on in 1997 include (i) the engineering development of a new
generation of disk drive inspection systems; (ii) the development of new
software for the Company's test and measurement systems; (iii) continued
development of its high performance Britelight(TM) laser system and the
Microlight 1000 demonstration center; (iv) continued development of advanced
lithography for semiconductor manufacturing; and (v) further development of the
Company's Light Knife(TM) products.

DISTRIBUTION

        JMAR sells its products on a worldwide basis. It



                                       11
<PAGE>   12
uses a combination of direct regional sales personnel and sales representatives
to market its products in the United States. Foreign sales are handled through
independent distributors and representatives. In 1998, PPL plans to increase its
foreign sales channels in both Europe and Asia to improve market share of its
existing products and make additional sales channels available for JMAR's
emerging Britelight products.

        The distributors normally purchase equipment for their own account and
resell it to the end user in compliance with local law and customs. They are
normally appointed as exclusive distributors or representatives for either a
geographic area or a targeted product line and are responsible for service
support, training and installation to local customers.

        In 1998, PPL plans to increase its service network to include additional
direct personnel to meet the demands of its customers. The Company believes this
will not only improve customer satisfaction but also increase revenues for both
service and maintenance issues as well as generate new sales.

COMPETITION

        JMAR believes that it is recognized as a leader in precision motion
control X-Y staging, components and systems. There are three major domestic
competitors. These competitors carry a much broader line, have much larger
distribution channels, and have a large stock of off-the-shelf inventory. In
addition, there are approximately five smaller competitors specializing in
narrower niches. Rather than compete in the generalized motion control and
positioning product marketplace, the Company has established itself as an
integrater of X-Y positioning and motion control systems and platforms for
several substantial OEM customers. However, the Company has indications that the
market for its precision X-Y stages may be larger than originally estimated.
Market research is being performed in 1998 to identify additional market niches
and OEM customers that could allow the Company to increase market share.

        The Company has also recently expanded its internal machine shop
capabilities to improve its competitiveness in price, quality and delivery time.
JMAR believes this expansion will significantly improve its position in the
market place and should result in increased sales in 1998 and beyond.

        The Company believes that it is recognized as a leader in measurement
and inspection systems utilizing vision and laser based depth probes. There are
approximately five domestic and three foreign competitors within JMAR's
marketplace. The majority of the competition supplies standard off-the-shelf
measurement and inspection systems for the microelectronics industry including
the mass storage industry. JMAR's strengths against its competition are its
ability to integrate its positioning and motion control products with its
standard measurement and inspection systems to provide turnkey system solutions
for manufacturing, process control and quality control requirements. The
Company's vision and laser-based systems are targeted for high-end applications
requiring high resolution, sub-micron edge detection, positioning and
measurement accuracy. This enables the Company to set itself apart from the
mainline competition which chooses to compete in the lower resolution
marketplace.

        The Company believes that it has established itself as the leading
developer of laser-plasma X-ray lithography point source systems. Although other
X-ray point source technologies are under development, the Company also believes
that upon achievement of commercially viable outputs laser-plasma point sources
of the type under development at JMAR may have the best long-term potential for
meeting commercial X-ray lithography requirements. The Company believes that its
diode pumped solid state laser-driven Picosecond X-ray Source (PXS), when
fitted with X-ray collimator devices developed by other DARPA contractors, will
be capable of



                                       12
<PAGE>   13
generating X-rays of sufficient intensity to demonstrate sub-quarter micron
feature sizes at commercially-viable manufacturing rates. JMAR's PXS system has
a significant competitive advantage over alternative technologies because of
certain unique technical features which the Company believes will allow it to be
readily integrated into semiconductor fabrication processes.

        In the area of specialty semiconductors, the Company's Cal ASIC division
faces competition from a small number of gate array and standard cell
microcircuit producers willing to serve the low volume markets that Cal ASIC
targets. While not limited in the volume it can supply, Cal ASIC chooses to
target lower volume customers who are not served by the major producers.
Currently, customers needing only small volumes of custom microcircuits have few
choices. They must either use expensive field programmable gate arrays, or pay
high costs to a major producer for limited production, or develop their
application using discrete components. Using high performance software tools,
proprietary design routines, and flexible foundry and production arrangements,
Cal ASIC provides a cost effective solution to these low volume customers. Cal
ASIC is a "fab-less" producer of semiconductors. By foregoing the high costs of
owning and operating its own wafer fabrication facility and aligning itself with
state of the art semiconductor manufacturers, Cal ASIC has the ability to offer
high performance sub-micron semiconductor products to a wide range of
applications, without the overhead burden of its own manufacturing facility.

        Three main competitors, all located in the western part of the U.S.
exist in the niche that Cal ASIC serves. All three competitors offer sub-micron
technologies and possess their own wafer fabrication facilities. The Company
believes this locks the competitor into the process, performance, and cost
structure of the fabrication facilities it owns. As a result of its recent
reorganization, Cal ASIC does not have this constraint. Using its multiple
foundry arrangements, Cal ASIC can target its customer into the technology and
cost structure that best serves the customer need.

PATENTS AND PROPRIETARY TECHNOLOGY

        JMAR owns a substantial body of proprietary software used in the
operation of its systems and believes that this software provides it with a
unique competitive advantage compared with its competitors in the laser systems
and measurement systems business. JMAR's advanced laser expertise base has
produced a considerable body of patentable technology during the past several
years. For instance, JMAR was issued patents for a "Laser Plasma X-ray Source"
on February 2, 1992 and for a "Low Cost, High Brightness Solid State Laser" on
July 18, 1995, and for a "Pico Second Laser" on September 3, 1997. These latter
two patents cover its PXS and Britelight(TM) solid state laser technologies.

        The Company holds numerous other patents relating to lasers, their
applications and associated systems and one non-laser patent. The Company's
policy is to apply for a patent on each of its significant inventions not only
to preserve its proprietary rights but also to protect against reverse
engineering by others and to avoid being "locked out" of the use of its own
technology by other patents. The Company does not place its principal reliance
on patent protection; rather, it seeks to maintain a competitive advantage
through an aggressive R&D program, protection of non-patented proprietary data,
maintenance of its advanced laser-optics expertise, superior product performance
and active marketing of its products. However, it is recognized that lasers and
X-ray lithography are the subject of very substantial R&D activity by many very
competent companies and that other approaches may be developed and patented,
making the field very competitive.

        As is the case with its competitors in the laser market, the Company's
use of its laser technology is subject to the basic laser patents owned and
licensed by the Patlex Corporation ("Patlex"). Patlex holds title to several of
the basic laser and laser application patents originally owned by Gordon Gould.
Its position with respect to these patents has been confirmed by the



                                       13
<PAGE>   14
courts within recent years. The lasers sold by the Company are currently subject
to royalties under Patlex U.S. Patent No. 4,704,583. In as much as most laser
companies have signed royalty agreements with Patlex since that time the
existence of these patents appears to have little impact on the relative
positions of the companies in this market.

DEVELOPMENT AND PRODUCTION STRATEGY FOR X-RAY LITHOGRAPHY

        JMAR's X-ray lithography source development strategy is based on
developing a modular X-ray source system which can be readily integrated with
any X-ray stepper, such as the current development-stage X-ray steppers from
Silicon Valley Group Lithography (SVGL), Canon, and Suss Advanced Lithography
(SAL). JMAR's commercialization plan for its X-ray source technology is based
on:

        1) JTC's understanding of the market requirements for advanced
lithography; its X-ray source technology; and its experience with prototype
design and interface integration requirements of available steppers,

        2) Its PPL division's capability in engineering, product manufacturing,
assembly, test, and integration of precision manufacturing equipment for the
microelectronics industry, and

        3) The use of established industrial sources to supply and service the
principal components of the PXS systems (combined in a unique, patented manner).

CUSTOMERS

        For fiscal years 1997, 1996 and 1995, the United States Government
accounted for approximately 10%, 9% and 15%, respectively, of total sales.
Foreign sales accounted for 42%, 21% and 15% of the Company's revenues in 1997,
1996 and 1995, respectively. In 1997, IBM accounted for 38.6% of JMAR's
revenues. In 1996, three customers each accounted for in excess of 10% of JMAR's
revenues: IBM (29.5%), Medtronic (12.1%) and Therma-Wave (10.7%). In 1995, four
customers each accounted for in excess of 10% of JMAR's revenues: Therma-Wave
(16.4%), IBM (15.8%), Seagate Technology (11.3%) and Magnecomp (11.0%).

EMPLOYEES

        Currently, the Company has approximately 115 full-time employees. The
Company is not subject to any collective bargaining agreements and believes that
it maintains excellent relations with its employees.

INDUSTRY SEGMENT INFORMATION

        Prior to the sale of its Surgilase, Inc. medical equipment business in
December, 1994, the Company operated in two industry segments for financial
reporting purposes as follows: the Medical Equipment Group and the Manufacturing
Equipment Group. Financial information relating to the Company's export sales
for the three years ended December 31, 1997 is incorporated by reference from
Note 14 of Notes to Consolidated Financial Statements.



                                       14
<PAGE>   15
ITEM 2.  PROPERTIES

        The Company has a total of approximately 44,000 square feet of
laboratory, office, manufacturing and storage space under lease, including 9,280
square feet located in the Torrey Pines Business Park in the Sorrento Valley
region of San Diego, 15 miles north of San Diego International Airport. The
Sorrento Valley space is used for JTC's technology development activities,
including X-ray lithography and government contract businesses and for the
Company's corporate headquarters. That lease, which expires in February, 1999,
is at a current monthly rental of $7,610.

        In 1996 PPL added approximately 3,500 square feet of industrial space to
its existing 25,000 square feet. The new space was required to expand the
internal machining capability and to consolidate large inventory and storage
requirements. This enabled the main manufacturing plant of approximately 25,000
square feet to increase its production capability. In addition, the Company
maintains a sales office in San Jose, California. PPL's manufacturing, office
and storage facilities are located 25 miles north of Los Angeles International
Airport and have a monthly rental of $16,173.

        In addition, the Company leases 6,596 square feet of office and storage
space south of Los Angeles in Irvine, California for Cal ASIC at a monthly
rental of $4,500 which expires in April, 1998.

        The Company believes that its physical properties are adequate for its
current needs.


ITEM 3.  LEGAL PROCEEDING

                                      None.


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

                                      None.


                                       15
<PAGE>   16

                                    PART II

ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED
         SHAREHOLDER MATTERS

        The Company's common stock and warrants are traded on the Nasdaq
National Market tier of the Nasdaq Stock Market ("NASDAQ-NMS") under the symbols
JMAR and JMARW, respectively. The 1997 and 1996 high and low transaction prices
for the common stock as reported by NASDAQ-NMS are set forth in the following
table.


                               COMMON STOCK PRICE

<TABLE>
<CAPTION>
                                                                      HIGH         LOW
                                                                     --------    --------
<S>                                                                  <C>         <C>
1996
    First Quarter..............................................      1 15/32       15/16
    Second Quarter.............................................      4  9/16     1   1/8
    Third Quarter..............................................      3   5/8     1 15/16
    Fourth Quarter.............................................      3  1/16     2  3/32
1997
    First Quarter..............................................      2 29/32     2  3/16
    Second Quarter.............................................      3 23/32     1 15/16
    Third Quarter..............................................      4 19/32     3  1/16
    Fourth Quarter.............................................      4 31/32     2  -1/2
</TABLE>

     There were approximately 5,982 holders of JMAR's common stock and 477
holders of JMAR's publicly traded warrants as of March 3, 1998.

        The Company has never paid cash dividends on its Common Stock. The
Company currently intends to retain earnings for use in the operation and
expansion of its business and therefore does not anticipate paying any cash
dividends in the foreseeable future. The payment of dividends in the future by
the Company on its Common Stock will be dependent on its earnings and financial
condition and such other factors considered relevant by the Company's Board of
Directors.

     In November, 1997, the Company sold units (the "Units") consisting of
1,000,000 shares of Common Stock and warrants exercisable for 250,000 shares of
Common Stock at an exercise price of $4.40 per share, for an aggregate of
$3,400,000 in offering proceeds, of which $168,061 in commissions and placement
fees was paid. The Units were issued to accredited investors in a transaction
which was exempt under Regulation D of the Securities Act of 1933.

     Pursuant to the Director Compensation Program adopted by the Company in
August, 1997, the Company issued a total of 216 shares of Common Stock in
October, 1997 and a total of 296 shares of Common Stock in December, 1997 to its
outside directors as compensation for services as a director. These transactions
were exempt under Section 4(2) of the Securities Act of 1933.

ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

        The selected consolidated financial data that follows has been extracted
from the Company's Consolidated Financial Statements, which have been audited by
Arthur Andersen LLP, independent public accountants. It should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements and Notes
thereto, which are included elsewhere in this report.



                                       16
<PAGE>   17

        The amounts for 1994 and 1993 have been adjusted from that previously
reported to reflect the operations of Surgilase as discontinued operations as a
result of its sale on December 9, 1994 but continue to contain the results of
several other business activities which the Company also terminated in 1994. The
financial data for 1996 includes the operations of Cal ASIC since May, 1996. The
financial data for 1993 includes the operations of PPL since October, 1993. The
balance sheet information includes the accounts of Surgilase at December 31,
1993, the accounts of Benchmark at December 31, 1994 and 1993, the accounts of
PPL at December 31, 1997, 1996, 1995, 1994 and 1993 and the accounts of Cal ASIC
at December 31, 1997 and 1996. The financial data below includes the operations
of Texcel through December 31, 1993.



                                       17
<PAGE>   18


<TABLE>
<CAPTION>
                                         CONSOLIDATED STATEMENTS OF OPERATIONS DATA
=======================================================================================================================
                                         1993              1994                1995            1996           1997
                                         ----              ----                ----            ----            ----
<S>                                 <C>                <C>                 <C>             <C>             <C>
Operating revenues ...............  (1)$9,148,925      (1)$10,821,025      $ 12,210,490    $ 16,331,090    $ 21,461,627
Revenues excluding terminated
  operations .....................   (2)3,620,925        (2)7,782,025        12,210,490      16,331,090      21,461,627
Gross profit .....................      2,233,515           4,034,613         4,879,420       6,692,136       8,830,316
Operating expenses excluding
  restructuring charges ..........      5,814,072           5,439,430         4,694,233       6,188,169       7,303,374
Restructuring charges ............      5,112,000            (458,309)               --              --              --
Income (loss) from operations ....     (8,692,557)           (946,508)          185,187         503,967       1,526,942
Interest expense .................       (900,482)           (570,094)         (321,162)       (288,372)       (181,562)
Interest and other income
  (expense), net .................        245,271             390,594           212,240         388,974         104,905
Income (loss) from continuing
 operations before income taxes ..  (3)(9,347,768)      (3)(1,126,008)           76,265         604,569       1,450,285
Income tax benefit ...............             --                  --                --         175,000         345,000
Income (loss) from continuing
 operations ......................     (9,347,768)         (1,126,008)           76,265         779,569       1,795,285
Discontinued operations:
    Loss from operations of
      discontinued operations ....     (3,627,869)         (2,999,242)               --              --              --
    Loss on disposal of
      discontinued  operations ...             --            (540,404)               --              --              --
Net income (loss) ................    (12,975,637)         (4,665,654)           76,265         779,569       1,795,285
Basic per share data:
    Income (loss) per common
     share  from continuing
     operations ..................          (1.57)               (.11)              .01             .05             .11
    Loss from discontinued
     operations ..................           (.61)               (.33)               --              --              --
    Net income (loss) per share ..          (2.18)               (.44)              .01             .05             .11
Basic shares used in
  calculation of net income (loss)
  per share ......................      5,958,413          10,596,661        13,525,886      15,582,579      17,065,860
=======================================================================================================================
</TABLE>

<TABLE>
<CAPTION>
                    CONSOLIDATED BALANCE SHEET DATA - DECEMBER 31,
===========================================================================================
                           1993          1994          1995         1996           1997
                           ----          ----          ----         ----           ----
<S>                    <C>           <C>           <C>           <C>           <C>
Working capital ....   $ 1,423,318   $ 4,007,846   $ 4,655,087   $ 5,743,747   $ 9,634,527

Total assets .......    19,137,447     9,107,968     9,248,995    15,395,518    17,268,878

Short-term debt ....     4,928,447       914,590     1,526,929     2,317,861       922,246

Long-term debt .....     3,189,664     2,165,417     1,536,273       667,310       907,235

Stockholders' equity     3,709,032     3,849,822     5,085,202     9,368,905    12,488,212
===========================================================================================
</TABLE>

(1)     Excludes revenue from the discontinued Surgilase operations of
        $5,277,406 and $6,776,603 for 1994 and 1993, respectively.

(2)     Excludes revenue from Terminated Operations (See page 19).

(3)     Includes losses from Terminated Operations (See page 19).


                                       18
<PAGE>   19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

            The Company's product lines are subdivided into two categories:
Current Products and Emerging Products. Current Products are those currently
produced and sold whereas the Emerging Product lines are developing businesses
some of which are supported by third party customer R&D contracts.

            Pursuant to its restructuring in 1994, the Company sold several
operations and assets (the "Terminated Operations") which, in accordance with
generally accepted accounting principles, were not classified as "discontinued
operations". Therefore, the revenues and results of operations from the
Terminated Operations are required to be included in the Operating Revenues
reported in the statements of operations for prior years. To enable the
comparison of the revenues generated by those assets which remained after the
disposition of the Terminated Operations with the revenues generated by such
assets prior to the disposition of the Terminated Operations, however, the
second line of the Consolidated Statements of Operations Data on the previous
page reflects the revenues of the Company excluding the revenues from the
Terminated Operations.

RESULTS OF CONSOLIDATED OPERATIONS

            Net income for 1997, 1996 and 1995 was $1,795,285, $779,569 and
$76,265, respectively, while operating income for those same periods was
$1,526,942, $503,967 and $185,187, respectively. Included in the operating
income for 1997 is a net non-recurring gain of $589,969 (see below).

            Revenues for each of the fiscal years ended December 31, 1997, 1996
and 1995 were $21,461,627, $16,331,090 and $12,210,490, respectively
(approximately 33% compounded annual growth rate for the three year period 1995
to 1997 compared with a compounded annual growth rate in excess of 56% for
revenues excluding Terminated Operations for the five year period 1993 to 1997).
The increase in revenues for the year ended December 31, 1997 over the year
ended December 31, 1996 is primarily attributable to the heightened and growing
demand for the Company's core disk drive inspection and measurement systems.
Management believes this growth to be the result of ongoing expansion of the
global market for high-performance hard disk drives, particularly those
incorporating advanced magneto-resistive (MR) head technology. Demand for the
Company's Mirage family of tabletop test and measurement systems increased as
the microelectronics industry, including makers of ion beam manufacturing
equipment, discovered new ways to utilize JMAR's products to improve their
manufacturing yields. In addition, the revenues generated by the Company's
DARPA-funded X-ray lithography source development program increased
approximately 40 percent over the prior year. These increases were offset in
part by the inclusion in 1996 of revenues related to the Company's laser
hermetic sealing systems. Inventories have increased from $3,855,312 at December
31, 1996 to $4,685,883 at December 31, 1997 primarily due to increases in
sub-assemblies and raw material related to the Company's increased revenues. The
revenue increase for the year ended December 31, 1996 over the year ended
December 31, 1995 of $4,120,600 was primarily attributable to the overall
increased volume of orders for Disk Drive Head Inspection Workstations and new
products, primarily the Mirage tabletop video measurement system. Due to, among
other factors, a current oversupply in the high-end disk drive industry and the
economic turmoil in Asia, revenues in the first quarter of 1998 will be less
than revenues in the fourth quarter of 1997, however, the Company anticipates
that orders and revenues will increase in the second and third quarters. In
addition, certain of the Company's revenues are from a limited number of
customers. As a result, the timing of receipt and shipment of orders for those
customers could have a material impact on quarterly results.

            Gross margins for the fiscal years ended December 31, 1997, 1996 and
1995 were 41.1%, 41% and 40%, respectively. The increase in gross profit margins
for the fiscal year ended December 31, 1996 versus the fiscal year ended
December 31, 1995 is primarily due to greater



                                       19
<PAGE>   20
efficiencies in the manufacturing process resulting from higher sales and
production volume and the elimination of a low margin product at PPL. The
Company continues to experience competitive pressures on certain products, which
may impact gross margins in the future.

            Selling, general and administrative ("SG&A") expenses for the fiscal
years ended December 31, 1997, 1996 and 1995, were $6,194,333, $4,884,050 and
$3,812,433, respectively. The increase in SG&A expenses in 1997 of $1,310,283 is
due to (i) higher sales and marketing costs related to the Company's increased
sales volume; and (ii) higher payroll costs. The increase in SG&A expenses in
1996 as compared to 1995 was due to (i) SG&A expenses of $448,040 related to Cal
ASIC in 1996 compared to none in 1995; (ii) increased depreciation with respect
to the larger quantity of demonstration equipment, primarily related to the
Mirage, required to support expanded marketing efforts; (iii) higher customer
service costs that resulted from expansion of the customers service staff to
support increased sales volume experienced in 1996; and (iv) higher payroll
costs.

            The Company's research, development and engineering program (RD&E)
consists of two types: Customer-Funded RD&E (U.S. government and other
companies) and Company-Funded RD&E. Both types of RD&E are expensed when
incurred. Customer-Funded RD&E costs incurred, included in "Contract Costs of
Sales" expenses totaled $1,487,139, $1,137,065 and $1,236,750 for the fiscal
years ended December 31, 1997, 1996 and 1995, respectively. The increase in
Customer-Funded RD&E for 1997 is primarily due to the delay in receipt of
additional contract funding from the U.S. government in 1996 which was funded in
1997. Company-Funded RD&E costs are shown in "Operating Expenses" and totaled
$1,699,010, $1,304,119 and $881,800, respectively. Hence, total RD&E expenses
for those three years were $3,186,149, $2,441,184 and $2,118,550, respectively.
Capitalized software costs of $444,355 and $222,010 for the years ended December
31, 1997 and 1996 are not included in the above amounts. The increase in RD&E is
primarily related to the engineering development of a new generation of disk
drive inspection systems, the development of new software for the Company's test
and measurement systems, continued development of the Britelight laser system
and the Microlight 1000 demonstration center, continued development of advanced
lithography for semiconductor manufacturing and further development of the
Company's Light Knife products.

            The non-recurring item for 1997 includes a gain of approximately
$2,839,000 from the settlement of certain claims against the former principal
shareholders of Cal ASIC offset in part by the writedown of certain assets
primarily related to Cal ASIC in the amount of $1,594,000 and costs incurred
related to the assets written down as a result of the reorganization of Cal ASIC
in the amount of $655,031 resulting in a net gain of $589,969.

            Interest expense for the fiscal years ended December 31, 1997, 1996
and 1995, was $181,562, $288,372 and $321,162, respectively. The decrease in
interest expense in 1997 versus 1996 is primarily due to the conversion of
$1,000,000 and $470,000 of convertible notes into JMAR common stock in October,
1996 and August, 1997, respectively. The decrease in interest expense in 1996
versus 1995 is due to the conversion of $1,000,000 of convertible notes into
JMAR common stock in October 1996. Included in interest expense for fiscal years
1997, 1996 and 1995 are loan fees totaling $10,369, $30,780 and $51, 525,
respectively.

            Interest and other income (expense) for 1996 includes a gain of
approximately $405,700 related to the settlement with Atlantic American Holding
Company Limited ("Atlantic") and early redemption of the preferred stock of
Atlantic that the Company held and includes a non-recurring charge of $80,000
recorded in the first quarter relating to an investment disposed of in a prior
year.

            Included in the Statement of Income in 1997 and 1996 is a tax
benefit of $345,000 and $175,000, respectively, related to the utilization by
the Company of a portion of its net operating loss carryforward.

            The Company has conducted a review of its computer systems to
identify the systems that could be affected by the "Year 2000" issue and has
developed a plan to resolve the issue. The Year 2000 problem is the result of
computer programs being written using two digits rather than four digits to
define the applicable year. Any of the Company's programs that have
time-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in a major system failure or
miscalculations. The Company presently believes that the Year 2000 problem will
not pose significant operational problems for the Company's computer systems.



                                       20
<PAGE>   21

CONSOLIDATED LIQUIDITY AND FINANCIAL CONDITION

            Cash and cash equivalents at December 31, 1997 and December 31, 1996
were $3,644,117 and $2,629,286, respectively. The increase (decrease) in cash
and cash equivalents for the fiscal years ended December 31, 1997, 1996 and 1995
was $1,014,831, $791,639 and $(107,731), respectively. The increase in cash for
1997 resulted from proceeds from the issuance of common stock of $3,215,253,
payments received on notes receivables of $897,857, proceeds from the exercise
of options and warrants of $668,355 and net borrowings of notes payable of
$273,222 offset in part by cash used in operations of $1,951,488, payment of
short-term debt of $969,281, capital expenditures of $763,697, increase in notes
and other receivables of $307,939 and patent costs of $47,451. The cash used in
operations was primarily used to finance accounts receivable and inventory
purchases offset in part by an increase in accounts payable and accrued
liabilities. Accounts receivable increased primarily due to an increase in
revenues for the twelve months ended December 31, 1997. Accounts payable and
accrued liabilities increased primarily due to an increase in inventory
purchases to support planned production increases. Cash from net income plus
non-cash operating items for the year ended December 31, 1997 was $1,518,033.

            The increase in cash for 1996 resulted from payments received on
notes receivable of $1,004,502, borrowings from notes payable of $706,921,
proceeds from the exercise of warrants of $649,168 and proceeds from the
issuance of common stock of $156,000 offset in part by capital expenditures of
$941,597, cash used in operations of $413,687, increase in notes and other
receivables of $187,722, acquisition costs of $86,393 and patent costs of
$12,905.

            JMAR operations will continue to require the use of working capital.
The working capital of PPL is generally funded through its $3,500,000 working
capital line (the "Line") with a bank (the "Bank"). The operations of JTC are
currently funded through third party contracts. As of December 31, 1997, PPL's
availability pursuant to the Line was approximately $3,025,000 of which
approximately $475,000 was borrowed at that time by PPL. The Line contains
several covenants relating to, among other matters, the maintenance of certain
minimum income levels and financial ratios, which if not met by the Company
could impact the availability of advances pursuant to the Line. In addition, in
December, 1997, the Company borrowed $500,000 from the Bank to be used for
capital equipment and other costs associated with the Company's expansion of its
internal machine shop capabilities at PPL and other equipment to be purchased by
PPL. Management believes that the Company has existing resources to adequately
fund operations and working capital requirements for the next twelve months
based on the current level of operations and business conditions.

            At December 31, 1997, the Company had in excess of $25 million of
Federal net operating loss carryforwards, subject to certain annual limitations.
To the extent the Company has taxable income in the future, these carryforwards
will be used by the Company to reduce its cash outlay for taxes.

FACTORS THAT MAY AFFECT FUTURE RESULTS

            Certain statements contained in this Form 10-K which are not related
to historical results are forward-looking statements that necessarily are based
on certain assumptions and are subject to certain risks and uncertainties that
could cause actual future performance and results to differ materially from
those stated or implied in the forward-looking statements. These risks and
uncertainties include concentration of sales to markets and customers, delays or
cancellations in orders, fluctuations in margins, timing of specific orders,
customer reorganizations, demand fluctuations, timely development, introduction
and acceptance of new products, technical obsolescence of existing products,
technical problems in the development or modification of current products or
manufacturing processes, the impact of competitive products and pricing, shifts
in demand for the Company's products, the degree of success of technology
transfer (e.g., advanced lithography sources, laser blood sampler,
micromachining, etc.) to commercial products, availability of working capital to
support growth, continued government funding of



                                       21
<PAGE>   22

advanced lithography, successful integration of acquisitions, other competitive
factors and temporary cessation of operations at one or more of its division
facilities due to acts of nature such as floods, earthquakes and fires.

            JMAR's future operating results are also dependent on its ability to
develop, manufacture and market, in a timely manner, innovative products that
meet customers' needs and the continued growth of the semiconductor, computer
disk drive and medical equipment industries. Inherent in this process are a
number of risks that the Company must successfully manage in order to achieve
favorable operating results. The process of developing new high technology
products is complex and uncertain and requires innovations that anticipate
customer needs and technological trends. After the products are developed, the
Company must quickly manufacture them in sufficient volumes at acceptable costs
to meet demand and establish the necessary sales and marketing capabilities to
assure adequate and timely sales volume.

            In addition, portions of the Company's manufacturing operations are
sometimes dependent on the ability of a targeted base of suppliers to provide
core technology, sub-assemblies and common manufactured parts in time to meet
critical distribution and manufacturing schedules. From time-to-time the Company
could experience constrained supply of certain component parts due to a variety
of reasons, including strong demand in those product lines as well as strong
demand in the industry. Such constraints could adversely affect JMAR's operating
results until alternate sourcing is developed.

            As is the case for a large number of California-based companies, a
significant portion of the Company's operations are located near major
earthquake faults. The ultimate impact on the Company, significant suppliers and
the general infrastructure is unknown, but operating results could be materially
affected in the event of a major earthquake. The Company is predominantly
self-insured for losses and interruptions caused by earthquakes.

            The operations of the Company involve the use of substances
regulated under various federal, state and international laws governing the
environment. It is the Company's policy to apply strict standards for
environmental protection even if not subject to regulations imposed by local
governments. The liability for environmental remediation and related costs is
accrued when it is considered probable and the costs can be estimated.
Environmental costs are presently not material to JMAR's operations or financial
position.

            Although JMAR believes that it has the necessary product offerings
and resources for continuing success, future revenue and margin trends cannot be
reliably predicted and may cause the Company to adjust its operations. Factors
external to the Company can result in volatility of the Company's common stock
price. Because of the foregoing factors, recent trends should not be considered
reliable indicators of future stock prices or financial results.

            The ultimate commercial success of the Company's pocket size laser
blood samplers will depend on a number of factors including technical
performance, cost to produce, desire of the Company's customer to introduce the
product into the commercial market, the ability to obtain FDA approval to market
the products and the ability of the Company's customer to ultimately generate
adequate sales volume.

            The Company has not yet achieved commercially viable outputs in its
X-ray lithography program. In order to prove that its technology works and to
produce a completed product, the Company must complete the development and
integration of these highly technical and complicated systems into a
fully-integrated prototype. With any new technology, there is a risk that the
market may not appreciate the benefits of the product. In addition, the
Company's X-ray lithography system will compete against other developing
technologies. Development by others of new or improved products, processes or
technologies may make the Company's proposed product obsolete or less
competitive. Also, the development of sophisticated laser products is a



                                       22
<PAGE>   23
lengthy and capital intensive process and is subject to unforeseen risks,
delays, problems and costs.

            Although JMAR has demonstrated initial versions of its Britelight
lasers and its Microlight 1000, it has not yet introduced either product into
the commercial marketplace. Along with some of the risks discussed in the
preceding paragraph, the size of the potential market for the product is not yet
known.

            The Company denominates its foreign sales in U.S. dollars and the
Company does not believe that foreign currency fluctuations will have a
material adverse impact on its ability to compete with its competitors. Foreign
currency fluctuations, however, could make the Company's products less
affordable and thus reduce the demand for such products. The Company attempts
to mitigate credit risk relative to sales to foreign customers through its
policy of generally requiring letters of credit.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

            The financial statements prepared in accordance with Regulation S-X
are set forth beginning on page 26 hereof.


                                       23
<PAGE>   24


<TABLE>
<CAPTION>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<S>                                                                                       <C>
Report of Independent Public Accountants................................................  25

Consolidated Balance Sheets as of December 31, 1997 and 1996............................  26

Consolidated Statements of Income for the Years Ended December 31, 1997,
1996 and 1995...........................................................................  27

Consolidated Statements of Stockholders' Equity for the Years Ended December 31,
1997, 1996 and 1995.....................................................................  28

Consolidated Statements of Cash Flows for the Years Ended December 31, 1997,
1996 and 1995...........................................................................  29

Notes to Consolidated Financial Statements..............................................  30
</TABLE>



                                       24
<PAGE>   25



                         REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To JMAR Industries, Inc.:

        We have audited the accompanying consolidated balance sheets of JMAR
Industries, Inc. (a Delaware corporation) and subsidiaries as of December 31,
1997 and 1996, and the related consolidated statements of income, stockholders'
equity and cash flows for each of the three years in the period ended December
31, 1997. These consolidated financial statements and the schedule referred to
below are the responsibility of the Company's management. Our responsibility is
to express an opinion on these consolidated financial statements and schedule
based on our audits.

        We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of JMAR Industries,
Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.

        Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The schedule listed in Item
14 is presented for purposes of complying with the Securities and Exchange
Commission's rules and is not part of the basic consolidated financial
statements. This schedule has been subjected to the auditing procedures applied
in the audits of the basic consolidated financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic consolidated financial statements
taken as a whole.



                                             /s/ Arthur Andersen LLP
                                             -----------------------------------
                                             ARTHUR ANDERSEN LLP

San Diego, California
March 27, 1998


                                       25


<PAGE>   26

                              JMAR INDUSTRIES, INC.
                           CONSOLIDATED BALANCE SHEETS
                  AS OF DECEMBER 31, 1997 AND DECEMBER 31, 1996

<TABLE>
<CAPTION>
                                       ASSETS                                                   December 31,
                                       ------                                                   ------------
                                                                                             1997           1996
                                                                                         ------------    ------------
<S>                                                                                      <C>             <C>
Current Assets:
     Cash and cash equivalents .......................................................   $  3,644,117    $  2,629,286
     Accounts receivable, net ........................................................      4,308,777       2,994,762
     Notes and other receivable ......................................................        111,285         902,005
     Inventories .....................................................................      4,685,883       3,855,312
     Prepaid expenses and other ......................................................        757,896         721,685
                                                                                         ------------    ------------
          Total current assets .......................................................     13,507,958      11,103,050
Receivable from officer ..............................................................         78,378          73,824
Property and equipment, net ..........................................................      2,500,404       2,704,460
Other assets, net ....................................................................        794,073         402,294
Goodwill, net ........................................................................        388,065       1,111,890
                                                                                         ------------    ------------

         TOTAL ASSETS ................................................................   $ 17,268,878    $ 15,395,518
                                                                                         ============    ============

            LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
     Accounts payable ................................................................   $  1,175,717    $    914,272
     Accrued liabilities .............................................................        540,933         535,885
     Accrued payroll and related costs ...............................................      1,228,853         849,072
     Customer deposits ...............................................................          5,682         742,213
     Convertible notes payable .......................................................         20,000         589,631
     Notes payable and capital lease obligations .....................................        902,246       1,728,230
                                                                                         ------------    ------------
          Total current liabilities ..................................................      3,873,431       5,359,303
                                                                                         ------------    ------------
Notes payable and capital lease obligations, net of current portion ..................        907,235         667,310
                                                                                         ------------    ------------
Commitments and contingencies (Notes 7 and 9) Stockholders' equity :
     Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued and
         outstanding as of December 31, 1997 and December 31, 1996 ...................             --              --
     Common stock, $.01 par value; 40,000,000 shares authorized;
       Issued and outstanding 17,890,952 shares as of December 31, 1997 and 16,760,269
       shares as of December 31, 1996 ................................................        178,910         167,603
     Additional paid-in capital ......................................................     36,587,674      35,274,959
     Accumulated deficit .............................................................    (24,278,372)    (26,073,657)
                                                                                         ------------    ------------
          Total stockholders' equity .................................................     12,488,212       9,368,905
                                                                                         ------------    ------------

         TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ..................................   $ 17,268,878    $ 15,395,518
                                                                                         ============    ============
</TABLE>

  The accompanying notes to consolidated financial statements are an integral
part of these consolidated balance sheets.



                                       26
<PAGE>   27
                              JMAR INDUSTRIES, INC.
                        CONSOLIDATED STATEMENTS OF INCOME
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995


<TABLE>
<CAPTION>
                                                                                              Year ended December 31,
                                                                                              -----------------------
                                                                                   1997            1996            1995
                                                                               ------------    ------------    ------------
<S>                                                                            <C>             <C>             <C>
Product sales ..............................................................   $ 19,228,621    $ 14,585,585    $ 10,351,949
Contract sales .............................................................      2,233,006       1,745,505       1,858,541
                                                                               ------------    ------------    ------------
          Total revenues ...................................................     21,461,627      16,331,090      12,210,490
Product costs of sales .....................................................     11,144,172       8,501,889       6,094,320
Contract costs of sales ....................................................      1,487,139       1,137,065       1,236,750
                                                                               ------------    ------------    ------------
          Gross profit .....................................................      8,830,316       6,692,136       4,879,420
                                                                               ------------    ------------    ------------
Operating Expenses:
     Selling, general and administrative ...................................      6,194,333       4,884,050       3,812,433
     Research, development and engineering .................................      1,699,010       1,304,119         881,800
     Non-recurring items ...................................................       (589,969)             --              --
                                                                               ------------    ------------    ------------
          Total operating expenses .........................................      7,303,374       6,188,169       4,694,233
                                                                               ------------    ------------    ------------
Income from operations .....................................................      1,526,942         503,967         185,187
Interest and other income (expense), net ...................................        104,905         388,974         212,240
Interest expense ...........................................................       (181,562)       (288,372)       (321,162)
                                                                               ------------    ------------    ------------
Income before income taxes .................................................      1,450,285         604,569          76,265
Income tax benefit .........................................................        345,000         175,000              --
                                                                               ------------    ------------    ------------
Net income .................................................................   $  1,795,285    $    779,569    $     76,265
                                                                               ============    ============    ============
Net income per share:
     Basic .................................................................   $        .11    $        .05    $        .01
                                                                               ============    ============    ============
     Diluted ...............................................................   $        .10    $        .05    $        .01
                                                                               ============    ============    ============
Weighted average shares outstanding:
     Basic .................................................................     17,065,860      15,582,579      13,525,886
                                                                               ============    ============    ============
     Diluted ...............................................................     18,601,119      16,755,753      14,133,258
                                                                               ============    ============    ============

</TABLE>

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


                                       27
<PAGE>   28
                              JMAR INDUSTRIES, INC.
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995



<TABLE>
<CAPTION>
                                                                              Additional                       Total
                                         Common Stock        Preferred Stock  Paid-in      Accumulated     Stockholders'
                                    Shares          Amount    Shares Amount   Capital         Deficit         Equity
                                 ------------    ------------    --- ---   ------------    ------------    ------------
<S>                                <C>           <C>           <C>   <C>   <C>             <C>             <C>
Balance, December 31, 1994 ...     12,242,433    $    122,424     --  $-   $ 30,656,889    $(26,929,491)   $  3,849,822
Debt converted to equity .....        700,000           7,000     --  --        443,002              --         450,002
Issuance of common stock .....      1,278,152          12,782     --  --        688,075              --         700,857
Stock issued upon litigation
  settlement .................          8,000              80     --  --          8,176              --           8,256
Net income ...................             --              --     --  --             --          76,265          76,265
                                 ------------    ------------    --- ---   ------------    ------------    ------------
Balance, December 31, 1995 ...     14,228,585         142,286     --  --     31,796,142     (26,853,226)      5,085,202
Issuance of stock related to
   acquisition of Cal ASIC ...      1,427,526          14,275     --  --      1,707,270              --       1,721,545
Debt converted to equity .....        440,000           4,400     --  --        973,021              --         977,421
Stock issued upon exercise of
    warrants .................        474,158           4,742     --  --        644,426              --         649,168
Issuance of common stock .....        190,000           1,900     --  --        154,100              --         156,000
Net income ...................             --              --     --  --             --         779,569         779,569
                                 ------------    ------------    --- ---   ------------    ------------    ------------
Balance, December 31, 1996 ...     16,760,269         167,603     --  --     35,274,959     (26,073,657)      9,368,905
Stock issued upon exercise of
   warrants and options ......        681,618           6,816     --  --        661,539              --         668,355
Debt converted to equity .....        156,634           1,566     --  --        467,622              --         469,188
Issuance of common stock .....      1,008,252          10,083     --  --      3,219,472              --       3,229,555
Retirement of common stock
related to acquisition of Cal
   ASIC ......................       (715,821)         (7,158)    --  --     (3,035,918)             --      (3,043,076)
Net income ...................             --              --     --  --             --       1,795,285       1,795,285
                                 ------------    ------------    --- ---   ------------    ------------    ------------
Balance, December 31, 1997 ...     17,890,952    $    178,910     --  $-   $ 36,587,674    $(24,278,372)   $ 12,488,212
                                 ============    ============    === ===   ============    ============    ============

</TABLE>


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


                                       28
<PAGE>   29
                              JMAR INDUSTRIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995


<TABLE>
<CAPTION>
                                                                                      Year ended December 31,
                                                                                      -----------------------
                                                                                1997          1996           1995
                                                                            -----------    -----------    -----------
<S>                                                                         <C>            <C>            <C>
Cash flows from operating activities:
     Net income .........................................................   $ 1,795,285    $   779,569    $    76,265
     Adjustments to reconcile net income to net cash
      used in operating activities:
         Depreciation and amortization ..................................       700,644        668,172        565,750
         Services received in exchange for
            common stock or warrants ....................................         9,864             --         21,056
         Non-recurring net gain .........................................      (589,969)            --             --
     Change in assets and liabilities net of effects from acquisition and
       non-recurring items:
          Increase in:
          Accounts receivable, net ......................................    (1,434,015)    (1,252,278)      (589,073)
          Inventories ...................................................      (830,571)    (1,307,937)      (464,635)
          Prepaid expenses and other ....................................      (556,109)      (654,320)       (31,760)
          Other assets ..................................................      (699,349)      (132,172)      (108,350)
          Increase (decrease) in:
          Customer deposits .............................................      (724,325)       736,950       (253,152)
          Accounts payable and accrued liabilities ......................       377,057        748,329       (841,220)
                                                                            -----------    -----------    -----------
     Net cash used in operating activities ..............................    (1,951,488)      (413,687)    (1,625,119)
                                                                            -----------    -----------    -----------
Cash flows from investing activities:
     Patent costs .......................................................       (47,451)       (12,905)       (16,675)
     Capital expenditures ...............................................      (763,697)      (941,597)      (251,502)
     Increase in notes and other receivables ............................      (307,939)      (187,722)        (7,147)
     Payments received on notes receivable ..............................       897,857      1,004,502      1,339,661
     Proceeds from sale of assets .......................................            --             --         12,498
     Acquisition costs, net of cash acquired ............................            --        (86,393)            --
                                                                            -----------    -----------    -----------
          Net cash provided by (used in) investing activities ...........      (221,230)      (224,115)     1,076,835
                                                                            -----------    -----------    -----------
Cash flows from financing activities:
     Net borrowings (payments) under short-term debt agreements .........      (969,281)       (82,648)       734,866
     Net borrowings (payments)  of notes payable ........................       273,222        706,921       (313,860)
     Net proceeds from the issuance of common stock .....................     3,215,253        156,000         19,547
     Net proceeds from the exercise of options and  warrants ............       668,355        649,168             --
                                                                            -----------    -----------    -----------
          Net cash provided by financing
            activities ..................................................     3,187,549      1,429,441        440,553
                                                                            -----------    -----------    -----------
Net increase (decrease) in cash and cash
  equivalents ...........................................................     1,014,831        791,639       (107,731)
Cash and cash equivalents, beginning of
  period ................................................................     2,629,286      1,837,647      1,945,378
                                                                            -----------    -----------    -----------
Cash and cash equivalents, end of period ................................   $ 3,644,117    $ 2,629,286    $ 1,837,647
                                                                            ===========    ===========    ===========
</TABLE>

SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITY: On May 23, 1996, the Company
acquired approximately 94 percent of the outstanding common stock of California
ASIC. As consideration for the acquisition, the Company issued an aggregate of
approximately 1,427,526 shares of its common stock (See Note 3).


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


                                       29
<PAGE>   30


                              JMAR INDUSTRIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.  DESCRIPTION OF THE COMPANY

            The accompanying consolidated financial statements include the
accounts of JMAR Industries, Inc. (the "Company" or "JMAR") and its
subsidiaries. All significant intercompany balances and transactions have been
eliminated in consolidation.

            The Company develops, manufactures and markets precision
measurement, process control and manufacturing systems and laser products and
supplies specialty semiconductors for the microelectronics and medical
industries and is a leading developer of advanced lithography sources for
production of higher performance semiconductors.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     a.  Cash and Cash Equivalents

            The Company defines cash and equivalents to include cash on hand and
cash invested in short-term securities which have original maturities of less
than 90 days.

     b.  Fair Value of Financial Instruments

            The carrying value of certain of the Company's financial
instruments, including accounts receivable, accounts payable and accrued
expenses approximates fair value due to their short maturities. Based on
borrowing rates currently available to the Company for loans with similar terms,
the carrying value of its notes payable, capital lease obligations and
borrowings under the Company's line of credit approximates fair value.

      c.  Pervasiveness 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.

     d.  Inventories

            Inventories are carried at the lower of cost on the first-in,
first-out basis or market and are comprised of materials, direct labor and
applicable manufacturing overhead.

    e.  Income Taxes

            The Company accounts for income taxes in accordance with Statement
of Financial Accounting Standard No. 109 ("SFAS 109"). Under the asset and
liability method of SFAS 109, deferred tax assets and liabilities are recognized
for the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. Under
SFAS 109, the effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
Valuation allowances are established for net deferred tax assets when it is
uncertain that such tax assets will be realized.


                                       30
<PAGE>   31

                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


     f.  Property and Equipment

            Property and equipment are recorded at cost. Depreciation and
amortization are provided over the assets' estimated useful life of three to ten
years using the straight-line method. Maintenance and repairs are expensed as
incurred. Costs capitalized for self constructed assets include direct material,
labor and applicable overhead.

     g.  Goodwill and Other Assets

            Goodwill is amortized by systematic charges to income over the
periods estimated to be benefited, generally five to ten years. The Company
periodically reevaluates the original assumptions and rationale utilized in the
establishment of the carrying value and estimated lives of these assets. During
1997 management had determined that such an impairment had occurred relative to
a portion of its custom semiconductor business. Accordingly, the Company
wrote-off a portion of the goodwill associated with that business. Management
believes that there has been no impairment of goodwill as reflected in the
Company's consolidated financial statements as of December 31, 1997. Accumulated
amortization of goodwill was $474,651 and $244,599 at December 31, 1997 and
1996, respectively. Patent costs are amortized over ten years, and other assets
are amortized over not more than five years. Accumulated amortization of other
assets was $338,382 and $184,340 at December 31, 1997 and 1996, respectively.

    h.  Long-Lived Assets

            In March 1995, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 121 ("SFAS 121") "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of", which requires the adjustment of the carrying value of long-lived assets
and certain identifiable intangibles, if their value is determined to be
impaired. The Company adopted the provisions of this standard on January 1,
1996. The adoption of SFAS 121 had no material impact on the accompanying
financial statements.

    i.  Revenues

            Product revenues are generally recognized when the product is
shipped and all risks of ownership have passed to the customer. Contract
revenues are recognized based on the percentage of completion method wherein
income is recognized pro-rata over the life of the contract based on the ratio
of total incurred costs to anticipated total costs of the contract. Actual costs
could differ from these estimated costs. Estimated losses are fully charged to
operations when identified.

     j.  Earnings Per Share

            Effective December 15, 1997, the Company adopted Statement of
Financial Accounting Standards No. 128 ("SFAS 128"), Earnings per Share. There
was no impact on previously reported earnings per share (see Note 13).

    k.  Stock Options

            Effective January 1, 1996, the Company adopted the disclosure only
requirement of Statement of Financial Accounting Standards No. 123 ("SFAS 123"),
Accounting for Stock-Based Compensation. The adoption of SFAS 123 had no
material impact on the accompanying financial statements (see Note 12).


                                       31
<PAGE>   32

                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


     l.  Reclassifications

            Certain reclassifications have been made to the prior year financial
statements to conform with the 1997 presentation.

    m.  New Accounting Pronouncements

            In 1997, Statements of Financial Accounting Standards ("SFAS") No.
130 ("SFAS 130"), Reporting Comprehensive Income, and SFAS No. 131 ("SFAS 131"),
Disclosures about Segments of an Enterprise and Related Information were issued.
SFAS 130 requires the reporting of additional financial information while SFAS
131 requires the reporting of certain information about operating segments. Both
pronouncements are effective for the Company starting in 1998. The Company does
not anticipate that the adoption of the disclosure provisions of SFAS 130 and
SFAS 131 will have a material impact on the Company's financial statements and
results of operations.

3.  ACQUISITION OF CALIFORNIA ASIC, INC.

            On May 23, 1996, the Company acquired (the "Acquisition")
approximately 94 percent of the outstanding common stock of California ASIC
Technical Services, Inc., a Nevada corporation (subsequently renamed California
ASIC ("Cal ASIC")). The Acquisition involved a private tender offer to the
shareholders of Cal ASIC (the "Sellers"). As consideration for the Acquisition,
the Company issued to the Sellers an aggregate of 1,427,526 shares of its Common
Stock. The purchase price was negotiated at arm's length.

            In addition, concurrent with the closing of the Acquisition, the
Company loaned $400,000 of its funds to Cal ASIC (in addition to $100,000
previously loaned), $500,000 was loaned in 1996, and $1,179,700 was loaned in
1997, to be used by Cal ASIC for equipment purchases and working capital
purposes.

            Cal ASIC is engaged in the design, fabrication, assembly and testing
of application specific integrated circuits for the electronics industry and is
operated as a division of the Company.

            The Company has accounted for the Acquisition as a purchase
effective June 1, 1996. The allocation of the purchase price of Cal ASIC
reflected in the accompanying financial statements has been prepared based upon
an independent appraisal of certain of the acquired assets and using
management's estimate of fair value for the remaining net assets. Goodwill
related to this acquisition is being amortized over five years.

            The following unaudited consolidated JMAR pro forma information
gives effect to the Acquisition of Cal ASIC as if the Acquisition occurred on
January 1 of each respective pro forma period. In connection with the
Acquisition, Cal ASIC entered into agreements with several of its creditors
which reduced the related liabilities due those creditors by approximately
$850,000. Such debt reductions are not reflected in the statement of operations
of the Company. The pro forma loss from continuing operations excludes any
impact from the debt settlements of Cal ASIC directly attributable to the
Acquisition. These statements do not purport to be indicative of the results of
operations which actually would have occurred had the acquisition of Cal ASIC
occurred on January 1 of each respective period or which may be expected to
occur in the future.



                                       32
<PAGE>   33
                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


<TABLE>
<CAPTION>
                                          For the Year Ended December 31,
                                          -------------------------------
                                               1996          1995
                                           -----------   ------------
<S>                                        <C>           <C>
Total revenues .........................   $16,343,000   $ 12,401,000
                                           ===========   ============

Income (loss) from continuing operations   $   368,000   $   (304,000)
                                           ===========   ============

Income (loss) per share ................   $       .02   $       (.02)
                                           ===========   ============
</TABLE>

            In October, 1997, the Company received approximately 716,000 freely
tradable shares of Company common stock from the former principal shareholders
of Cal ASIC as settlement (the "Settlement") of certain claims under the terms
of the original purchase agreement. These shares were retired by the Company.
JMAR's ownership position in Cal ASIC remained unchanged as a result of the
Settlement. This non-recurring gain of approximately $2,839,000 has been offset
in part by the writedown of certain assets primarily related to Cal ASIC in the
amount of $1,594,000 and costs incurred as a result of the reorganization of Cal
ASIC in the amount of $655,031 resulting in a net gain of $589,969.

  4.  INVENTORIES

            At December 31, 1997 and 1996, inventories consisted of the
following:

<TABLE>
<CAPTION>
                                                  1997         1996
                                               ----------   ----------
<S>                                            <C>
Raw materials, components and sub-assemblies   $3,673,414   $2,695,803
Work-in-process ............................      680,883      913,403
Finished goods .............................      331,586      246,106
                                               ----------   ----------
                                               $4,685,883   $3,855,312
                                               ==========   ==========
</TABLE>


5.  ACCOUNTS RECEIVABLE

            At December 31, 1997 and 1996, accounts receivable consisted of the
following:

<TABLE>
<CAPTION>
                                          1997           1996
                                       -----------    -----------
<S>                                    <C>            <C>
Trade ..............................   $ 3,367,271    $ 2,802,417
Trade - unbilled ...................       367,875             --
U.S. Government - billed ...........        10,350         38,130
U.S. Government - unbilled .........       598,828        171,445
                                       -----------    -----------
                                         4,344,324      3,011,992
Less - Reserve for doubtful accounts       (35,547)       (17,230)
                                       -----------    -----------
                                       $ 4,308,777    $ 2,994,762
                                       ===========    ===========
</TABLE>

        All unbilled receivables at December 31, 1997 and 1996, are expected to
be billed and collected within one year. Payment to the Company, for performance
on certain U.S. Government contracts, is subject to progress payment audits by
the Defense Contract Audit Agency and are recorded at the amounts expected to be
realized.



                                       33
<PAGE>   34

                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


6.  PROPERTY AND EQUIPMENT

        At December 31, 1997 and 1996, property and equipment consisted of the
following:

<TABLE>
<CAPTION>
                                    1997           1996
                                -----------    -----------
<S>                             <C>            <C>
Equipment and machinery .....   $ 4,505,804    $ 4,243,555
Furniture and fixtures ......       407,722        313,909
Leasehold improvements ......        85,892         62,380
                                -----------    -----------
                                  4,999,418      4,619,844
Less-Accumulated depreciation    (2,499,014)    (1,915,384)
                                -----------     -----------
                                $ 2,500,404    $ 2,704,460
                                ===========    ===========
</TABLE>


7.  COMMITMENTS AND CONTINGENCIES

            The Company leases office facilities under operating leases and
certain equipment and software under capital leases. Minimum future rental
payments as of December 31, 1997 are as follows:

<TABLE>
<CAPTION>
                          Capital Leases    Operating Leases
                               ---------    ---------
<S>                          <C>          <C>
1998 .......................   $ 167,278    $ 321,941
1999 .......................     130,179      118,780
2000 .......................         936           --
2001 .......................          --           --
2002 .......................          --           --
                               ---------    ---------
                                 298,393    $ 440,721
                                            =========
Amount representing interest     (23,039)
                               ---------
                                 275,354
Less: Current portion ......    (167,278)
                               ---------
                               $ 108,076
                               =========
</TABLE>

            During September, 1996, the Company entered into a $950,000 lease
financing agreement with Leasing Technologies International, Inc., the proceeds
of which have been used to finance Cal ASIC equipment and software financing
requirements. The above amount for capital leases represents the amount
outstanding pursuant to that agreement at December 31, 1997.

        Related rent expense was $363,339, $315,515 and $260,672 for the years
ended December 31, 1997, 1996 and 1995, respectively.

        In the ordinary course of business, the Company has been involved in
various legal proceedings and claims. Currently there are no significant legal
proceedings or claims which in the opinion of management would have a material
adverse effect on the Company's consolidated financial position or results of
operations.

8.  NOTES PAYABLE

Notes payable as of December 31, 1997 and 1996, were as follows:


                                       34
<PAGE>   35

                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


<TABLE>
<CAPTION>
                                                                                           1997           1996
                                                                                       -----------    -----------
<S>                                                                                    <C>            <C>
Working capital line of credit in the amount of $3,500,000 with Comerica Bank -
California. Advances are based on 80% of eligible accounts receivable and 35% of
eligible inventories up to $1,000,000. Advances bear interest at prime plus
1.25%. The line is renewable at the Bank's option yearly on May 1st and interest
on the line is payable monthly. Advances are secured by all assets of PPL. The
bank agreements contain covenants, among other items, relating to income levels
 and financial ratios ..............................................................   $   475,000    $ 1,444,281

Unsecured convertible promissory notes in the amount of $20,000 and $600,000 at
December 31, 1997 and 1996, respectively, bearing interest at 8.25 percent .........        20,000        589,631

Note payable due in monthly principal installments of $10,417 plus interest
through October 2000, interest at prime plus 1.25%, secured by all assets of PPL ...       343,745        468,749

Note payable with monthly interest payments only through April 1998. Commencing
May 1998, due in monthly principal installments of $10,417 plus interest at
prime plus .5% through May 2002, secured by all assets of PPL ......................       500,000             --

Notes payable due in monthly principal and interest installments of $6,306
through May 2000, interest at 12 percent, secured by certain machinery and equipment       187,462        218,234

Capital leases (see Note 7) ........................................................       298,393        259,397

Other notes payable ................................................................         4,881          4,879
                                                                                       -----------    -----------
                                                                                         1,829,481      2,985,171

Less: Current portion ..............................................................      (922,246)    (2,317,861)
                                                                                       ===========    ===========
                                                                                       $   907,235    $   667,310
                                                                                       ===========    ===========
</TABLE>

        During October 1993 the Company issued $2,500,000 of convertible
promissory notes (the "Notes") of which $20,000 remained outstanding at December
31,1997. The Notes bear interest at 8.25 percent and were initially convertible
into shares of Common Stock of the Company at $3.75 per share. In October 1996,
the Company entered into an agreement to amend the terms of the Notes, whereby
the conversion price for a pro-rata share of the Notes (62.5 percent) was
lowered to $2.27 per share, which was the fair market value of the Company's
Common Stock at the time of the amendment. Pursuant to these amended terms,
holders of $1,000,000 in Notes converted the Notes into 440,000 shares (see Note
11). In July, 1997, the Company entered into an agreement to amend the terms of
the Notes, whereby the conversion price for a pro-rata share of the Notes (80
percent) was lowered to $3.00 per share. Pursuant to these amended terms,
holders of $470,000 in Notes converted the Notes. These transactions had no
impact on the Company's results of operations for any of the periods presented
in the accompanying financial statements, other than the corresponding reduction
in interest expense.



                                       35
<PAGE>   36

                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


        The weighted average interest rate on the loan with Comerica
Bank-California was 9.25% and 9.52% for 1997 and 1996, respectively. The maximum
amount outstanding was $1,250,000 and $1,632,666 and the average amount
outstanding was $353,541 and $1,055,497 during 1997 and 1996, respectively.

        Interest paid for the years ended December 31, 1997, 1996 and 1995 was
$162,488, $289,248 and $254,648, respectively.

9.  RELATED PARTY TRANSACTIONS

        During 1996, the Company renewed the employment contract with its Chief
Executive Officer, Dr. John S. Martinez to provide for a yearly salary of not
less than $175,000 and extended the term thereof to December 31, 1999. In 1993,
the Company loaned Dr. Martinez $59,000 with interest at 6% per annum to assist
Dr. Martinez in paying certain income taxes that he personally incurred in
connection with a transaction that he undertook in support of the Company.

10. INCOME TAXES

        For the years ended December 31, 1997 and 1996, the Company has recorded
a tax benefit of $345,000 and $175,000, respectively, related to the estimated
future utilization of net operating loss carryforwards. No provision for federal
and state income taxes has been made for the year ended December 31, 1995 due to
the Company's carryforward position.

        At December 31, 1997, the Company had Federal net operating loss
carryforwards as follows:

<TABLE>
<CAPTION>
EXPIRES
-------
<S>                                                       <C>
2004..........................................            $457,000
2005..........................................           2,840,000
2006..........................................             961,000
2007..........................................           4,546,000
2008..........................................           6,932,000
2009..........................................           6,860,000
2010..........................................           2,265,000
2011..........................................             585,000
                                                     ==============
Total.........................................         $25,446,000
                                                     ==============
</TABLE>


        The Company has approximately $3,058,000 of favorable temporary
differences that will offset future taxable income subject to the change in
ownership limitations discussed below.

        Realization of future tax benefits from utilization of the net operating
loss carryforwards for income tax purposes is limited by the change in ownership
(as defined for Federal Income Tax Reporting Purposes) as a result of the
Company's initial public offering in May 1990. As a result of additional
financings in 1992 and 1993 as discussed in Note 11, additional ownership
changes have occurred which restrict the Company's ability to utilize its net
operating loss carryforwards and any "built in losses." In addition, the net
operating losses of acquired companies are also subject to separate change of
ownership limitations. Of the above net operating loss carryforwards, annual
limitations of approximately $813,000 apply to approximately $6,162,000 of


                                       36
<PAGE>   37


                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


Company and acquired company loss carryforwards. Approximately $19,284,000 of
net operating loss carryforwards are not subject to annual limitations.

            The tax effects of temporary differences that give rise to
significant portions of the deferred tax assets and deferred tax liabilities at
December 31, 1997 and 1996 are presented below:

<TABLE>
<CAPTION>
DEFERRED TAX ASSETS:                              1997          1996
                                              -----------    -----------
<S>                                           <C>            <C>
Net operating loss carryforwards ..........   $ 8,652,000    $ 8,922,000
Losses from equity and other investments ..       492,000        363,000
Other .....................................       547,000         42,000
                                              -----------    -----------
            Total gross deferred tax assets     9,691,000      9,327,000
            Less valuation reserve ........    (9,171,000)    (9,152,000)
                                              -----------    -----------
            Net deferred tax asset ........   $   520,000    $   175,000
                                              ===========    ===========
</TABLE>

        The valuation reserve as of December 31, 1997 represents deferred tax
assets which management believes, based on the Company's history of operating
losses, may not be realized in future periods.

        The effective income tax rate for 1997, 1996 and 1995 varied from the
statutory federal income tax rate as follows:


<TABLE>
<CAPTION>
                                                            1997   1996    1995
                                                            ---     ---     ---
<S>                                                         <C>     <C>    <C>
Statutory federal income tax (benefit) rate .............    34%     34%    (34)%
State income tax ........................................     6       6      (6)
Permanent differences ...................................     1       2      16
Benefit (recorded) not recorded due to net operating loss
  carryforward position .................................   (65)    (71)     24
                                                            ---     ---     ---
                                                            (24)%   (29)%    --
                                                            ===     ===     ===
</TABLE>

11.  STOCKHOLDERS' EQUITY

        During October, 1993, the Company issued $2,500,000 of convertible
promissory notes (the "Notes") of which $20,000 remained outstanding at December
31, 1997. During 1995, $200,000 in Notes were converted into 500,000 shares and
the Company repaid another $200,000 of the Notes. During the third quarter of
1995, holders of $300,000 in Notes converted the Notes into 200,000 shares. In
October 1996, holders of $1,000,000 in Notes converted the Notes into 440,000
shares and in July, 1997, holders of $470,000 in Notes converted the Notes into
156,634 shares (see Note 8).

        During 1995, the Company received approximately $90,000 from private
placements of Common Stock.


                                       37
<PAGE>   38

                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


        During 1995, the Company issued 1,000,000 shares of Common Stock in
exchange for preferred stock (the "Preferred Stock") of Atlantic American
Holding Company Limited ("Atlantic"). The investment was recorded at a cost of
$621,000 at December 31, 1995. In December 1996, the Company and Atlantic
entered into an Escrow Agreement and Agreement of Settlement and General Release
whereby Atlantic agreed to (i) an early redemption of the remaining shares of
Preferred Stock held by the Company less that portion redeemed by the receipt of
$224,500 in November 1996; (ii) the payment of all accrued but unpaid dividends
under the Preferred Stock; and (iii) the reimbursement of certain legal fees and
out-of-pocket costs incurred by the Company in connection with a civil action
(the "Civil Action") filed by the Company against Atlantic. In return, JMAR
agreed to dismiss the Civil Action and in January, 1997, JMAR received
approximately $885,000 as a final settlement from Atlantic.

        During the year ended December 31, 1996, the Company received net
proceeds of approximately $805,000 from the exercise of warrants into
approximately 474,000 shares of common stock and private placements of
approximately 190,000 shares of common stock.

        During the year ended December 31, 1997, the Company received net
proceeds of approximately $3,898,000 from the private placements of
approximately 1,008,000 shares of common stock and the exercise of warrants and
options into approximately 682,000 shares of common stock.

12.  STOCK-BASED COMPENSATION PLANS

        The Company has four stock option or warrant plans, the 1988 Stock
Option Plan (the "1988 Plan"), the 1991 Stock Option Plan (the "1991 Plan"), the
Management Anti-Dilution Plan (the "Anti-Dilution Plan"), and an incentive plan
which provides for the issuance of warrants to PPL employees (the "PPL Plan").
The Company accounts for these plans under APB Opinion No. 25, under which no
compensation cost has been recognized. Had compensation cost for these plans
been determined consistent with FASB Statement No. 123 ("SFAS 123"), the
Company's net income and earnings per share would have been reduced to the
following pro forma amounts:


<TABLE>
<CAPTION>
                                             1996               1997
                                             ----               ----
<S>                                       <C>              <C>
Net Income:          As Reported          $779,569         $1,795,285
                     Pro Forma             668,169          1,492,559

Basic EPS:
                     As Reported               .05                .11
                     Pro Forma                 .04                .09

Diluted EPS:
                     As Reported               .05                .10
                     Pro Forma                 .04                .08
</TABLE>


        Because the SFAS 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma compensation
cost may not be representative of that expected in future years.


                                       38
<PAGE>   39
                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


        The Company was authorized to grant options or warrants to its employees
(including directors) and consultants for up to 120,000 shares under the 1988
Plan, 1,480,000 shares under the 1991 Plan, 806,637 shares under the
Anti-Dilution Plan, and 450,000 shares under the PPL Plan. As of December 31,
1997, the Company has granted options for 110,782 shares under the 1988 Plan,
900,220 options under the 1991 Plan, 424,246 warrants under the Anti-Dilution
Plan, and 214,500 warrants under the PPL Plan. Under all Plans the option or
warrant exercise price is equal to or more than the stock's market price on date
of grant. In 1996, the Company repriced 737,340 options and warrants under the
1991 Plan, the Anti-Dilution Plan and PPL Plan and changed the initial vesting
period of 655,230 of such warrants to provide for vesting on the earliest of (i)
forty five days after such time as the closing high bid price of the Company's
common stock for 20 consecutive trading days is greater than $6.38; (ii) the
exercise by the warrantholders of at least 90 percent of the Company's warrants
which currently trade on the Nasdaq NMS; or (iii) nine years and six months
after the date of grant.

        A summary of the status of the total number of stock options or warrants
pursuant to all four of the above "plans" as of December 31, 1995, 1996 and 1997
and changes during the years then ended is presented in the table and narrative
below:



<TABLE>
<CAPTION>
                                  1995                   1996                 1997
                          --------------------- --------------------- --------------------
                           Shares     Wtd Avg     Shares    Wtd Avg    Shares     Wtd Avg
                                     Ex Price               Ex Price              Ex Price
                          ---------- ---------- ----------- --------- ----------  --------
<S>                       <C>         <C>      <C>          <C>       <C>         <C>
Outstanding at beg. of    1,054,983      $4.56     993,518     $4.35  1,319,369     $2.69
year
Granted                     107,000        .85     330,184      2.37    587,500      2.67
Exercised                         -          -           -         -    (70,764)     2.27
Forfeited                  (168,465)      5.09      (4,333)     3.27   (246,353)     3.69
                          ----------            -----------           ----------
Outstanding at end of year  993,518       4.35   1,319,369      2.69  1,589,752      2.54
                          ----------            -----------           ----------
Exercisable at end of       186,783                261,418              375,071
year
Weighted average fair
 value of options or            .62                   1.61                 2.51
 warrants granted
</TABLE>


        213,340 of the 1,589,752 options and warrants outstanding at December
31, 1997 have exercise prices between $.53 and $1.09 with a weighted average
exercise price of $.82 and a weighted average remaining contractual life of 7
years. 164,606 of these options and warrants are exercisable. 466,964 of the
options and warrants outstanding at December 31, 1997 have exercise prices
between $1.79 and $2.94 with a weighted average exercise price of $2.34 and a
weighted average remaining contractual life of 8.5 years. 77,732 of these
options and warrants are exercisable. 849,448 of the options and warrants at
December 31, 1997 have exercise prices of $3.00 with a weighted average exercise
price of $3.00 and a weighted average remaining contractual life of 6.3 years.
132,733 of these options and warrants are exercisable. 60,000 of the options and
warrants outstanding at December 31, 1997 have exercise prices between $3.53 and
$4.06 with a weighted average exercise price of $3.74 and a weighted average
remaining contractual life of 9.5 years. None of these options and warrants are
exercisable.

        The fair value of each option and warrant grant is estimated on the date
of grant using the Black-Scholes option pricing model with the following
weighted-average assumptions used for grants in 1995, 1996 and 1997: risk-free
interest rates between 6 and 7 percent; expected dividend yields of 0 percent,
expected lives of 6 years, and expected volatility of 39.



                                       39
<PAGE>   40
                              JMAR INDUSTRIES, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


13.  EARNINGS PER SHARE

        In 1997, the Company adopted FASB Statement No. 128 ("SFAS No. 128"),
Earnings per Share, effective December 15, 1997. Basic earnings per common share
were computed by dividing net income by the weighted average number of shares of
common stock outstanding during the year. Diluted earnings per common share for
the years ended December 31, 1997, 1996 and 1995 were computed by dividing net
income by the sum of the weighted average number of shares of common stock
(17,065,860, 15,582,579 and 13,525,886 for 1997, 1996 and 1995, respectively)
plus dilutive employee stock options and warrants (314,276, 154,364 and 13,100
for 1997, 1996 and 1995, respectively) and other dilutive warrants and options
(1,220,983, 1,018,810 and 594,272 for 1997, 1996 and 1995, respectively). There
was no change to previously reported earnings per share as a result of the
adoption of this new Financial Accounting Standard.

14.  SIGNIFICANT CUSTOMERS AND EXPORT SALES

        Government contracts generated 10%, 9% and 15% of the Company's revenues
in the years ended December 31, 1997, 1996 and 1995, respectively. In 1997, one
non-government customer accounted for 38.6% of the Company's revenues. In 1996,
three other non-government customers accounted for 29.5%, 12.1% and 10.7% of the
Company's revenues. In 1995, four non-government customers accounted for 11.0%,
11.3%, 15.8% and 16.4% of the Company's revenues.

        A summary of export sales by geographic area is as follows:

                             YEAR ENDED DECEMBER 31,

<TABLE>
<CAPTION>
                                    1997              1996              1995
                                -------------     -------------    ----------------
<S>                             <C>               <C>              <C>
Europe.....................         $831,110        $1,544,390             $40,384
Asia.......................       $4,225,013        $1,420,767          $1,684,083
Other......................       $3,882,252          $440,291             $76,973

</TABLE>



                                       40
<PAGE>   41

ITEM 9.  CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

Not applicable

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

            The officers and directors of the Company are as follows:


<TABLE>
<CAPTION>
NAME                               AGE                                      POSITION
--------------------------------  ------  -----------------------------------------------------------------------------
<S>                               <C>     <C>
John S. Martinez, Ph.D.             67    Chief Executive Officer, President, Chairman of the Board and Director
--------------------------------  ------
Dennis E. Valentine                 42    Vice President Finance, Chief Financial Officer, Chief Administrative
                                          Officer and Secretary
--------------------------------  ------
Leonid Yoffe                        51    President of PPL

--------------------------------  ------
Richard M. Foster                   65    President of JTC

--------------------------------  ------
James H. Banister, Jr.              67    Director

--------------------------------  ------
C. Neil Beer, Ph.D.                 62    Director

--------------------------------  ------
Vernon H. Blackman, Ph.D.           68    Director

--------------------------------  ------
Barry Ressler                       57    Director

--------------------------------  ------
John P. Ricardi                     45    Vice President for Corporate Development and Senior Vice President for
                                          Sales and Marketing of PPL
--------------------------------  ------
Marvin W. Sepe                      42    President of Cal ASIC

--------------------------------  ------
</TABLE>

      The directors of the Company are elected by the shareholders to hold
office until the next annual meeting of stockholders and until their respective
successors have been elected and qualified. Officers of the Company are elected
annually by the Board of Directors and hold office until their successors are
duly elected and qualified.

      JOHN S. MARTINEZ, PH.D., became Chairman of the Board, President, Chief
Executive Officer and a Director of the Company at its inception. Prior to
co-founding the Company in October, 1987, he was President of HLX Laser, Inc.,
an excimer laser development company and President of Jamar Enterprises, a
management and investment consultant to high-technology companies. From 1976 to
1984, Dr. Martinez was President and Chief Executive Officer of Physics
International Company ("PI"), a high-technology research, development and
manufacturing company specializing in high-intensity energy technology and X-ray
generation equipment. During that period, PI's annual sales grew from
approximately $9,000,000 to over $42,000,000 and profits grew at a compounded
annual rate in excess of 32%. From 1961 to 1976, he held a number of management
positions at TRW, Inc. He formed that company's High Energy Laser program in
1970 and managed it until he left the company in 1976. Dr. Martinez, a Ford
Foundation and Atomic Energy Commission Fellowship holder, earned his Ph.D. in
Engineering Science from the University of California (Berkeley) in 1962, his
Bachelor's degree from Rensselaer Polytechnic Institute (Troy, N.Y.) in 1951 and
is a graduate of the Oak Ridge School of



                                       41
<PAGE>   42

Reactor Technology. He served on active duty in the U.S. Marine Corps during the
Korean War and was discharged as a Captain in 1954. He is the holder or
co-holder of six patents.

      DENNIS E. VALENTINE, has been the Vice President-Finance of the Company
since August, 1990, Chief Financial Officer and Chief Administrative Officer
since March, 1991 and Secretary since January, 1992. Prior to joining the
Company, Mr. Valentine had over ten years of financial and management experience
with Arthur Andersen LLP. His experience at Arthur Andersen LLP included
extensive work with public companies and consultation regarding mergers and
acquisitions. He was the manager in-charge of the local office merger and
acquisition program and was on the Board of Advisors of the Orange County
Venture Forum. Mr. Valentine received a Bachelor of Science degree in Business
from the University of Southern California in 1978. He is a member of the
American Institute of Certified Public Accountants and the California Society of
Certified Public Accountants.

        LEONID YOFFE, was elected President of PPL, effective June 13, 1997. He
had previously served as President of PPL from February, 1994 through July,
1994. From July, 1994 through June, 1997, Mr. Yoffe served as Executive Vice
President, Chief Operating Officer and Chief Financial Officer of PPL. Mr. Yoffe
has been with PPL since December, 1988 and has played a major role in organizing
all the traditional departments making up the classical manufacturing, material
planning and control, procurement, inventory and cost control. Prior to 1988 he
served as Manufacturing Manager for International Remote Imaging Systems, Inc.,
a publicly-held capital equipment manufacturer in the Biomedical field. Mr.
Yoffe has over 20 years of continuing experience in the management of
manufacturing operations and held various managerial positions in the high
technology capital equipment industry. Mr. Yoffe holds a B.S. degree in
Industrial Engineering and M.B.A. in Economics and Manufacturing Administration
from the State University of St. Petersburg in Russia.

        RICHARD M. FOSTER, has been the President and a director of JTC since
January 1994. From 1984 to 1990, he was Corporate Vice President and Director of
Marketing at Physics International Co. From 1968 to 1984, he was with TRW
Defense and Electronics and was Marketing Director for a number of product lines
including communication satellite systems, high energy lasers, power and
propulsion and the Physical Research Center. Mr. Foster also spent three years
in Washington D.C. as a TRW Senior Representative. He was a principal engineer
at Ford Aeronutronic in Newport Beach from 1960 to 1968 and an Air Force Captain
at Edwards AFB Rocket Propulsion Laboratory from 1957 to 1960. Mr. Foster
graduated cum laude with a B.S. and M.S. in Engineering from Stanford University
in 1957.

      JAMES H. BANISTER, JR., has been a director since December, 1989 and was a
consultant of the Company from September, 1989 until March 31, 1994. He was the
Company's Chief Financial Officer, Chief Administrative Officer and Treasurer
through March, 1991. Since October, 1993 Mr. Banister has been President, Chief
Executive Officer and a Director of Kinetic Ceramics, Inc. From August, 1987 to
June, 1988 he was President and CEO of MSI, a subsidiary of Olin Corporation
supplying Signal Intelligence and electronic warfare equipment and services.
When that company was sold by Olin, Mr. Banister retired to manage his personal
investments. Mr. Banister was with Physics International Company (which became a
subsidiary of Olin Corp. in 1985), from June, 1964 to August, 1987, successively
holding the positions of Contracts Manager, Director of Marketing and Contract
Relations, Vice President and Director of Administration and Senior Vice
President responsible for finance and administration. From 1953 to 1964, Mr.
Banister was with Stanford Research Institute, now SRI International, holding
the position of Manager of Contract Administration. Mr. Banister received a
Bachelor of Science degree in Business and Engineering administration from MIT
and has taken graduate courses in law at Golden Gate College. He has been an
officer and director of several subsidiaries of Physics International Company.

      C. NEIL BEER, PH.D., has been a director since July, 1988 and was an
employee of the Company from May, 1991 until November, 1992 and a consultant to
the Company from April,



                                       42
<PAGE>   43
1993 to September, 1993. Dr. Beer currently is the President of SECON, a
software engineering company primarily supporting the national intelligence
community . Prior to that, he was the Vice President, Advanced Programs, OAO
Corporation and, prior to that, was the Colorado Space Advocate, responsible for
the growth of Colorado's space industry. From September, 1986 to October, 1989
he was President of Thermo Technologies Corporation which develops advanced
lasers, optics, signal processing, and energy conversion hardware. Previously he
was Deputy for Strategic Defense, Military Applications, at Livermore National
Laboratory. During his career with the U.S. Air Force, Dr. Beer achieved the
rank of Major General and was deputy Chief of Staff, plans and programs, for the
Air Force Space Command. Earlier, while assigned to the office of the Secretary
of Defense, he worked with the White House staff on policy and support
requirements. Dr. Beer was associate professor of mathematics at the Air Force
Academy and a combat pilot in Southeast Asia. Dr. Beer graduated magna cum
laude, with a B.S. degree in engineering from the University of Oklahoma, and
received his doctorate in Operations Research in 1972 from that same University.
Dr. Beer is recipient of the NSIA Medal for Outstanding Achievement in Space.

        VERNON H. BLACKMAN, PH.D., has been a director of the Company since
July, 1991 and from time to time has been a consultant of the Company since
December, 1991. Dr. Blackman served as Chairman of the Board and Chief Executive
Officer of Esscor, a training and simulation service company to the utility
industry, from December, 1991 to July, 1997. He continues to serve on the Board
of Directors of Esscor. Dr. Blackman also served as Chairman of the Board,
President and Chief Executive Officer of JAYCOR from 1989 until March, 1991.
JAYCOR is a high technology company which supplies R&D services to various
agencies of the U.S. Government; primarily the Department of Defense. Prior to
joining JAYCOR, Dr. Blackman acted as a venture investor for his own account and
helped to fund the early stage development of several companies. Dr. Blackman
currently serves on the Board of Directors of Digivision, a privately-held
company which provides products to the medical industry. Dr. Blackman has also
served on the Boards of Directors of several other public companies, including
Newport Pharmaceuticals International, Inc. (1967-1974); Maxwell Laboratories,
Inc. (1966-1974); Topaz, Inc. (1979-1983) at which time Topaz was acquired by
Square D Corporation; and Optical Radiation Corporation (1970-1995). From 1974
to 1982, Dr. Blackman served as President, CEO and Chairman of the Board of
S-Cubed, a high technology company which provided services and products to
agencies of the U.S. Government. In 1959, Dr. Blackman co-founded MHD Research
which was acquired by Hercules Corporation in 1964. Dr. Blackman received a BA
in Physics from Colgate University in 1951 and a Ph.D. in Physics from Princeton
University in 1955, subsequent to which he served on the faculty as a research
associate for 2 years.

        BARRY RESSLER, has been a director of the Company since January, 1994.
Mr. Ressler is the Chief Executive Officer and Chairman of the Board of Triton
Thalassic Technologies, Inc. (T3I), a marine technology company specializing in
antifouling, water portability and industrial fluid contaminant technologies and
products. Mr. Ressler is also the President of Star Associates, Inc., a company
engaged in the basic research and development of particle accelerators and free
electron lasers for industrial and medical applications. From 1983 to December,
1993 he served as Chief Executive Officer and Chairman of the Board and a
director of Thermo Voltek, a subsidiary of Thermo Electron. From 1963 until his
appointment as CEO and Chairman, he served on various capacities at Thermo
Voltek. Mr. Ressler is a member of the Biotechnology Center External Advisory
Board of the University of Connecticut, advising the University on the expansion
of biotechnology research initiatives to foster University Industry
collaborative activities. Mr. Ressler graduated from the Pratt Institute with a
B.S. in Engineering Science.

        JOHN P. RICARDI, joined the Company in February, 1997. Mr. Ricardi is
the Company's Vice President for Corporate Development and Senior Vice President
for Sales and Marketing of PPL. He brings more than 20 years of related industry
experience to the Company, having served in numerous management positions with
various responsibilities for product development, national and international
sales and marketing and engineering operations. Most recently, he was Vice
President, General Manager of the Imaging Systems Division of Datron/Transco,
Inc. and Vice President, Marketing for Datron/Transco Inc. a subsidiary of
Datron Systems, Inc. His background



                                       43
<PAGE>   44

also includes eight years with North American Phillips Corporation as corporate
Director of Marketing of its Airpax subsidiary and seven years with Texas
Instruments Inc. He holds both a bachelor and a master of science degree in
electrical engineering from Northeastern University in Boston.

        MARVIN W. SEPE, joined California ASIC in July, 1996 as Executive Vice
President and General Manager and was elected President of that division in May,
1997. Mr. Sepe was a director of the Company from July, 1996 to December, 1997.
For the prior 15 years he was with TRW Components International Inc., a wholly
owned subsidiary of TRW Inc. where he served as Director of Business Development
for this division of TRW, which grew from $16,000,000 in sales to nearly
$40,000,000 under his strategic direction. Previously, Mr. Sepe held other
management positions within TRW including Marketing, Programs and Engineering.
Prior to joining TRW, Mr. Sepe was responsible for the development and oversight
of multiple semiconductor manufacturing operations both in the U.S. and
internationally. Mr. Sepe held the position of Manager of Worldwide Assembly
Operations for Silicon General Inc. (1980-1981) with manufacturing operations
throughout Southeast Asia, as well as the U.S. He served in the same role at
Silicon Systems Inc. (1977-1980), a fast growing start-up operation for custom
semiconductors and previously held various management responsibilities at Hi-Rel
Laboratories (1974-1977), a well respected evaluation laboratory. Mr. Sepe
attended Don Bosco Technical Institute, California Polytechnic State University
SLO, and holds a Masters Degree in Business Administration from Pepperdine
University. Mr. Sepe has published a number of papers and taught numerous
workshops on the economics and use of semiconductors in space applications.


                                       44
<PAGE>   45
ITEM 11.  EXECUTIVE COMPENSATION

            The following table sets forth the annual and long-term compensation
for services in all capacities to the Company during each of the last three
fiscal years of the Company's Chief Executive Officer and the four most highly
compensated individuals serving as executive officers as of the latest fiscal
year end, other than the Chief Executive Officer, whose compensation (salary and
bonus) exceeded $100,000 (collectively, the "Named Officers").

<TABLE>
<CAPTION>
                           Summary Compensation Table
                          -------------------------------
                                                           Long-Term
                                                           Compensation
                              Annual Compensation(1)(7)    Awards (2)
                              -------------------------    ----------

                                                          Securities Underlying
  Name and Principal      Year    Salary       Bonus      Options and
      Position                     ($)        ($)(3)       Warrants(#)
                          ----   -------      -------       -------
<S>                       <C>    <C>          <C>           <C>
John S. Martinez, .....   1997   187,112      175,000       125,000
Chief Executive .......   1996   170,184       83,369       384,622(4)
Officer ...............   1995   150,000       15,552        55,000
                          ----   -------      -------       -------

Dennis E. Valentine, ..   1997   106,919       60,000        55,000
Chief Financial Officer   1996    98,065       33,347        67,595(4)
                          1995    90,000        6,221        20,000
                          ----   -------      -------       -------

John P. Ricardi, ......   1997   147,699(5)    25,000        60,000
Senior Vice President
for Sales and Marketing
of PPL
                          ----   -------      -------       -------

Leonid Yoffe, .........   1997   146,905       65,000             0
President of PPL ......   1996   111,908       27,703        70,000(4)
                          1995    96,160            0             0
                          ----   -------      -------       -------


Marvin W. Sepe ........   1997   125,000            0         5,000
President of Cal ASIC .   1996    52,083(6)         0       129,554(4)
                          ====   =======      =======       =======
</TABLE>


(1)     Excludes perquisites and other personal benefits, the aggregate annual
        amount of which for each Named Officer was less than the lesser of
        $50,000 or 10% of the total salary and bonus reported.

(2)     The Company did not grant any restricted stock or stock appreciation
        rights or make any long term incentive plan payments during the fiscal
        years ended December 31, 1997, 1996 and 1995.

(3)     Includes bonus payments earned by the Named Officers in the year
        indicated for services rendered in such year, but which were paid in the
        following year.

(4)     Includes 324,420, 50,000, 109,149 and 42,393 options and warrants for
        Messrs. Martinez, Yoffe, Sepe and Valentine, respectively, which were
        granted and reported in prior years, but


                                       45
<PAGE>   46

        which (together with options and warrants issued to other employees of
        the Company) were amended on August 15, 1996 to reduce their respective
        exercise prices to $3.00 per share, 20 percent over the trading price on
        NASDAQ on August 15, 1996.

(5)     Compensation is for eleven months. Includes $22,000 commissions on
        sales.

(6)     Compensation is for six months.

(7)     See "Incentive Plans".

OPTION GRANTS IN THE LAST FISCAL YEAR

            The following table sets forth each grant of stock options and
warrants made during the fiscal year ended December 31, 1997 to each of the
Named Officers. Pursuant to Securities and Exchange rules, the table also shows
the value of the options at the end of the terms if the stock price were to
appreciate annually by 5% and 10%, respectively. The assumed values may not
reflect actual value at the times indicated.

<TABLE>
<CAPTION>
                                   PERCENTAGE
                        SHARES      OF TOTAL                                  POTENTIAL REALIZABLE
                      UNDERLYING     OPTIONS                                    VALUE AT ASSUMED
NAME                   OPTIONS     GRANTED TO                                    ANNUAL RATES OF
                       GRANTED      EMPLOYEES   EXERCISE                           STOCK PRICE
                       (SHARES)     IN FISCAL   PRICE PER      EXPIRATION       APPRECIATION FOR
                        (1)(7)        YEAR        SHARE         DATE (2)           OPTION TERM

-------------------- ------------- ------------ ----------- ----------------- ----------------------
<S>                   <C>            <C>         <C>        <C>                  <C>       <C>
                                                                                  5%         10%
John S. Martinez      70,000 (3)      11.91       $2.38     January 29, 2007     $104,774  $265,517
                      50,000 (5)       8.51       $2.25       April 23, 2007       70,751   179,296
                       5,000 (4)        .85       $3.53        July 18, 2008       12,537    30,943

Dennis E. Valentine   30,000 (6)       5.11       $2.38     January 29, 2007      $44,903  $113,793
                      25,000 (5)       4.26       $2.25       April 23, 2007       35,375    89,648

John P. Ricardi       60,000 (5)      10.21       $2.41     February 3, 2007      $90,938  $230,455

Leo Yoffe                 0              0         N/A            N/A               N/A        N/A

Marvin W. Sepe        5,000 (4)         .85       $3.53        July 18, 2008      $12,537    $30,943
</TABLE>

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

(1) Such options were all granted under the Company's 1991 Stock Option Plan.
    The exercise price of shares covered by the stock options reported above was
    equal to the fair market value of the Company's common stock at the date of
    grant. The terms of each such option and the increments in which it is
    exercisable are determined by the Board of Directors. The exercise price and
    tax withholding obligations related to exercise may be paid by delivery of
    already owned shares or by the offset of the underlying shares, subject to
    certain conditions.

(2) Options also expire if not exercised within 60 days after termination of
    optionee's employment or one year following death of optionee if not
    exercised by optionee's personal representative or one year following
    resignation as a director.

(3) These options are incentive stock options. 17,113 of these options are
    currently exercisable; 17,112 become exercisable on January 29, 1999, 2000
    and 2001; and 1,551 become exercisable on January 29, 2002.

(4) These options are non-qualified stock options. These options become
    exercisable and vest one-third each year commencing on the first year after
    their grant.

(5) These options are incentive stock options. These options become exercisable
    and vest one-third each year commencing on the first year after their grant.

(6) These options are incentive stock options. 7,334 of these options are
    currently exercisable; 7,334 become exercisable on January 29, 1999 and
    2000; 7,333 become exercisable on January 29, 2001; and 665 become
    exercisable on January 29, 2002.

(7) These options contain a Reload Option feature whereby if the optionee
    exercises the option in whole or in part using shares of Common Stock owned
    by the optionee for at least six



                                       46
<PAGE>   47

    months, the Company shall grant to the optionee a Reload Option to
    purchase that number of shares equal to the shares transferred to the
    Company in payment of the exercise price of the option.

AGGREGATE OPTION EXERCISES IN LAST FISCAL YEAR AND YEAR END OPTION VALUES

        The following table sets forth for each of the Named Officers the shares
acquired and the value realized on each exercise of stock options, if any,
awarded to said officers as additional compensation during the fiscal year ended
December 31, 1997 and the number of shares of common stock underlying options
and warrants outstanding at December 31, 1997 and the value of such options and
warrants which are "in-the-money":

<TABLE>
<CAPTION>
                                             SHARES UNDERLYING          VALUE OF
                                                UNEXERCISED            UNEXERCISED
                                                OPTIONS AND       IN-THE-MONEY OPTIONS
                                                  WARRANTS AT         AND WARRANTS AT
                        SHARES                DECEMBER 31, 1997   DECEMBER 31, 1997 (1)
                       ACQUIRED              -----------------   ---------------------
NAME                      ON       VALUE       EXERCISABLE/          EXERCISABLE/
                       EXERCISE   REALIZED     UNEXERCISABLE         UNEXERCISABLE
--------------------- ----------- ---------- ------------------- -----------------------
<S>                   <C>         <C>         <C>                   <C>
John S. Martinez          0           0       115,422/463,056       $150,890/$58,374

Dennis E. Valentine       0           0        53,917/88,678        $55,744/$24,556

John P. Ricardi           0           0           0/60,000             $0/$7,200

Leonid Yoffe              0           0         6,666/63,334         $9,999/$20,001

Marvin W. Sepe            0           0        43,183/79,704             $0/$0
</TABLE>

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

 (1)    Options are "in-the-money" if the fair market value of the underlying
        common stock exceeds the exercise price of the option or warrant at
        December 31, 1997. The fair market value of a share of common stock at
        December 31, 1997 was $2.53 per share as quoted on the NASDAQ Stock
        Market at the close of trading.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

        During fiscal year 1997, the entire Board of Directors acted as the
Compensation Committee, with Dr. Martinez also serving as the Chief Executive
Officer, President and Chairman of the Board of the Company.

EMPLOYMENT AND CONSULTING AGREEMENTS

        Pursuant to Dr. Martinez's employment agreement, the Company agreed to
retain him as Chief Executive Officer of the Company and to pay him an annual
salary of not less than $175,000 plus expenses and normal employee insurance
benefits and a $600 per month auto lease allowance. The term of the employment
agreement continues until December 31, 1999. If the employment agreement is
terminated by the Company without cause, Dr. Martinez would become entitled to
receive as severance pay an amount equal to the greater of 36 month's pay or the
balance of the compensation that would have been payable to Dr.
Martinez under the employment agreement.

        Pursuant to Mr. Ricardi's employment agreement, the Company agreed to
retain him as Senior Vice President for Sales and Marketing at PPL and Vice
President for Corporate Development for JMAR and to pay him an annual salary of
$145,000 plus expenses and normal



                                       47
<PAGE>   48
employee insurance benefits and a $500 per month auto allowance. The employment
agreement can be terminated by the Company with thirty days notice. If the
employment agreement is terminated by the Company, Mr. Ricardi will receive 60
days pay as severance.

        Pursuant to Mr. Sepe's employment agreement, Cal ASIC agreed to pay him
an annual salary of not less than $125,000 plus expenses and normal employee
insurance benefits. The term of the employment agreement continues until July 1,
1998. If the employment agreement is terminated by the Company without cause,
Mr. Sepe would become entitled to receive as severance pay the balance of the
compensation that would have been payable to Mr. Sepe under the employment
agreement.

INCENTIVE PLANS

        In February, 1993, the Board of Directors of the Company approved the
Management Anti-Dilution Incentive Plan (the "Plan") for the Company's senior
management. The Plan was designed to provide senior management with an incentive
to maximize stockholder value. Pursuant to the Plan, the executive officers and
directors of the Company were issued warrants ("Incentive Warrants") to purchase
an amount of Common Stock which, at the time of issuance of the warrants, would
bring each participant's percentage ownership of Common Stock closer to the
percentage such participant owned prior to the completion of the Company's
public offering in February, 1993. An aggregate of 424,246 Incentive Warrants
were outstanding on December 31, 1997. The Incentive Warrants expire sixty days
following the termination of the holder's employment with the Company if such
Incentive Warrants are not then exercisable. The Incentive Warrants terminate
three years following the date such warrants are first exercisable or, in any
event, ten years from the date of issuance. The Company has agreed that if it
files a Registration Statement or a post-effective amendment to a Registration
Statement following the date on which the Incentive Warrants are exercisable,
the holders of the Incentive Warrants shall have the opportunity to register or
qualify the shares of Common Stock underlying the Incentive Warrants for
offering to the public at no cost to such holders.

        In connection with the acquisition of PPL by the Company in October,
1993, the Company established an incentive plan for the key employees of PPL
which provides for the issuance of warrants (the "PPL Warrants") to purchase up
to 450,000 shares of Common Stock. As of December 31, 1997, warrants to purchase
up to 214,500 shares of Common Stock have been granted. The PPL Warrants have
substantially the same terms as the Incentive Warrants.

        Prior to August 15, 1996, both the Incentive Warrants and the PPL
Warrants were not exercisable until such time as the average of the closing high
bid prices of the Common Stock as reported on NASDAQ or NASDAQ-NMS, as the case
may be, during any consecutive 180 day period was equal to or greater than
$8.50. Upon becoming exercisable, the Incentive Warrants and PPL Warrants were
then exercisable at a per share exercise price of $5.10. On August 15, 1996, the
Board of Directors approved an amendment to the Incentive Warrants and the PPL
Warrants to provide that the warrants will not be exercisable until the earlier
of (i) forty five days after such time as the closing high bid price of the
Common Stock for 20 consecutive trading days is greater than $6.38 (which is
150% of the offering price of the Company's 1993 public offering); (ii) the
exercise by the warrantholders of at least 90 percent of the Company's warrants
which currently trade on the Nasdaq National Market System under the symbol
JMARW; or (iii) nine years and six months after the date of grant. Upon becoming
exercisable, the Incentive Warrants and PPL Warrants will be exercisable at a
per share exercise price of $3.00, which represents a price equal to 20 percent
over the closing price of the Company's shares as quoted on the NASDAQ-NMS on
August 15, 1996.

        In 1993, JMAR established a Management Incentive Bonus Plan (the
"MIBP") based on profits generated each year. The Company has been profitable
for the past three consecutive years. Accordingly, MIBP bonuses were paid in
1995, 1996 and 1997 to those employees deemed to have made the greatest
contributions toward the Company's ability to generate those profits.

        In March 1998, the Board of Directors approved a resolution requiring
that starting with 1997, a substantial portion of each Management Incentive
Bonus earned by its senior officers be used by such officers to: 1) buy JMAR
common shares in the Public Market; and/or 2) exercise existing stock options or
warrants, including payment of income taxes (if any) resulting from such option
or warrant exercises. The long term goal is for each senior officer designated
in the Beneficial Ownership table in this Report to acquire JMAR shares having a
market value of a minimum of one times his annual salary. Once any such
designated employee achieves that goal they will no longer be required to
allocate a specific portion of their bonus to the purchase of additional JMAR
shares unless their share holdings fall below that level.

DIRECTORS' FEES

        Effective April 1, 1994, Directors who are not salaried employees of the
Company receive a retainer (the "Retainer") of $1,000 per quarter and $750 for
their attendance at each Board of



                                       48
<PAGE>   49
Directors meeting and Committee meeting and are reimbursed for their travel,
lodging and food expense incurred when attending such meetings. In August, 1997,
the Company adopted the Director Compensation Plan whereby $250 of the Board
meeting compensation will be paid in Company stock.

        In addition, the 1991 Stock Option Plan, as amended, provides that
directors are eligible to participate in the 1991 Stock Option Plan on the same
basis as key employees of the Company and grants of options will be made by the
Board of Directors on a case-by-case basis on such terms as the Board in its
discretion may provide. During the fiscal year ended December 31, 1997, a grant
of options to purchase 5,000 shares of Common Stock was received by Messrs.
Martinez, Banister, Beer, Ressler, Blackman and Mr.
Sepe in their capacity as directors.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The following table sets forth, as of March 6, 1998, certain information
regarding the beneficial ownership of the Company's Common Stock by each person
or entity known to the Company to be the beneficial owner of more than five
percent of the Company's Common Stock and by each director and executive officer
of the Company. In all cases, unless otherwise indicated, the named person has
sole voting power and sole investment power over the securities.

<TABLE>
<CAPTION>
                                       NUMBER OF SHARES OF               PERCENTAGE OF
                                          COMMON STOCK             OUTSTANDING COMMON STOCK
        BENEFICIAL OWNER               BENEFICIALLY OWNED             BENEFICIALLY OWNED
        ----------------               ------------------             ------------------
<S>                                    <C>                            <C>
John S. Martinez (1)                        1,597,340                        8.58%

Kernco Trust SA (2)                         1,250,000                        6.86%
2 rue Jargonnant
CH-1211 Geneva 6
Switzerland

Marvin W. Sepe (3)                            189,452                        1.04%

Dennis E. Valentine (4)                       133,120                        (13)

Richard M. Foster (5)                          78,980                        (13)

Leonid Yoffe (6)                               55,679                        (13)

James H. Banister, Jr. (7)                     51,984                        (13)

Vernon H. Blackman (8)                         26,921                        (13)

Barry Ressler (9)                              21,857                        (13)

John P. Ricardi (10)                           20,000                        (13)

C. Neil Beer (11)                              14,247                        (13)

All executive officers and                  2,189,580                       11.45%
directors as a group (10
persons) (12)
</TABLE>
----------------------

 (1) Includes: (a) 372,965 shares owned of record by the John S. Martinez
     Separate Property Trust, of which Dr. Martinez as trustee, has sole voting
     and investment power; (b) 648,375 shares of Common Stock which are issuable
     upon exercise of currently exercisable warrants and stock options; and (c)
     576,000 shares of Common Stock subject to a voting agreement



                                       49
<PAGE>   50
     pursuant to which Dr. Martinez has sole voting power (but no investment
     power) until the earlier of October 6, 2003 or until the transfer of the
     shares according to the terms of the voting agreement (the ?Voting
     Agreement?).

(2)  Includes 250,000 shares which are issuable upon exercise of currently
     exercisable warrants.

(3)  Includes 187,251 shares which are issuable upon exercise of currently
     exercisable stock options and warrants.

(4)  Includes 131,115 shares which are issuable upon exercise of currently
     exercisable stock options and warrants.

(5)  Includes 28,333 shares which are issuable upon exercise of currently
     exercisable stock options.

(6)  Includes 42,297 shares which are issuable upon exercise of currently
     exercisable stock options and warrants.

(7)  Includes 43,396 shares which are issuable upon exercise of currently
     exercisable stock options and warrants.

(8)  Includes 26,733 shares which are issuable upon exercise of currently
     exercisable stock options and warrants.

(9) Includes 21,669 shares which are issuable upon exercise of currently
    exercisable stock options and warrants.

(10) All shares are issuable upon exercise of currently exercisable stock
     options.

(11) Includes 12,499 shares which are issuable upon exercise of currently
     exercisable stock options.

(12) Includes 1,161,668 shares which are issuable upon exercise of currently
     exercisable stock options and warrants.

(13) Less than one percent.


ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        On March 29, 1993, the Company loaned Dr. Martinez $59,000 with interest
at 6% per annum to assist Dr. Martinez in paying certain income taxes that he
personally incurred in connection with a transaction that he undertook in
support of the Company. The December 31, 1997 loan amount, including accrued
interest, is $78,378. The loan is secured by 14,750 shares of Common Stock owned
by Dr. Martinez.


                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

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

1.      Financial Statements. A list of financial statements is contained in
        "Index to Consolidated Financial Statements" on page 24 hereof.

                                       50
<PAGE>   51

2.      Financial Statement Schedules. The following financial statement
        schedule of JMAR Industries, Inc., for the years ended December 31,
        1997, 1996 and 1995 is filed as part of this Report and should be read
        in conjunction with the Consolidated Financial Statements of JMAR
        Industries, Inc.

Schedule

        II.  Valuation and Qualifying Accounts

        Schedules not listed above have been omitted because they are not
applicable or are not required or the information required to be set forth
therein is included in the Consolidated Financial Statements or Notes thereto.

3.      Exhibits. The Exhibits listed on the accompanying index to Exhibits are
        filed as part of this Report.


EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS:

        The Company's 1988 Stock Option Plan (Exhibit 10(I) to Registration
Statement 33-32446).

        The Company's 1991 Stock Option Plan, with amendments (Exhibits A to
Proxy Statements for 1991, 1992, 1993, 1995 and 1996 Annual Meetings of
Shareholders).

        Management Anti-Dilution Incentive Plan, as amended (Exhibit 10.12 to
December 31, 1996 Form 10-K).

        Amended and Restated Employment Agreement between the Company and John
S. Martinez, dated May 1, 1996 (Exhibit 10.3 to December 31, 1996 Form 10-K).

        Management Incentive Plan Agreement for Pacific Precision Laboratories,
Inc., as amended (Exhibit 10.24 to December 31, 1996 Form 10-K).

        Employment Agreement between Pacific Precision Laboratories, Inc. and
John P. Ricardi, dated February 3, 1997 (Exhibit 10.11 to this Form 10-K).

        Employment Agreement between California ASIC, Inc. and Marvin W. Sepe
dated July 1, 1996 (Exhibit 10.1 to December 31, 1996 Form 10-K).

(b)   Reports on Form 8-K.

        There were no reports filed on Form 8-K during the three months ended
December 31, 1997.


                                       51
<PAGE>   52

                              JMAR INDUSTRIES, INC.
                           ANNUAL REPORT ON FORM 10-K
                          YEAR ENDED DECEMBER 31, 1997
                                INDEX TO EXHIBITS

<TABLE>
<S>        <C>
3.1 (1)(3) Articles of Incorporation and amendments thereto.

3.2(10)    Amendments to Articles of Incorporation, filed on July 9, 1992,
           December 11, 1992, January 11, 1993 and February 1, 1993.

3.3 (1)    Bylaws and amendments thereto.

3.4 (12)   Amendment to Certificate of Incorporation, filed on August 23, 1994.

4.1 (4)    Form of Common Stock Certificate.

4.2 (4)    Form of Warrant Certificate for Warrants sold in February, 1993.

9.1 (12)   Voting Trust Agreement, dated October 6, 1993 between John S. Martinez and
           Cato Portfolio, A.G.

10.1 (16)  Employment Agreement between California ASIC, Inc. and Marvin W. Sepe, dated
           July 1, 1996.

10.2 (16)  Amended and Restated Employment Agreement between the Company and John S.
           Martinez, dated May 1, 1996.

10.3 (1)   The Company's 1988 Stock Option Plan.

10.4 (1)   Form of Invention and Secrecy Agreement.

10.5 (3)   Form of Warrant, with attached Piggyback Registration Rights provisions,
           issued in April, 1991 to John S. Martinez, James H. Banister, Jr., C. Neil
           Beer, Jay Borker, Scott Love, A. Lee Morsell, Vernon H. Blackman, Susan
           Miller-French, Lester Levy and Ali M. M. Mojdehi.

10.6 (2) (8) (9) (11) (13) The Company's 1991 Stock Option Plan, as amended.

10.7 (5)   Warrant Agreement, dated February 16, 1993, among the Company,
           Commonwealth, Lieberbaum and American Securities Transfer,
           Incorporated.

10.8 (16)  Management Anti-Dilution Incentive Plan, as amended.

10.9 (6)   Form of 8?% Senior Subordinated Convertible Promissory Note dated October 6,
           1993 issued to Cato Portfolio A.G.

10.10 (16) Employment Agreement between Pacific Precision Laboratories, Inc. and John
           P. Ricardi, dated February 3, 1997.

10.11 (7)  Revolving Credit Loan Agreement, dated October 6, 1993, by and among PPL and
           Comerica Bank - California; Security Agreement between PPL and Comerica;
           Guaranty executed  by the Company.

</TABLE>


                                       52
<PAGE>   53


<TABLE>
<CAPTION>
EXHIBIT
NO.              DESCRIPTION
----------       -----------------------
<S>        <C>
10.12 (10) Form of 1994 Warrant, between the Company and Baytree Associates,
           Inc.

10.13 (12) Form of Warrant, with attached Piggyback Registration Rights provisions issued
           to John S. Martinez, Vernon H. Blackman, Robert S. Hash, Larry M. Levy, Dennis
           E. Valentine, Barry Ressler, Leonid Yoffe and Carole Hash issued in connection
           with the Company's August, 1994 Loan Program.

10.14 (14) Agreement of Purchase and Sale of Assets dated as of May 23,
           1996, by and among the Company, Nancy Schwalbe, Edwin Barrowcliff and
           California ASIC Technical Services, Inc.

10.15 (15) Master Lease Agreement and related documents dated as of
           September 10, 1996 between Leasing Technologies International, Inc.,
           the Company and California
           ASIC Technical Services, Inc.

10.16 (15) Installment Note dated September 1, 1996 between Comerica
           Bank-California and Pacific Precision Laboratories, Inc.

10.17 (16) Management Incentive Plan Agreement for Pacific Precision Laboratories, Inc.,
           as amended.

10.18      Subscription Agreement by and between the Company and Banque Edouard
           Constant SA dated November 7, 1997.

22.1       Subsidiaries of the Company include JMAR Technology Co. (a California
           corporation), Pacific Precision Laboratories, Inc. (a California corporation)
           and California ASIC, Inc. (a Nevada corporation).

23         Consent of Independent Public Accountants.

27.1       Financial Data Schedule

</TABLE>

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



                                       53
<PAGE>   54


(1)   Incorporated by reference to the exhibit filed with the Company's
      Registration Statement on Form S-1 (No. 33-32446) filed on December 5,
      1989 and amended on January 30, 1990, March 30, 1990 and April 23, 1990,
      which Registration Statement became effective May 11, 1990.

(2)   Incorporated by reference to the exhibit filed with the Company's Proxy
      Statement for the 1991 Annual Meeting of Shareholders.

(3)   Incorporated by reference to the exhibit filed with the Company's Form
      10-K for the year ended December 31, 1991.

(4)   Incorporated by reference to the exhibit filed with the Company's
      Registration Statement on Form S-1 (No. 33-47390) filed on April 22, 1992
      and amended November 23, 1992, January 11, 1993, January 27, 1993,
      February 9, 1993, February 11, 1993, February 12, 1993 and declared
      effective on February 16, 1993.

(5)   Incorporated by reference to the exhibit filed with the Company's Form
      10-K for the year ended December 31, 1992.

(6)   Incorporated by reference to the exhibit filed with the Company's Form
      10-Q for the quarter ended September 30, 1993.

(7)   Incorporated by reference to the exhibit filed with the Company's Form 8-K
      dated October 6, 1993.

(8)   Incorporated by reference to the exhibit filed with the Company's Proxy
      Statement for the 1992 Annual Meeting of Shareholders.

(9)   Incorporated by reference to the exhibit filed with the Company's Proxy
      Statement for the 1993 Annual Meeting of Shareholders.

(10)  Incorporated by reference to the exhibit filed with the Company's Form
      10-K for the year ended December 31, 1993.

(11)  Incorporated by reference to the exhibit filed with the Company's Proxy
      Statement for the 1995 Annual Meeting of Shareholders.

(12)  Incorporated by reference to the exhibit filed with the Company's Form
      10-K for the year ended December 31, 1994.

(13)  Incorporated by reference to the exhibit filed with the Company's Proxy
      Statement for the 1996 Annual Meeting of Shareholders.

(14)  Incorporated by reference to the exhibit filed with the Company's Form 8-K
      dated May 23, 1996.

(15)  Incorporated by reference to the exhibit filed with the Company's Form
      10-Q for the quarter ended September 30, 1996.

(16)  Incorporated by reference to the exhibit filed with the Company's Form
      10-K for the year ended December 31, 1996.


                                       54
<PAGE>   55
SIGNATURES

Pursuant to the requirement 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.

                                    JMAR INDUSTRIES, INC.

Date: March 30, 1998                By: /s/ John S. Martinez
      ----------------                  ---------------------------------
                                           John S. Martinez
                                           Chairman of the Board and
                                           Chief Executive Officer

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


<TABLE>
<CAPTION>
            SIGNATURE                    TITLE                   DATE
            ---------                    -----                   ----
<S>                                <C>                       <C>

/s/ JOHN S. MARTINEZ               Chairman of the           March 30, 1998
----------------------------------                           --------------
John S. Martinez                   Board, Chief
                                   Executive Officer
                                   and Director


/s/ DENNIS E. VALENTINE            Chief Financial           March 30, 1998
----------------------------------                           --------------
Dennis E. Valentine                Officer and Chief
                                   Accounting Officer

/s/ James H. Banister, Jr.         Director                  March 27, 1998
----------------------------------                           --------------
James H. Banister, Jr.


/s/ C. NEIL BEER                   Director                  March 26, 1998
----------------------------------                           --------------
C. Neil Beer


/s/ VERNON H. BLACKMAN             Director                  March 27, 1998
----------------------------------                           --------------

Vernon H. Blackman


/s/ BARRY RESSLER                  Director                  March 26, 1998
----------------------------------                           --------------
Barry Ressler

</TABLE>



                                       55


<PAGE>   56
                                                                     SCHEDULE II


                              JMAR INDUSTRIES, INC.
                        VALUATION AND QUALIFYING ACCOUNTS
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<TABLE>
<CAPTION>
                                                                           Additions
                                                           -----------------------------------------
                                           Balance at      Charged to                                     Balance at
Description                             Beginning of Year  Costs and         Other         Deductions     End of Year
-----------                             -----------------  ---------         -----         ----------     -----------
                                                           Expenses
<S>                                         <C>            <C>             <C>             <C>             <C>

For the year ended December 31, 1997:

  Warranty reserve ..................       $ 14,800       $ 27,000        $(14,729)       $     --        $ 27,071

  Reserve for inventory obsolescence         118,976         55,000           7,181              --         181,157

  Allowance for doubtful accounts ...         17,230         20,000          (1,683)             --          35,547
                                            --------       --------        --------        --------        --------


For the year ended December 31, 1996:

  Warranty reserve ..................       $ 14,729       $     --        $     --        $     71        $ 14,800

  Reserve for inventory obsolescence         171,573             --         (52,597)             --         118,976

  Allowance for doubtful accounts ...         18,250             --              --          (1,020)         17,230
                                            --------       --------        --------        --------        --------

For the year ended December 31, 1995:

  Warranty reserve ..................       $ 36,548       $     --        $     --        $(21,819)       $ 14,729

  Reserve for inventory obsolescence         136,403         (4,900)         47,283          (7,213)        171,573

  Allowance for doubtful accounts ...         57,000             --         (38,750)             --          18,250
                                            ========       ========        ========        ========        ========

</TABLE>