<PAGE>   1
 
                                [NOVACARE LOGO]
================================================================================
 
                                   FORM 10-K
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934
 
                    FOR THE FISCAL YEAR ENDED JUNE 30, 1997
 
                         Commission file number 1-10875
                                 NOVACARE, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                           <C>
                  DELAWARE                                  13-3247827
          (STATE OF INCORPORATION)             (I.R.S. EMPLOYER IDENTIFICATION NO.)
1016 WEST NINTH AVENUE, KING OF PRUSSIA, PA                   19406
  (ADDRESS OF PRINCIPAL EXECUTIVE OFFICE)                   (ZIP CODE)
</TABLE>
 
Registrant's telephone number, including area code: (610) 992-7200
 
Securities registered pursuant to Section 12(b) of the Act:
 
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<S>                    <C>                                       <C>
Title of each class                                              Name of each exchange on which registered
            COMMON STOCK, PAR VALUE $.01 PER SHARE                     NEW YORK STOCK EXCHANGE, INC.
 
               5 1/2% CONVERTIBLE SUBORDINATED                         NEW YORK STOCK EXCHANGE, INC.
                     DEBENTURES DUE 2000
</TABLE>
 
     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. [  ]
 
     AS OF SEPTEMBER 5, 1997, 61,076,427 SHARES OF COMMON STOCK WERE
OUTSTANDING, AND THE AGGREGATE MARKET VALUE OF THE SHARES OF COMMON STOCK HELD
BY NON-AFFILIATES WAS APPROXIMATELY $806,909,547. (DETERMINATION OF STOCK
OWNERSHIP BY NON-AFFILIATES WAS MADE SOLELY FOR THE PURPOSE OF RESPONDING TO
THIS REQUIREMENT AND THE REGISTRANT IS NOT BOUND BY THIS DETERMINATION FOR ANY
OTHER PURPOSE.)
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     PART III INCORPORATES INFORMATION BY REFERENCE FROM PORTIONS OF THE
REGISTRANT'S PROXY STATEMENT FOR THE 1997 ANNUAL MEETING OF SHAREHOLDERS TO BE
HELD ON OCTOBER 30, 1997.
================================================================================
<PAGE>   2
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                  FORM 10-K -- FISCAL YEAR ENDED JUNE 30, 1997
 
                       CONTENTS AND CROSS REFERENCE SHEET
          FURNISHED PURSUANT TO GENERAL INSTRUCTION G(4) OF FORM 10-K
 
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FORM 10-K   FORM 10-K                                                                    FORM 10-K
 PART NO.   ITEM NO.                             DESCRIPTION                             PAGE NO.
----------  ---------   -------------------------------------------------------------    ---------
<S>         <C>         <C>                                                              <C>
I                1      Business.....................................................         1
                               The Company...........................................         1
                               Industry Background...................................         1
                               Company Strategy......................................         3
                               Plan for Growth and Operations........................         5
                               Business Profile......................................         8
                               Competition...........................................        14
                               Reimbursement/Government Relations....................        15
                               Government Regulation.................................        17
                               Insurance.............................................        20
                               Employees.............................................        20
                               Executive Officers of the Registrant..................        21
                 2      Properties...................................................        22
                 3      Legal Proceedings............................................        23
                 4      Submission of Matters to a Vote of Security Holders..........        23
II               5      Market for Registrant's Common Equity and Related Stockholder
                          Matters....................................................        23
                 6      Selected Financial Data......................................        24
                 7      Management's Discussion and Analysis of Financial Condition
                          and Results of Operations..................................        25
                 8      Financial Statements and Supplementary Data..................        32
                 9      Changes in and Disagreements with Accountants on Accounting
                          and Financial Disclosure...................................        51
III             10      Directors and Executive Officers of the Registrant...........        51
                11      Executive Compensation.......................................        51
                12      Security Ownership of Certain Beneficial Owners and
                          Management.................................................        51
                13      Certain Relationships and Related Transactions...............        51
IV              14      Exhibits, Financial Statement Schedules and Reports of Form
                          8-K........................................................        51
 
Signatures...........................................................................        52
</TABLE>
 
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                                     PART I
 
ITEM 1. BUSINESS
 
THE COMPANY
 
     NovaCare, Inc. ("NovaCare" or the "Company") was organized and formed in
1985 and is a national leader in physical rehabilitation services and employee
services. As the clinical leader in rehabilitation services, the Company treats
37,000 patients per day in cost-effective outpatient and long-term care settings
and has achieved number one market shares in long-term care and orthotics and
prosthetics. In addition, NovaCare is the nation's second largest provider of
outpatient rehabilitation services and the second largest employee services, or
professional employer organization ("PEO"), administering the full array of
human resource functions, including the management of health care benefits and
workers' compensation, principally for small and medium-sized businesses.
 
     Rehabilitation services are the processes that restore individuals disabled
by trauma or disease to their optimal level of functionality and
self-sufficiency. Over 80% of individuals receiving rehabilitation services
return to the community in productive endeavors or to active retirement.
NovaCare's comprehensive medical rehabilitation services include (i) providing
rehabilitation therapy and rehabilitation program consulting and management
services on a contract basis to health care institutions, primarily long-term
care facilities, and (ii) providing outpatient, orthotic and prosthetic ("O&P")
and occupational health rehabilitation services through a national network of
patient care centers and integrated delivery systems. The Company operated
medical rehabilitation hospitals until April 1, 1995, the effective date of the
sale of such hospitals, discussed in Part II to this Form 10-K. For the fiscal
year ended June 30, 1995, the medical rehabilitation hospitals represented 12%
of the Company's consolidated net revenues.
 
     Employee services are generally provided to small and medium-sized
businesses and are comprehensive, fully integrated outsourcing solutions to
human resource management, including payroll management, workers' compensation,
risk management, benefits administration, unemployment services and human
resource consulting services. The Company creates relationships with both its
clients and worksite employees by contractually assuming certain administrative
and financial employer responsibilities with respect to worksite employees in a
"co-employment" relationship. By focusing on employee services, the Company
helps create a more satisfying, more productive relationship between clients and
employees. The Company supports its clients by: (i) improving profitability
through lowering or controlling costs associated with workers' compensation,
health insurance, other benefit coverage and regulatory compliance; (ii)
improving productivity through reducing the time and effort required by business
owners and executives to deal with the complexities of employment management,
enabling them to focus on their business core competencies and growth; and (iii)
improving employee satisfaction and performance. The Company helps employers
improve job satisfaction and performance of their employees by: (i) providing
improved health care and related benefits; (ii) delivering training programs;
and (iii) delivering dependable payroll and benefits administration.
 
INDUSTRY BACKGROUND
 
     REHABILITATION SERVICES
 
     Depending on an individual's diagnostic and therapeutic needs,
rehabilitation services are delivered in a variety of settings, including
rehabilitation hospitals, rehabilitation units in acute care hospitals,
long-term care facilities, outpatient rehabilitation facilities, rehabilitation
agencies and clinics, industrial settings, schools and patients' homes. These
services are provided by a variety of health care professionals including
physiatrists and other qualified rehabilitation physicians, occupational,
physical and respiratory therapists, rehabilitation nurses, speech-language
pathologists, audiologists, psychologists, social workers, orthotists,
prosthetists, recreational therapists, rehabilitation counselors and others.
 
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     Recent industry analysis suggests that medical rehabilitation is an
approximately $27 billion industry. The industry's growth has been fueled
primarily by the following three factors:
 
          Increased demand for services.  Advances in technology, the aging
     population and high quality of life expectations among disabled people
     continue to drive demand for rehabilitation services. Technological
     advances in medical care have lengthened lifespans and improved the quality
     of life for patients who have suffered severe injury or disease. The U.S.
     Bureau of the Census statistics show that the fastest growing segment of
     the population is the group over 65 years of age. This group, among the 33
     million Americans who have a disability and cannot perform basic physical
     activity or need assistance to do so, has the highest requirement for
     rehabilitation services. Approximately 75% of strokes and 70% of
     amputations occur in persons over the age of 65. Almost 50% of Americans
     over 75 years of age currently require some form of rehabilitation.
 
          Proven cost-effectiveness of services.  Payers (insurance companies,
     managed care plans, employers, government programs and individual patients)
     now recognize the benefits of rehabilitation in reducing lifetime costs of
     health care. Recent studies suggest that from $11.00 to $30.00 in medical
     costs are saved for every dollar spent on rehabilitation. Efforts to reduce
     workers' compensation expenses also have stimulated demand for
     rehabilitation of injured workers and the installation of work-hardening
     and injury-prevention programs in the work place.
 
          Comprehensive reimbursement for services.  Rehabilitation services are
     covered for payment by Medicare and Medicaid and are typically covered by
     commercial health insurance policies, workers' compensation and managed
     care plans.
 
     EMPLOYEE SERVICES
 
     The National Association of Professional Employer Organizations ("NAPEO")
estimates the PEO or employee services industry is currently approximately $18
billion in revenues with an annual growth rate over the last five years of
approximately 30%. The U.S. Small Business Administration estimates there were
approximately 6 million businesses in the United States with fewer than 100
employees in 1996. These businesses employed approximately 52 million persons
and had an aggregate annual payroll of approximately $1.1 trillion. Management
believes approximately 49 million of these employees are currently unserved by
the PEO industry. The PEO industry is highly fragmented. NAPEO data suggest that
as many as 2,400 PEOs are currently in operation and that the ten largest PEOs
account for less than 10% of the existing market. The Company expects there will
continue to be significant industry consolidation as smaller PEOs face
increasing regulatory complexity and capital requirements associated with
developing larger service delivery infrastructures and management information
systems.
 
Increased demand for services.  The PEO industry evolved in the early 1980's in
response to increasing employment and benefit costs, and the complexities of the
legal and regulatory environment for the rapidly expanding small to medium-sized
business sector. The Company believes demand for PEO services will continue to
increase as (i) employment-related governmental regulation grows more complex,
(ii) growth continues within the small to medium-sized business community, (iii)
the need to provide health and retirement benefits in a cost-effective
convenient manner increases, and (iv) the business and regulatory communities
accept and recognize the PEO industry. The Company believes PEO services will
continue to experience growing demand because of anticipated growth in the
number of small businesses in the United States and the growing trend among
small to medium-sized employers to: (i) outsource non-core competencies; (ii)
reduce employee benefit costs; (iii) avoid employee-related risks and regulatory
complexities, and (iv) attract better employees and retain them through improved
benefit plans.
 
Cost effectiveness of services.  According to estimates by the U.S. Small
Business Administration, the management of an average small to medium-sized
business devotes from 7% to 25% of its time to employee-related matters, leaving
management with less time to focus on core competencies. A National Federation
of Independent Business survey of small businesses in 1996 showed that six of
the top 13 major problem areas for small business are issues that can be
addressed by PEOs. These include (with their rank in importance) cost of health
insurance (1), workers' compensation costs (3), federal paperwork (7), frequent
 
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<PAGE>   5
 
changes in federal tax laws (9), finding qualified employees (11), and
state/local paperwork (13). Work-related injuries cost employers over $70
billion in medical expenses and employee productivity each year. Employees are
attracted to small and medium-sized businesses that provide employees with human
resources services characteristic of large employers. An industry analyst's
study indicated that 40% of the clients that outsourced services with a PEO were
able to upgrade their employee benefits offerings and one-fourth of those
clients were able to offer health care and other benefits for the first time.
 
COMPANY STRATEGY
 
  VALUES-BASED BUSINESS
 
     NovaCare believes that the most important and differentiating quality of
outstanding organizations is the set of values which inspires, unites and
sustains them. Values are constant and enduring, and precede and underlie
business plans, policies, procedures, practices, performance and outcomes. The
Company's values are:
 
<TABLE>
    <S>                       <C>
    Credo                     Helping Make Life a Little Better
    Beliefs                   Respect for the Individual
                              Service to the Customer
                              Pursuit of Excellence
                              Commitment to Personal Integrity
    Purpose
      Rehabilitation          To effectively meet the rehabilitation needs of our patients
        Services              through clinical leadership
      Employee Services       To be the brand, service and performance leader in the PEO
                              industry by creating a more satisfying, more productive
                              relationship between employers and employees
</TABLE>
 
     It is management's belief that the strong commitment to these values by all
employees enables the Company to provide a unique level of service to its
customers by enabling employees to build the business and enhance their careers.
 
  STRATEGY STATEMENT
 
     OVERALL
 
     NovaCare's strategy is to achieve a leading market position in each of its
businesses. The Company selects industry sectors that are large, fragmented,
growing rapidly and would benefit from the Company's core competencies:
outsourcing, information technology and human resource management.
 
Outsourcing.  NovaCare provides creative, cost-effective outsourced solutions to
business. Instrumental in the Company's success in outsourcing is an ability to
understand and anticipate the needs of customers, while smoothly integrating
into their operations, so they can focus on their business' core competencies.
NovaCare manages activities that its customers may not have the necessary scale,
expertise, time or staff to handle. The Company seeks to be a partner with its
customers, whether a small business or a health care organization, adding and
adapting services as customer needs change.
 
Information Technology.  NovaCare strives to improve its customers' performance
by providing knowledge-based services and technology beyond the reach of their
internal systems. The same information technology capability that adds value for
customers is utilized to improve NovaCare's efficiency and profitability.
 
Human Resource Management.  Due to the competitive environment for clinical
rehabilitation professionals in which demand exceeds supply, NovaCare has
developed strong capabilities to attract and retain employees. With
approximately 19,000 employees working in small groups in customer facilities
and NovaCare outpatient centers, the Company has experience in effectively
managing a highly dispersed workforce on a national level.
 
                                        3
<PAGE>   6
 
     NovaCare's market leadership starts with a consolidation and integration
program designed to achieve the scale required to create margin opportunity and
warrant the investment made in service differentiation. The Company focuses its
consolidation activities in target geographic markets to leverage the cost of
field management and concentrate its resources on the most critical
relationships in a community. NovaCare orients the employees of acquired
businesses to the Company's values, creating alignment with common goals which,
in turn, facilitates integration.
 
     REHABILITATION SERVICES
 
     NovaCare's rehabilitation services strategy is to leverage its core
competencies and expert rehabilitation and specialty health care services to
expand and integrate with physicians, hospitals, long-term care, post-acute care
and managed care delivery systems. The Company's strategy is to enhance
NovaCare's position as the largest provider of low-cost, clinically excellent
medical rehabilitation services outside the medical rehabilitation hospital
setting. The strategy is based on the belief that:
 
     -  Medical rehabilitation services will continue to experience steady or
        growing demand because health care payer cost-containment efforts will
        continue to drive patients toward the most cost-effective health care
        solution to satisfy patients' needs and customers' requirements.
 
     -  Large integrated delivery systems comprising health care providers and
        payers will be networked to facilitate integrated patient care, to ease
        administration, and reduce costs for payers and providers and to ensure
        high quality care at competitive cost in local and regional geographic
        markets.
 
     -  The aging of the population will increase the demand for medical
        rehabilitation services as the elderly consume a disproportionate amount
        of rehabilitation care.
 
     -  Purchasers of medical rehabilitation services will increase their
        emphasis on cost-effective, clinically proven outcomes in the selection
        of rehabilitation providers.
 
     -  Costs can be lowered through clinical and information systems
        innovations coupled with "flat" organizations having broad spans of
        control.
 
     -  Effective data management capabilities can enhance quality health care.
 
     -  Medical rehabilitation services, outside the medical rehabilitation
        hospital setting, are not capital intensive, allowing for responsiveness
        to changes in reimbursement or market conditions, without the use of
        substantial capital resources.
 
     EMPLOYEE SERVICES
 
     The Company's strategy is to be the brand, service and performance leader
in the PEO industry by leveraging its expertise in human resource management,
information systems and outsourcing, in focused geographic markets. The strategy
is based on management's beliefs that:
 
     -  PEO services will continue to experience growing demand because of the
        trend among small to medium-sized employers to: (i) outsource non-core
        competencies, (ii) reduce employee benefit costs, (iii) avoid
        employee-related risks and regulatory complexities, and (iv) attract
        better employees through improved benefit plans.
 
     -  The industry for PEO services, based on analyst reports, is more than
        95% unserved with the served portion expected to grow at the rate of 30%
        per year for the next five years.
 
     -  The PEO industry is highly fragmented with significant consolidation
        opportunities for companies with access to capital, larger service
        delivery infrastructures, and well-developed and sophisticated
        management information systems.
 
     -  PEOs typically take a transaction processing approach to their services
        and do not emphasize the improved workforce performance characteristic
        of satisfied employees.
 
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<PAGE>   7
 
     -  In selecting PEO providers, small to medium-sized businesses will
        increase their emphasis on cost-effectiveness, service excellence and
        the breadth of services provided.
 
     -  Employees are attracted to small and medium-sized businesses that
        provide employees with human resources services characteristic of large
        employers.
 
PLAN FOR GROWTH AND OPERATIONS
 
  REHABILITATION SERVICES
 
     The rehabilitation services growth plan has four principal components: (i)
expand outpatient services, (ii) develop occupational health services, (iii)
focus growth and integration efforts in select target markets, and (iv) meet the
needs of the long-term care industry.
 
     Expand Outpatient Services.  NovaCare plans to continue to expand the
Company's extensive network of outpatient rehabilitation and O&P sites in target
geographic markets through acquisitions and start-up centers. Management
believes that the size and density of NovaCare's outpatient services network in
many markets positions the Company favorably to affiliate with integrated
delivery systems and to compete for referrals from managed care organizations,
physician groups, hospitals and commercial customers. In fiscal 1997, the
Company acquired 52 outpatient businesses with aggregate annualized revenues of
$140 million, increasing its network of facilities by 34% to 644 locations.
 
     Develop Occupational Health Services.  Occupational health integrates
injury prevention, physician, rehabilitation, case management and other
ancillary services to return the work injured employee to the workplace as
safely and quickly as possible. NovaCare provides "workplace-to-workplace"
service which combines worksite evaluation, injury/illness diagnosis, physician
treatment, rehabilitation and back to work programs. The goal is to minimize
health care and disability costs to employers while providing the employee the
opportunity to recover, as fully as possible, from a work-place injury. The
system includes a network of physician practices specializing in occupational
health care which oversee the workers' initial evaluation, care planning, and
clinical progress through their return to work. Treatment of patients is
generally performed in health care centers equipped in a manner similar to
NovaCare's outpatient rehabilitation centers.
 
     The Company plans to build on its existing foundation and to acquire
established occupational health services practices, clinics and services in
target geographic markets. The Company believes such acquisitions will
complement the Company's expansion of outpatient services, capitalize on patient
flow synergies and further position NovaCare for affiliation with hospital
systems, managed care payers and commercial customers.
 
     Focus Growth and Integration Efforts in Select Target Markets.  NovaCare
intends to build and maintain leading market positions in 17 target geographic
markets by affiliating its rehabilitation services with leading health care
systems in these target markets. The Company's goal is to enhance referral and
health care system relationships, increase brand awareness and leverage its
clinical resources and infrastructure investments in target markets. Management
believes that with the largest combined outpatient rehabilitation and O&P
services network as the largest provider of rehabilitation services to the
long-term care industry and with the development of an occupational health
services network, NovaCare is in a strong position to meet the needs of health
care systems in a local or regional market. NovaCare offers the attributes that
a health care system partner or payer looks for: (i) dispersed outpatient
services capabilities, (ii) excellent clinical reputation and outcomes, (iii)
sophisticated systems capabilities to track and measure patient progress through
their plan of care, and (iv) a strong financial position to support network
growth. In fiscal 1997, 87% of NovaCare's rehabilitation services acquisitions
and start-up facilities were in target markets.
 
     Meet the Needs of the Long-Term Care Industry.  NovaCare intends to
continue to enhance its industry leadership position in long-term care.
Management believes that NovaCare's clinical programs, information technology
and ability to recruit and manage therapists will enable the Company to continue
to grow at a disproportionately higher rate than the long-term care industry.
 
                                        5
<PAGE>   8
 
     The Company's operating plan for rehabilitation services encompasses cost
containment and clinical leadership.
 
     Cost Containment.  A central aspect of the Company's strategy is to
position itself as a low-cost provider of high quality rehabilitation services.
Clinical improvements and innovation are expected to lower the cost of
rehabilitation service delivery. Management believes its efforts to flatten and
increase the flexibility of the organization to respond to change and its
investment in common, efficiency-enhancing clinical and administrative systems
will allow the Company to operate successfully in an increasingly challenging
reimbursement environment.
 
     Clinical Leadership and Outcomes.  Management believes that payers will
ultimately demand that low cost be accompanied by proof of quality outcomes. The
Company has committed resources to develop information analysis and display
systems that capture outcomes in a useable format. Management believes that, as
payers become more sophisticated and require providers to prove the delivery of
quality service, the Company's commitment to outcomes measurement, coupled with
its emphasis on clinical performance, will enhance its competitive position.
 
  EMPLOYEE SERVICES
 
     Through its subsidiary, NovaCare Employee Services, Inc. ("NCES"), the
Company is the second largest PEO in the United States. NCES commenced
operations in October 1996, concurrent with the acquisition of Resource One,
Inc. in Florida. In February 1997, the Company acquired three additional PEOs --
Employee Services of America Inc. and Prostaff Human Resources, Inc. in Florida,
and The TPI Group Ltd. in New York. As of June 30, 1997, the Company served
approximately 1,700 client organizations with approximately 35,000 employees at
over 3,000 worksites primarily in ten industries and 45 states.
 
     NCES was established by the Company because it recognized that NovaCare's
core competencies are highly correlated with success in the PEO industry.
NovaCare's rehabilitation services are delivered in over 2,000 facilities
nationwide, and include worksite evaluation, injury prevention and work injury
rehabilitation. The ability to deliver employment-related services to small,
widely dispersed groups of employees and to effectively manage workers'
compensation risk are central to a PEO. NovaCare's investments in human resource
management, information technology, relationship selling and management control
systems are directly applicable to and can be leveraged through the employee
services business.
 
     The Company's employee services business intends to grow through: (i)
increased investment in sales and marketing, (ii) focused geographic expansion;
(iii) emphasis on specific industries; and (iv) acquisitions and strategic
alliances.
 
     Increased Investment in Sales and Marketing.  NCES intends to develop a
brand identity. A recognized brand name is a valuable market tool. By utilizing
the nationally advertised brand name of NovaCare, the Company believes it will
achieve a strong brand identity in the PEO industry, at lower cost. The Company
will utilize professional marketing tools and strategies to communicate its
brand promise and performance to target audiences. Brand loyalty is expected to
generate referrals and improve client retention. The Company plans to survey the
marketplace, its worksite employees and potential clients on a continuous basis
to measure satisfaction and the effectiveness of its marketing efforts.
 
     Focused Geographic Expansion.  The Company has identified key attractive
geographic target markets and has established a plan for entering those markets
in a disciplined manner. The target markets are those 17 markets in which the
rehabilitation services business is focusing its growth and integration efforts.
Rehabilitation services customers and other extensive business-to-business
relationships represent a significant opportunity to grow in these target
markets. By concentrating on markets where NovaCare's rehabilitation services
business has achieved density, NCES will immediately have scale because NCES
already co-employs the NovaCare rehabilitation services employees. The Company
believes its market development model will enable it to penetrate new markets
quickly. This market development model consists of a highly structured sales
management control system and efficient selling process.
 
                                        6
<PAGE>   9
 
     Emphasis on Specific Industries.  Target industries will vary from market
to market depending on economic characteristics and business demographics of
each geographic location. NovaCare intends to focus on industries with high
gross profit per worksite employee and significant worker's compensation profit
opportunities. The sales force is expected to utilize the key industry strategy
and become expert in one or more select industries in the markets in which they
are operating. Rehabilitation services customers represent a large potential
client base of small to medium-sized long-term care providers and other health
care customers who are currently obtaining outsourced contract rehabilitation or
who are referring patients to the Company.
 
     Acquisitions and Strategic Alliances.  The opportunities for PEO
consolidation are substantial with approximately 2,400 PEOs operating in a
highly fragmented industry. The Company believes that this industry
consolidation will be driven by increasing industry and regulatory complexity,
increasing capital requirements and the significant economies of scale available
to PEOs. The Company intends to make opportunistic acquisitions where
appropriate to achieve greater density in target geographic markets.
 
     The Company is creating strategic alliances with service providers to small
and medium-sized businesses. With the trend toward outsourcing non-core
competencies, small and medium-sized businesses typically have service
relationships with accountants, attorneys, banks, trade associations and other
business advisors. Alliances with these service providers offer a cross-selling
opportunity for NCES. The Company intends to develop such referral opportunities
as an extension of its sales and marketing capability.
 
     The NCES operating strategy is designed to control costs while supporting
growth. The operating strategy encompasses leveraging NovaCare's core
competencies and implementing a sophisticated business model.
 
     Leverage NovaCare's Existing Core Competencies.  As a national provider of
medical rehabilitation services, NovaCare has developed core competencies in (i)
delivering employment-related services to a dispersed workforce in third-party
worksites; (ii) establishing and maintaining national information systems
networks connecting clients, worksite employees and service providers; (iii)
developing and implementing workplace safety and injury prevention programs; and
(iv) regulatory change management. Other synergies include (i) the ability to
leverage to negotiate advantageous health care, workers' compensation and other
benefit program costs given NovaCare's scale in many geographic markets and (ii)
the availability of health care services for worksite employees from NovaCare
and other health care providers in NovaCare's local and regional health care
system networks in target markets.
 
     As a health care provider, NovaCare has been an industry leader in response
to regulatory and legislative change in a highly regulated market. The Company's
experience in and ability to effect change in the regulatory environment will be
valuable as states and the federal government seek to implement new approaches
to regulating the PEO industry.
 
     Implement Business Model.  NCES has implemented a portfolio management
system to control and improve its performance in the selection of new business,
meeting its brand promise with respect to existing customers, and analyzing
lapsed business in order to identify the reasons for and the corrective action
necessary in response to client cancellations. The new business criteria orient
marketing to potential clients in target industries with high gross profit per
worksite employee and acceptable underwriting risk. Potential clients meeting
preset criteria are the target audience for the sales effort. The current
business portfolio component of the control system enables management to monitor
new client start-ups, client-specific financial and risk performance and
employee and employer satisfaction. By focusing management attention on key
business variables, the system permits day-to-day management to direct actions
consistent with the Company's strategy and business plan. Lapsed business is
analyzed by reason to facilitate identification of service delivery system
issues and to improve future client retention.
 
     NCES has established an operating model that delivers services from two
different locations. The Company's local service center places an emphasis on
servicing the customer through local front-line activities. The local service
center conducts enrollment and orientation of new employees and clients, and
worksite safety evaluation and monitoring. Sales activity and customer service
will also be performed locally. Local activities relative to risk management
promote safety, early intervention of workers' compensation
 
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<PAGE>   10
 
reported claims and early return to work. Centralized activity includes
nationally directed telemarketing, standard development of marketing materials,
a national accounts sales force, payroll processing, benefits administration and
claims management. The major elements of finance, procurement and compliance
will also be centralized.
 
BUSINESS PROFILE
 
     REHABILITATION SERVICES
 
     OUTPATIENT SERVICES
 
     During fiscal year 1996, NovaCare merged its outpatient services
businesses, comprising outpatient rehabilitation and O&P services, under a
common management team to take advantage of administrative and operational
economies of scale and the evolution of rehabilitation services toward
affiliation with health care providers and payers. For the fiscal years ended
June 30, 1997 and 1996, outpatient services represented 38% and 35%,
respectively, of the Company's rehabilitation services net revenues.
 
  Outpatient Rehabilitation Services
 
     Management believes that NovaCare is a leading provider of freestanding
outpatient rehabilitation services in the United States, with a national network
of 336 centers, comprising stand-alone clinics, hospital-based clinics and
employer on-site clinics. Through these settings, licensed physical and
occupational therapists develop individual treatment plans to rehabilitate
patients recovering from musculoskeletal injury and/or surgery.
 
     Outpatient rehabilitation services include general rehabilitation, which is
designed to return injured and post-operative patients to their optimal
functional capacity; sports rehabilitation, which is designed to minimize the
"down-time" of injured sports participants and safely return them to sports
activities; industrial rehabilitation and work hardening, which are designed to
reduce work-related injuries and rehabilitate and strengthen injured patients to
allow a rapid, safe return to normal job activities; and hospital-based
services, which involve the provision of inpatient and outpatient rehabilitation
services on a contract basis to acute care hospitals.
 
     Patients are generally referred by physicians (most commonly orthopedists,
physiatrists, primary care physicians, internists and neurologists), managed
care insurers, workers' compensation insurers, case managers, industrial
companies and rehabilitation nurses. In a number of states, patients can obtain
outpatient therapy services by "direct access," that is without a physician's
referral.
 
     Analysts estimate that the outpatient rehabilitation industry approximates
$11 billion. NovaCare's share of the industry total, based on fiscal 1997
revenues, is approximately 2%.
 
  Orthotic and Prosthetic Services
 
     NovaCare is the largest custom O&P patient care services organization in
the U.S. with an approximate 11% market share of a $1.5 billion industry, based
on fiscal 1997 revenues. Services are provided by 663 orthotists and
prosthetists, referred to as practitioners, through 274 patient care centers.
 
     Orthotic rehabilitation involves the fitting, design, fabrication and use
of custom-made braces and support devices for treatment of musculoskeletal
conditions resulting from illness, injury or congenital anomalies. Prosthetic
rehabilitation involves the fitting, fabrication and use of custom-made
artificial limbs typically required by people who have suffered the loss of a
limb from vascular diseases, diabetes, cancer or trauma. The Company, through
its Sabolich socket and myoelectric technology, is a nationally renowned leader
in prosthetic research, design and patient care. Its breakthrough technology and
research is believed by management to clinically differentiate NovaCare in O&P
services worldwide.
 
     The principal referral source for O&P rehabilitation services is the
orthopedic surgeon. However, other specialized physicians, such as physiatrists
and vascular surgeons, and managed care payers have emerged as
 
                                        8
<PAGE>   11
 
important referral sources. Secondary referral sources include physical
therapists, orthopedic nurses, orthopedic technicians and other rehabilitation
professionals.
 
     OCCUPATIONAL HEALTH SERVICES
 
     Occupational health services comprise treatment for work-related injuries
and illnesses, physical and occupational rehabilitation therapy, pre-placement
physical examinations and evaluations, case management, diagnostic testing and
other employer-requested or government-mandated work-related health care
services. The most common work related injuries are soft tissue injuries,
lacerations, moderate trauma injuries to the spine or extremities, and exposure
to hazardous materials. Treatments typically are provided by licensed
physicians, physicians assistants, x-ray technicians and physical therapists.
The physicians generally are trained and experienced in occupational and
industrial medicine or have other medical backgrounds compatible with
work-related injuries.
 
     The occupational health services market is highly fragmented. Industry
analysts estimate that there are more than 2,000 occupational health care
locations in the United States, representing a $30 billion industry. The Company
believes that, due to increasing business and regulatory complexity, capital
requirements and the development of health care systems in local and regional
markets, an increasing number of physicians specializing in occupational health
services are seeking to affiliate with larger health care service organizations.
 
     The dollar amount of workers' compensation claims has increased
significantly in recent years, resulting in escalating employer costs. The
increase is attributable to (i) an increase in work-related injuries and
illnesses, (ii) the rise in the cost of health care, and (iii) the requirement
that employers pay the majority of lost wages, replacement wages, legal and
other benefit expenses. In the aggregate, workers' compensation costs amounted
to $70 billion annually in the United States. Occupational health services is an
employer's solution to controlling workers' compensation costs attributable to
medical costs and lost time from work.
 
     NovaCare currently manages work injury rehabilitation and prevention
programs for employers through on-site programs and outpatient care through the
Company's six freestanding occupational health centers and its 336 outpatient
rehabilitation clinics. NovaCare performs work-site analysis to assess workplace
risk, provides work-site safety programs and helps employers comply with
work-related state and federal requirements. By acquiring additional practices
and related occupational health services in target markets, NovaCare plans to
expand its linkage with workers needing occupational rehabilitation, enhance the
patient volume of outpatient rehabilitation and increase the attractiveness of
the Company to workers' compensation insurers, commercial customers and
potential health care system affiliates.
 
     LONG-TERM CARE SERVICES
 
     NovaCare's long-term care services portfolio consists of contract therapy
and management consulting delivered principally to long-term care providers. For
the fiscal years ended June 30, 1997 and 1996, long-term care services
represented 59% and 63%, respectively, of the Company's rehabilitation services
net revenues.
 
  Contract Rehabilitation Services
 
     NovaCare provides multi-disciplinary rehabilitation therapy services on a
contract basis, principally to long-term care facilities. The multi-disciplinary
team comprises physical therapists, occupational therapists, and speech-language
pathologists working together to improve the ability of patients to perform the
activities of daily living. Physical therapy enhances muscular and neurological
responses and is designed to improve the patients' physical strength and range
of motion. Occupational therapy is the evaluation and treatment of physical,
cognitive and psychosocial performance deficits in activities of daily living.
Speech-language pathology is the diagnosis and treatment of speech, language,
voice and swallowing disorders.
 
     NovaCare is the largest contract rehabilitation provider to the long-term
care industry with a market share of approximately 12%, as measured by fiscal
1997 net revenues. As of June 30, 1997, NovaCare provided these services in
approximately 1,750 facilities located in 44 states.
 
                                        9
<PAGE>   12
 
     Analysts estimate that the market for therapy services delivered under
contract to long-term care facilities is approximately $4.5 billion. A 1995
management-sponsored survey indicated that 73% of long-term care facility
rehabilitation services are performed on a contract basis.
 
     The long-term care industry has typically contracted for therapy services
for the following reasons:
 
          Insufficient caseload.  The average nursing facility of approximately
     100 beds has insufficient and/or fluctuating caseload, which makes it
     uneconomical to operate its own therapy program with full-time employment
     of therapists and the associated costs of management and administration.
 
          Supply of therapists.  There is an inadequate supply of therapists and
     the workforce is characterized by high turnover. Consistent staffing levels
     are difficult to maintain, which jeopardizes service levels and quality.
 
          Expertise.  Therapy revenues represent a relatively small percentage
     of a nursing facility's total revenues and operating activities.
     Reimbursement and regulatory complexities concerning appropriate
     utilization, documentation, denials management and quality oversight, if
     inadequately administered, can seriously erode the profitability of therapy
     programs staffed by and managed by employees of the long-term care
     facility. As a result, nursing facilities frequently choose to contract for
     specialized expertise.
 
     NovaCare has been successful in hiring therapists due in part to its
"employer of choice" programs and clinical and systems support networks. The
number of full-time-equivalent therapists hired in the Company's contract
rehabilitation business during fiscal 1997 was 2,605.
 
          Employer of Choice Programs.  NovaCare's employer of choice
     initiatives comprise defined career ladders for clinicians, clinical
     training and competitive compensation and benefit programs, as well as
     management and technological support designed to attract and retain
     therapists. At June 30, 1997, NovaCare employed 68 recruiters, which
     management believes is the largest therapist recruiting organization in the
     U.S. Over the past two years, one-fifth of the therapists who joined
     NovaCare's contract rehabilitation business chose NovaCare as a result of
     employee referrals.
 
          Clinical Support.  A network of local and national clinical experts is
     available to all clinicians as support resources in all aspects of the
     clinical practice.
 
          Systems Support.  NovaCare's proprietary information system, NovaNet
     PLUS, reduces therapist record-keeping burdens, streamlines administrative
     activities and captures information of value to clinicians, management and
     customers. Integrated outcomes measurement was incorporated into the system
     in fiscal 1997. Management believes that this innovative system continues
     to increase NovaCare's attractiveness as an employer of therapists.
 
          Clinical Leadership.  NovaCare and the Harvard School of Public Health
     have jointly devised a standard system for measuring the effectiveness of
     rehabilitation outcomes for geriatric patients. The outcomes measurement
     system now serves as a vehicle to determine the treatment and payment for
     rehabilitation services to the geriatric population. Management believes
     that NovaCare's leadership in outcomes measurement has and will continue to
     enhance the Company's visibility in the clinical community and its
     attractiveness as an employer.
 
     Nursing facility operators have from time to time provided therapy services
on an in-house basis, with varying degrees of success. A recent multi-year study
of the costs of in-house programs compared with the costs of contract therapy
indicated higher average therapy costs per patient care hour in long-term care
 
                                       10
<PAGE>   13
 
facilities with in-house programs. The study surveyed over 15,000 long-term care
facilities and examined several years of Medicare cost reports for long-term
care facilities with in-house therapy programs. Nevertheless, a number of
national multi-facility long-term care companies have directly hired therapists
to staff and manage their therapy program in-house. These in-house decisions
appear to be based, at least in part, on a desire to gain greater management
control over therapy programs, overriding economic concerns. This trend has been
exacerbated by consolidation activity in the nursing home industry.
 
     During fiscal years 1995 through 1997, NovaCare reduced its dependence on
national chains of long-term care facilities due primarily to the transition
from outsourcing with NovaCare to providing therapy services in-house. The
percentage of NovaCare's rehabilitation services revenue attributable to
national chains declined to 21% at June 30, 1997 from 27% in fiscal 1994.
Business lost due to the in-house transition was replaced with predominantly
regional and independent customers, diversifying the Company's customer base.
Management does not expect in-house transitions to have a significant impact on
future results due to the Company's reduced dependency on national
multi-facility long-term care companies and the economic opportunity outsourcing
provides.
 
     The anticipated annualized revenue of new contracts has increased from
approximately $120 million in fiscal 1996 to approximately $180 million in
fiscal 1997. Contract turnover has also declined to 15% in fiscal 1997 from 26%
in fiscal 1996. The anticipated annualized net revenue impact of new contracts
sold less contracts canceled improved to $98 million in fiscal 1997. In fiscal
1996, the anticipated annualized net revenue impact of contracts canceled
exceeded new contracts sold by $7 million.
 
     Employee turnover in the rehabilitation industry is high relative to other
industries because of the therapist supply/demand imbalance. Also affecting
turnover is the aggressive recruiting that occurs within the industry, and the
highly mobile therapist population. Therapist turnover rates in long-term care
facilities are traditionally higher than in other therapy settings.
 
     NovaCare's therapist turnover in the contract rehabilitation business
decreased in fiscal 1997 to 35% from 44% in fiscal 1996. Therapist turnover
initiated by employees decreased from 41.7% in fiscal 1996 to 31.23% in fiscal
1997. The balance of therapist turnover was based on the Company's decision to
terminate employment.
 
     NovaCare is compensated for its contract services on a fee-for-service
basis, and generally collects payment for services from the long-term care
facility, which in turn may receive reimbursement from Medicare, Medicaid,
private insurance or the patient. Payments from Medicare and Medicaid are
subject to complex regulations. Medicare regulations are subject to anticipated
changes that may have a material effect on the long-term care services business.
See "Reimbursement/Government Relations", discussed later. NovaCare generally
indemnifies its customers against medical denials of reimbursement by third
party payers, including Medicare. NovaCare has established internal utilization
and documentation standards and systems to minimize denials. During the past two
fiscal years, on average, less than 2% of NovaCare's services were ultimately
denied payment.
 
     NovaCare contracts predominantly with regional and local long-term care
companies and independently-owned nursing facilities for the provision of
rehabilitation therapy to their patients. Contracts are generally written for a
period of two years and include automatic renewals for one year. Contracts are
typically terminable upon 30 to 90 days notice by either party.
 
     In the current unsettled reimbursement environment (See
"Reimbursement/Government Relations", discussed later), NovaCare believes that
it is well-positioned to compete effectively with other contract therapy
companies and the "in house" alternative due to: (i) its highly centralized
administrative functions and flexible organization structure which can respond
to business growth and industry change; (ii) a nationwide recruiting
organization and substantial staffing capabilities; (iii) a multi-disciplinary
team approach to therapy that is designed to deliver a high level of quality and
efficient care, (iv) sophisticated management information systems to assist
clinicians and management in analyzing clinical outcomes, therapy utilization,
claim denials, staffing and educational activities; (v) a clinical support
network to provide timely expert clinical advice to care providers; (vi) a
nationwide sales organization to secure customer contracts in
 
                                       11
<PAGE>   14
 
support of business growth; and (vii) reimbursement and regulatory expertise to
assist nursing facility operators in their dealings with third-party payers,
principally Medicare.
 
     MANAGEMENT AND INFORMATION SERVICES
 
     The Company focuses on the delivery of expert management, information and
specialty consulting services to health care and long-term care institutions.
Such services currently include long-term care facility rehabilitation program
management, consulting and subacute program development, and management and
information services.
 
     Rehabilitation Program Management and Consulting.  The Company provides
rehabilitation program consulting and management services to long-term care and
hospital facilities through Polaris Group, a NovaCare business unit, and a
40%-owned subsidiary, Gill/Balsano Consulting, L.L.C. Due to regulatory and
reimbursement complexities in the long-term care and hospital industries, these
services assist these providers with utilization, documentation, receivables and
denials management, cost reporting, quality oversight and strategic direction
setting. The Company had arrangements to provide such services to 797 long-term
care facilities at June 30, 1997 as compared with 624 at June 30, 1996.
 
     Information Services.  NovaCare delivers a range of services based on its
proprietary NovaNet PLUS information system to its two largest long-term care
customers. These customers utilize NovaNet PLUS throughout their organizations
to: (i) promote a common clinical approach to case management; (ii) gather and
analyze clinical outcomes information; (iii) increase therapist administrative
and clinical efficiency; and (iv) provide operating unit financial information.
 
     EMPLOYEE SERVICES
 
     As co-employer of worksite employees, NovaCare assumes responsibility for
and manages the risks associated with: (i) worksite employee payroll; (ii)
workers' compensation insurance coverage; and (iii) compliance with certain
employment-related governmental regulations that can be effectively managed away
from the client's business. The client retains the right and responsibility for
supervision and direction of worksite employees' services in its business and
remains responsible for compliance with other employmentrelated governmental
regulations that are more closely related to worksite employee supervision. The
service fee charged by the Company to its clients covers the cost of certain
employment-related taxes, workers' compensation insurance coverage,
administrative and field services, salaries and wages of the worksite employees
and the client's portion of health and retirement benefit plan cost. NovaCare
also provides other value-added services such as temporary staffing, training
and human resource consulting.
 
     In keeping with its strategy to create a more satisfying and more
productive relationship between employers and employees, NovaCare provides six
primary categories of employee services: (i) workers' compensation cost
containment and safety management; (ii) unemployment insurance cost containment;
(iii) employee benefits administration; (iv) human resources and compliance
management; (v) payroll management and (vi) value-added services. By engaging
the Company to provide these services, clients can focus on their core
competencies and enhance their abilities to compete.
 
     These services are provided under the Company's standard services agreement
which provides for an initial one-year term; thereafter, the agreement is
renewed periodically. The agreement is subject to termination by the Company or
the client at any time upon 30 days' prior written notice. Service revenues,
billed to clients along with each periodic payroll, are based on a pricing model
that takes into account the gross pay of each employee and a mark-up which
includes the estimated costs of employment-related taxes, providing insurance
coverage and benefit plans, performing human resources, payroll, benefits and
compliance management and other services and an administration fee. The specific
mark-up varies by client based principally on the workers' compensation
classification of the worksite employees, their eligibility for health care
benefits and the size of the client. Accordingly, the Company's average mark-up
percentage will fluctuate based on client mix, which cannot be predicted with
any degree of certainty.
 
                                       12
<PAGE>   15
 
     Workers' Compensation Cost Containment and Safety Management.  Workers'
compensation is a state-mandated, comprehensive insurance program that requires
employers to fund medical expenses, lost wages and other costs that result from
work-related injuries and illnesses, regardless of fault and without any
copayment by the employee. Annual workers' compensation costs exceed $70 billion
in medical expenses and employee productivity each year (see "Government
Regulation" below). Pursuant to the Company's services agreement, the Company
assumes the obligations of its clients to pay workers' compensation claims. The
Company seeks to control its workers' compensation costs through comprehensive
risk evaluation of prospective clients, the prevention of workplace injuries,
timely intervention with each employee injury, aggressive management of the
medical costs related to such injuries and the prompt return of employees to
work. The Company seeks to prevent workplace injuries by implementing a wide
variety of training and safety programs. NovaCare's efforts to return employees
to work quickly involve both rehabilitation services and the placement of
employees in transitional, light duty positions until they are able to resume
their former positions.
 
     Unemployment Insurance Cost Containment.  Pursuant to the services
agreement, NovaCare assumes the obligation of its clients to pay unemployment
insurance costs. NovaCare manages its unemployment insurance costs by
establishing employee termination procedures, quickly responding to unemployment
claims, attending unemployment hearings and attempting to reassign employees to
other worksites when a reduction in force occurs at any one worksite location.
 
     Employee Benefits Administration.  In accordance with the services
agreement, NovaCare offers worksite employees a benefits package which includes
several health care options such as point-of-service ("POS"), HMOs and indemnity
plans. Supplemental benefit programs include dental care, prescription drugs,
and life and disability insurance options. The Company also offers 401(k)
retirement savings and cafeteria-style plans to its eligible employees. The
Company delivers participant benefits to worksite employees and monitors and
reviews claims for loss control purposes. NovaCare believes that its ability to
provide and administer a wide variety of employee benefits on behalf of its
clients tends to mitigate the competitive disadvantage small and medium-sized
businesses normally face in the areas of employee benefit cost control and
employee recruiting and retention.
 
     Human Resources and Compliance Management.  Pursuant to the services
agreement, the Company provides comprehensive human resources services to reduce
the employment-related administrative burdens faced by its clients, and provide
worksite employees with a wide array of benefits typically offered by large
employers. NovaCare develops and administers personnel policies and procedures
for each of its clients, relating to, among other things, recruiting, retention
programs, performance management, discipline and terminations. The Company also
provides orientation, training and development, counseling and substance abuse
awareness for worksite employees.
 
     By contract, NovaCare generally assumes responsibility for complying with
many employment-related regulatory requirements. In addition, the Company
assists its clients in understanding and complying with other employment-related
requirements for which the Company does not assume responsibility. Laws and
regulations applicable to employers include state and federal tax laws, state
workers' compensation laws, state unemployment laws, occupational safety laws,
immigration laws, and discrimination, sexual harassment and other civil rights
laws.
 
     Payroll Management and Reporting.  As a co-employer, NovaCare is
responsible for payroll processing, check preparation, distribution and record
keeping, payroll tax deposits, payroll tax reporting, employee file maintenance,
unemployment claims, and monitoring and responding to changing regulatory
requirements. Payroll reports are prepared for clients for financial and other
record keeping purposes. By having the Company assume the responsibility for
this significant administrative function, clients have certain guarantees of
regulatory compliance, reduced employment liabilities and greater management
resources to focus on their core business.
 
     Other Value-Added Services.  NovaCare offers rehabilitation temporary
staffing in the long term care industry. The rehabilitation temporary staffing
service currently accesses an active clinician pool of over 6,000 to provide
staff to skilled nursing facility clients at which over 1,300 worksite employees
were performing
 
                                       13
<PAGE>   16
 
services at June 30, 1997. This business is supported by state-of-the-art
technology, which provides precise recruitment and sales productivity
information for management purposes. It also generates billing and utilization
reports for clients.
 
     The Company plans to offer additional value-added services to clients and
worksite employees. Such services may include employee recognition programs,
travel discount arrangements, vision care, credit union membership, smart cards,
warehouse club memberships and various financial services. Some of these
services may generate fee income or commissions for the Company.
 
COMPETITION
 
  REHABILITATION SERVICES
 
     The health care industry in general, and rehabilitation in particular, are
highly competitive and subject to continual changes in methods of service
delivery and provider selection. Rehabilitation is largely a local market
business and competition varies considerably among markets. NovaCare competes in
the geographic markets where it provides long-term care services and where its
outpatient services patient care centers are located. The primary competitive
factors in such local markets are (i) quality of patient care services, (ii)
charges for services, (iii) responsiveness to meeting the needs of patients,
customers, referral sources and payers, and (iv) increasingly, networked
integration with other health care providers and payers.
 
     Key competitive factors in the long-term care services businesses include
the ability to provide therapy staff to meet the therapy needs at customer
facilities and the ability to provide management and clinical support to such
staff. NovaCare competes in local markets with other national, regional and
local contract therapy providers. NovaCare believes that its ability to recruit
therapists, manage geographically dispersed service professionals, provide
expert clinical support and develop new services allows it to compete
successfully with other contract therapy providers in the markets where NovaCare
provides services. The demographics of potential customers have changed and will
continue to change as some large long-term care facility chains choose to take
all or part of their therapy services in-house. This may increase the
competition for remaining customers. The Company has diversified its customer
base in the long-term care industry to replace business lost because of such
in-house programs (see "Contract Rehabilitation Services," previously
discussed).
 
     In the outpatient services business, key competitive factors include the
ability to develop and maintain relationships with referral sources (physicians,
rehabilitation professionals, hospitals and payers) and to provide sufficient
geographic coverage to allow the Company, alone or with other providers, to
compete successfully for patients from managed care payers, workers'
compensation payers and employers. The Company competes in local markets with
other national, regional and local outpatient rehabilitation service providers,
as well as hospital-based outpatient clinics and physician-directed therapy
practices. Some of these competitors may have greater patient referral,
personnel and geographic resources in certain local markets. Competition in the
O&P industry is highly fragmented; however, there are several regional providers
with multiple facilities in certain local markets. Management believes that the
Company competes successfully within its local markets based on its reputation
for quality and service, an ability to provide geographic coverage and
competitive prices, affiliation with health care systems, and technologically
superior O&P product offerings.
 
     In the occupational health services industry, the market is highly
fragmented and competitive. The largest competitor in the industry has less than
4% market share. Competitors include other occupational health services
companies, independent physicians, hospitals, insurance companies, HMO's,
managed care providers and networks of primary care physician specialists. The
ability to compete successfully is dependent upon (i) relationships with
employers, employees and payer sources, (ii) quality of rehabilitative care, and
(iii) returning employees to work quickly at the lowest cost for the care
provided.
 
     National and local sponsorship and support of organizations for injured and
disabled individuals enhance NovaCare's visibility and competitive position. In
addition, NovaCare has developed affiliations with academic institutions and has
provided funding for the development of a university level physical therapy and
occupational therapy programs.
 
                                       14
<PAGE>   17
 
  EMPLOYEE SERVICES
 
     The PEO industry consists of as many as 2,400 companies, most of which
serve a single market or region. The Company believes that it is the second
largest PEO in the United States. NovaCare considers its primary competition to
include: (i) traditional in-house human resources departments; (ii) other PEOs,
and (iii) providers of unbundled employment-related services such as payroll
processing firms, temporary employment firms, commercial insurance brokers,
human resource consultants, workers' compensation insurers, HMOs and other
specialty managed care providers.
 
     Competition in the highly fragmented PEO industry is generally on a local
or regional basis. Management believes that the primary elements of competition
are quality of service, choice and quality of benefits, reputation and price.
The Company believes that brand recognition, regulatory expertise, financial
resources, risk management, information technology capability and economies of
scale can distinguish a large-scale PEO from the rest of the industry. The
Company believes that it competes favorably in these areas.
 
     NovaCare believes that barriers to entry into the PEO industry are
increasing due to, among others, the following factors: (i) the complexity of
the PEO business and the need for expertise in multiple disciplines; (ii) the
three to five years of experience required to establish experience ratings in
key cost areas of workers' compensation, health insurance and unemployment; and
(iii) the need for sophisticated management information systems to track all
aspects of business in a high growth environment.
 
REIMBURSEMENT/GOVERNMENT RELATIONS
 
  REHABILITATION SERVICES
 
     Reimbursement for medical rehabilitation services is available through
Medicare, Medicaid, commercial insurance, managed care programs, workers'
compensation and other government programs. Medicare is a federally funded
health program which provides health insurance coverage for certain disabled
persons and persons age 65 or older. Medicaid is a health insurance program,
jointly funded by the federal and state governments, which provides health
insurance coverage for certain financially or medically needy persons regardless
of age. Medicaid benefits supplement Medicare benefits for financially needy
persons age 65 or older. Congress has provided, through the Medicare program,
for coverage of contract therapy services, outpatient rehabilitation services
and O&P devices and patient care services. Medicare reimbursement rules are
different for a number of these services. Moreover, in many states Medicaid
reimburses for rehabilitation services for eligible recipients. A substantial
portion of NovaCare's business, in effect, is reimbursed by Medicare, and a
small portion by Medicaid. As a result, regulations regarding Medicare and
Medicaid eligibility, certification and reimbursement are important to
NovaCare's activities and changes in these programs or regulations could
adversely affect NovaCare's business.
 
     The Company's gross profit directly or indirectly attributable to Medicare
for fiscal 1997 and 1996 was 45% and 49%, respectively.
 
     CONTRACT REHABILITATION SERVICES
 
     Contract rehabilitation services are covered and reimbursed in one of two
ways. In most cases, NovaCare bills a facility, which, in turn, invoices a
third-party payer, such as Medicare. NovaCare also provides services through its
own certified rehabilitation agencies, which directly bill a third-party payer,
such as Medicare.
 
     Medicare reimburses the long-term care facility for contract therapy
services on a cost basis, and reimbursement levels are determined based on a
reasonable-cost standard. Specific guidelines exist for evaluating the
reasonable cost of physical therapy and there are general guidelines for
evaluating the reasonable cost of occupational therapy and speech-language
pathology services. With respect to physical therapy, the specific guideline
system is called salary equivalency. The physical therapy salary equivalency
rates have been adjusted annually based on a 1983 standard but do not adequately
reflect salary inflation since 1983. As a result, the portion of contract
services that relate to physical therapy services are essentially a break-even
business for many contractors, including NovaCare.
 
                                       15
<PAGE>   18
 
     The Health Care Financing Administration ("HCFA"), the federal agency
responsible for the rules governing Medicare and Medicaid, has issued proposed
specific reimbursement guidelines for occupational therapy and speech-language
pathology services and revisions to the existing guidelines for physical therapy
services. The proposed rules specify that when occupational therapy and
speech-language pathology services guidelines become effective, physical therapy
salary equivalency guidelines will be increased in consideration of the
substantial increases in salary and services standards since these guidelines
were last revised. The proposed rules governing such guidelines have received
public comment. Final rules are expected in the fourth quarter of calendar year
1997.
 
     Until such time as salary equivalency guidelines are finally promulgated,
contract occupational therapy and speech-language pathology services are
evaluated based upon the reasonableness of costs incurred by the provider under
a "prudent buyer" standard. During the past three years, HCFA has issued several
directives to its fiscal intermediaries instructing them on how to ensure
therapy costs are reasonable. Intermediaries have been instructed to consider
relevant facts and circumstances concerning a facility's contracting costs. The
attention being given by HCFA to these instructions has increased scrutiny of
contracting practices. NovaCare is working with its customers to resolve issues
raised by fiscal intermediaries in cost report audits.
 
     The Balanced Budget Act of 1997 (the "Act") enacted in August 1997, made
several changes in the way Medicare will reimburse nursing homes and other
providers for their services. Those changes will take effect for nursing homes
at different times throughout calendar years 1998 and 1999, depending on the
starting date for each facility's cost reporting year. By the middle of 1999,
the Act mandates that each facility be reimbursed, in part, under a
comprehensive prospective payment system, which will include payment for therapy
services in a single all-inclusive per diem payment. Therapy services not
covered by the prospective payment system will be covered by a fee schedule with
total charges being subject to an annual cap.
 
     NovaCare also receives direct reimbursement by Medicare for 5% of its
contract therapy services provided through certified rehabilitation agencies.
See "Government Regulation", discussed later. NovaCare's certified
rehabilitation agencies file annual cost reports under the Medicare program
which are used to determine cost settlements for the prior year and interim
payment rates for the upcoming year. Funds received under various state programs
and Medicare are subject to audit with respect to proper application of the
various payment formulas. These audits can result in retroactive adjustments of
payments received from the program by NovaCare. If, as a result of such audits,
it is determined that overpayments for services were made to NovaCare, the
excess amount must be repaid by NovaCare to the government. If, on the other
hand, it is determined that an underpayment was made, the government agency will
make an additional payment to NovaCare.
 
     The Act also mandates changes to the payment structure for services
provided through certified rehabilitation agencies. Implementation of these
changes stretches over the next 18 months. As with nursing homes, rehabilitation
agencies will change from the current cost-based system to a system based on a
fee schedule with an annual cap.
 
     NovaCare is actively involved in trade groups assisting HCFA in designing
the regulations and reimbursement schedules necessary to implement the Act. By
changing Medicare reimbursement to nursing homes from a cost basis to a fixed
fee, the Act will make a fundamental change in the economic assumptions
underlying patient care in nursing homes. It cannot be predicted at this time
what effect this change will have on the demand for therapy services. Management
is taking steps which it believes will help to mitigate any adverse economic
impact of the changes made by the Act. There can be no assurance, however, that
these changes will not have a material adverse effect on the future operations
of the Company.
 
     OUTPATIENT AND OCCUPATIONAL HEALTH SERVICES
 
     The principal sources of reimbursement for outpatient and occupational
health services are commercial and workers' compensation insurance, managed care
plans, motor vehicle insurance and individual patients.
 
     Workers' Compensation.  Workers' compensation is a state mandated,
comprehensive insurance program that requires employers to fund medical
expenses, lost wages and other costs resulting from
 
                                       16
<PAGE>   19
 
work-related injuries and illnesses. (See "Government Regulation" below.)
Workers' compensation represented approximately 17% of fiscal 1997 outpatient
and occupational health revenues.
 
     Managed Care.  Managed care plans represented approximately 15% of fiscal
1997 outpatient and occupational health revenues. NovaCare receives revenues
under managed care plans either on a discounted fee-for-service basis or, in a
growing number of cases, on the basis of capitated fees per covered member per
month.
 
     Medicare.  NovaCare receives reimbursement by Medicare for outpatient and
occupational health care services primarily through NovaCare's certified
rehabilitation agencies and on a fee schedule basis for O&P services. See
"Government Regulation," discussed later. Medicare and other government health
insurance programs represent approximately 10% of revenues.
 
GOVERNMENT REGULATION
 
  REHABILITATION SERVICES
 
     The health care industry, including rehabilitation services, is subject to
extensive federal, state and local regulation. The various layers of regulation
affect NovaCare's business by requiring licensure or certification of its
employees and facilities and controlling reimbursement for services provided.
Government and other third-party payers' health care policies and programs have
been subject to changes in payment and methodologies for a number of years.
Efforts to reform the nation's health care system could induce additional
changes. See "Reimbursement/Government Relations," previously discussed.
 
     NovaCare operates certified rehabilitation agencies to facilitate billing
for outpatient services and a portion of its long-term care services. In order
to receive Medicare reimbursement directly, outpatient centers must be certified
by Medicare as rehabilitation agencies or comprehensive outpatient
rehabilitation facilities. The certification criteria relate to the type of
facility and its equipment, record keeping, staffing and service as well as
compliance with all state and local laws. In addition, certain states require
facilities to obtain state licensure as a health facility as a requirement for
reimbursement. As of June 30, 1997, NovaCare operated 18 and 72 certified
rehabilitation agencies for contract therapy services and outpatient
rehabilitation services, respectively. Management believes its operations are
structured to comply with all applicable rules and regulations.
 
     In order to participate in the Medicare program, NovaCare's O&P patient
care centers are required to secure and maintain a supplier number. This process
requires certain disclosures and procedural requirements, which change
periodically. All of NovaCare's O&P patient care centers presently maintain such
a supplier number.
 
     In most states, the employment of therapists by business corporations is a
permissible practice. However, several states, including states in which
NovaCare operates, have enacted legislation or regulations or have interpreted
existing licensing laws to restrict business corporations, such as NovaCare,
from practicing therapy through the direct employment of therapists. Management
believes its operations are structured to comply with applicable laws and
regulations.
 
     Various state and federal laws and regulations govern the relationships
between providers of health care services and physicians, including employment
or service contracts and investment relationships. These laws and regulations
include the fraud and abuse provisions of the Medicare and Medicaid statutes,
which prohibit the payment, receipt or offering of any direct or indirect
remuneration for the referral of or to induce a referral of Medicare or Medicaid
patients or for the ordering or providing of Medicare or Medicaid covered
services, items or equipment and the self-referral provisions of federal and
state law which generally prohibit referrals by a physician to persons with whom
the physician has certain types of financial relationships. Violations of these
provisions may result in civil or criminal penalties for individuals or entities
and/or exclusion from participation in the Medicare and Medicaid programs.
Management believes it is in compliance with these laws and regulations and has
established a broad-based compliance program to ensure conformance with these
rules as well as to other laws and regulations.
 
                                       17
<PAGE>   20
 
  EMPLOYEE SERVICES
 
     The Company is subject to local, state and federal regulations which
include operating, fiscal and licensing requirements. Adding complexity to the
Company's regulatory environment are (i) uncertainties resulting from the
non-traditional employment relationships created by PEOs; (ii) variations in
state regulatory schemes, and (iii) the ongoing evolution of regulations
regarding health care and workers' compensation.
 
     Many of the federal and state laws and regulations relating to labor, tax
and employment matters applicable to employers were enacted prior to the
development of non-traditional employment relationships and, accordingly, do not
specifically address the obligations and responsibilities of PEOs or the
co-employment relationship. Moreover, the Company's PEO services are regulated
primarily at the state level. Regulatory requirements regarding the Company's
business therefore vary from state to state, and as NovaCare enters new states
it will be faced with new regulatory and licensing environments. There can be no
assurance that the Company will be able to satisfy the licensing requirements or
other applicable regulations of any particular state in which it is not
currently operating, that it will be able to provide the full range of services
currently offered, or that it will be able to operate profitably within the
regulatory environment in any state in which it does not obtain regulatory
approval. The absence of required licenses would require NovaCare to restrict
the services it offers. New legislation or new interpretations of current
licensing and regulatory requirements could impose operating or licensing
requirements on the Company which it may not be able to satisfy or which could
have a material adverse effect on NovaCare's business, financial condition,
results of operations and liquidity. Additionally, interpretation of such
legislation or regulation by regulatory agencies with broad discretionary powers
could require the Company to modify its existing operations materially in order
to comply with applicable regulations.
 
     The application of many laws to NovaCare's services will depend on whether
the Company is considered an employer under the relevant statutes and
regulations. The Internal Revenue Service (the "IRS") is examining this issue.
See "Employee Benefit Plans" below. In addition, from time to time there have
been proposals to enact a statutory definition of employer for certain purposes
of the Internal Revenue Code of 1986, as amended (the "Code").
 
     PEO Licensing Requirements.  A critical aspect of the growth of the PEO
industry has been increasing recognition and acceptance of PEOs by state
authorities. While many states do not explicitly regulate PEOs, approximately
one-third of the states, including Florida, have passed laws that have licensing
or registration requirements for PEOs and several additional states, including
Pennsylvania, are considering such regulation. Such laws vary from state to
state but generally provide for monitoring the fiscal responsibility of PEOs.
State regulation assists in screening insufficiently capitalized PEO operations
and, in NovaCare's view, has the effect of legitimizing the PEO industry by
resolving issues concerning an employee's status for specific purposes under
applicable state law. However, because existing regulations are relatively new,
there is limited interpretive or enforcement guidance available. The development
of additional regulations and interpretation of existing regulations can be
expected to evolve over time.
 
     Federal and State Employment Taxes.  NovaCare assumes the sole
responsibility and liability for the payment of federal and state employment
taxes with respect to wages and salaries paid to its employees, including
worksite employees. To date, the IRS has relied extensively on the common law
test of employment in determining employer status and the resulting liability
for failure to withhold. However, the IRS has formed a Market Segment Study
Group for the stated purpose of examining whether PEOs, such as the Company, are
the employers of the worksite employees under the Code provisions applicable to
federal employment taxes and, consequently, whether they are exclusively
responsible for payment of employment taxes on wages and salaries paid to such
employees. Another stated purpose of the Market Segment Study Group is to
determine whether owners of client companies can be employees of PEOs under the
federal employment tax laws.
 
     The interpretive uncertainties raised by the Market Segment Study Group may
affect the Company's ability to report employment taxes on its own account
rather than for the accounts of its clients and would increase administrative
burdens on NovaCare's payroll service function. In addition, while the Company
 
                                       18
<PAGE>   21
 
believes that it can contractually assume the client company's withholding
obligations, in the event NovaCare fails to meet these obligations, the client
company may be held jointly and severally liable.
 
     Employee Benefit Plans.  NovaCare offers various employee benefit plans to
its worksite employees, including 401(k) plans, cafeteria plans, group health
plans, group life insurance plans, group disability insurance plans and employee
assistance programs. Generally, employee benefit plans are subject to provisions
of both the Code and the Employee Retirement Income Security Act of 1974, as
amended ("ERISA"). In order to qualify for favorable tax treatment under the
Code, the plans must be established and maintained by an employer for the
exclusive benefit of its employees. Most of these benefit plans are also offered
to the Company's corporate employees.
 
     The Market Segment Study Group established by the IRS is also examining
whether PEOs, such as NovaCare, are the employers of worksite employees under
Code provisions applicable to employee benefit plans and consequently are able
to offer to worksite employees benefit plans that qualify for favorable tax
treatment. The Company is unable to predict the timing or nature of the findings
of the Market Segment Study Group or the ultimate outcome of such conclusions or
findings. If the IRS study were to conclude that a PEO is not an employer of its
worksite employees for plan purposes, worksite employees could not continue to
make contributions to the Company's 401(k) plans or cafeteria plans. The Company
believes that although unfavorable to the Company, a prospective application by
the IRS of an adverse conclusion would not have a material adverse effect on its
financial position and results of operations. If such conclusion were applied
retroactively, employees' vested account balances would become taxable
immediately, the Company would lose its tax deduction to the extent the
contributions were not vested, the plans' trusts would become taxable trusts and
penalties could be assessed. In such a case, the Company would face the risk of
client dissatisfaction as well as potential litigation. A retroactive
application by the IRS of an adverse conclusion could have an adverse effect on
the Company's business, financial condition, results of operations and
liquidity. While the Company believes that a retroactive disqualification is
unlikely, there can be no assurance as to the ultimate resolution of these
issues.
 
     In addition to the employer/employee relationship requirement described
above, pension and profit-sharing plans, including the Company's 401(k) plans,
must satisfy certain other requirements under the Code. These other requirements
are generally designed to prevent discrimination in favor of highly compensated
employees to the detriment of non-highly compensated employees with respect to
both the availability of, and the benefits, rights and features offered in,
qualified employee benefit plans. The Company applies the nondiscrimination
requirements of the Code at both a consolidated and client company level to
ensure that its 401(k) plans are in compliance with the requirements of the
Code.
 
     Workers' Compensation.  Workers' compensation is a state mandated,
comprehensive insurance program that requires employers to fund medical
expenses, lost wages and other costs resulting from work-related injuries and
illnesses. In exchange for providing workers' compensation coverage for
employees, employers are not subject to litigation by employees for benefits in
excess of those provided by the relevant state statute. In most states, the
extensive benefits coverage (for both medical costs and lost wages) is provided
through the purchase of commercial insurance from private insurance companies,
participation in state-run insurance funds or employer self-insurance. Workers'
compensation benefits and arrangements vary on a state-by-state basis and are
often highly complex. These laws establish the rights of workers to receive
benefits and to appeal benefit denials. Workers' compensation laws also regulate
the methods and procedures which the Company may employ in its workers'
compensation managed care programs.
 
     As a creation of state law, workers' compensation is subject to change by
each state's legislature and is influenced by the political processes in each
state. Several states have mandated that employers receive coverage only from
state-operated funds. Other states have adopted legislation requiring that all
workers' compensation injuries be treated through a managed care program. While
such legislation may increase the market for the Company's workers' compensation
services, it may also intensify the competition faced by 24-hour health
coverage, in which the coverage of traditional employer-sponsored health plans
is combined with workers' compensation coverage to provide a single insurance
plan for health problems, whether or not related to work. Incorporating workers'
compensation coverage into conventional health plans may adversely affect
 
                                       19
<PAGE>   22
 
the market for the Company's services and may intensify the competition faced by
the Company from HMOs and other health care providers. Moreover, because
workers' compensation benefits are mandated by law and are subject to extensive
regulation, payers and employers do not have the same flexibility to alter
benefits as they have with other health benefit programs. Finally, because
workers' compensation programs vary from state to state, it is difficult for
payers and multi-state employers to adopt uniform policies to administer, manage
and control the cost of benefits.
 
     Other Employer Related Requirements.  As an employer, NovaCare is subject
to a wide variety of federal and state laws and regulations governing
employer-employee relationships, including the Immigration Reform and Control
Act, the Americans with Disabilities Act, the Family Medical Leave Act, the
Occupational Safety and Health Act, wage and hour regulations, and comprehensive
state and federal civil rights laws and regulations, including those prohibiting
discrimination and sexual harassment. The definition of employer may be broadly
interpreted under these laws.
 
     Responsibility for complying with various state and federal laws and
regulations is allocated by agreement between the Company and its clients, or in
some cases is the joint responsibility of both. Because NovaCare acts as a
co-employer with the client company, it is possible that the Company could incur
liability for violations of laws even though the Company is not contractually or
otherwise responsible for the conduct giving rise to such liability. The
Company's standard client agreement generally provides that the client will
indemnify the Company for liability incurred as a result of an act of negligence
of a worksite employee under the direction and control of the client or to the
extent the liability is attributable to the client's failure to comply with any
law or regulation for which it has specified contractual responsibility.
However, there can be no assurance that NovaCare will be able to enforce such
indemnification and the Company may therefore be ultimately responsible for
satisfying the liability in question.
 
INSURANCE
 
     The Company maintains professional liability insurance in amounts deemed
appropriate by management based upon historical claims and the nature and risks
of the business. The Company also maintains property and general liability
insurance for the customary risks inherent in the operation of businesses in
general. While NovaCare believes its insurance policies to be adequate in amount
and coverage for its current operations, there can be no assurance that any
future claims will not exceed the limits of those policies or that such
insurance will continue to be available.
 
EMPLOYEES
 
     At June 30, 1997, the Company had approximately 39,800 employees. Of these,
approximately 19,300 are rehabilitation services personnel and 20,500 are
employee services personnel. Only six of the Company's employees are represented
by a labor union and the Company is not aware of any current activity to
organize any of its non-worksite employees. Management considers relations
between the Company and its employees to be good. For information with respect
to the Company's worksite employees, see "Business Profile -- Employee Services"
above.
 
                                       20
<PAGE>   23
 
                      EXECUTIVE OFFICERS OF THE REGISTRANT
 
     The executive officers of NovaCare who served during the fiscal year are as
follows:
 
<TABLE>
<CAPTION>
            NAME                                       POSITION                            AGE
----------------------------  -----------------------------------------------------------  ---
<S>                           <C>                                                          <C>
John H. Foster..............  Chairman of the Board and Director                           55
Timothy E. Foster...........  Chief Executive Officer and Director                         45
James W. McLane.............  President, Chief Operating Officer and Director              58
Daryl A. Dixon..............  President and General Manager, Contract Rehabilitation
                              Division                                                     37
Ronald G. Hiscock...........  President and General Manager, Outpatient Division           46
Peter D. Bewley.............  Senior Vice President, General Counsel and Secretary         51
Robert E. Healy, Jr. .......  Senior Vice President, Finance and Administration and Chief
                                Financial Officer                                          44
Laurence F. Lane............  Senior Vice President, Regulatory Affairs                    52
Aven Kerr...................  Senior Vice President, Human Resources                       51
Susan J. Campbell...........  Vice President, Communications and Investor Relations        46
Richard A. McDonald.........  Vice President, Treasurer                                    50
Barry E. Smith..............  Vice President, Controller and Chief Accounting Officer      44
James T. Walmsley...........  Vice President, Reimbursement                                47
Steven M. Wise..............  Vice President, Information Systems and Chief Information
                              Officer                                                      41
</TABLE>
 
     No family relationships exist among any of the directors or executive
officers of NovaCare. Executive officers serve at the discretion of the NovaCare
Board of Directors.
 
     JOHN H. FOSTER has been Chairman of the Board of NovaCare since December
1984. From 1984 to May 1997 he was also Chief Executive Officer of the Company.
Mr. Foster is also Chairman of the Board and Chief Executive Officer of Apogee,
Inc., a national mental health services company and a director of Corning
Incorporated, an international corporation with business interests in specialty
materials, communications, laboratory services and consumer products. Mr. Foster
is founder and Chairman of the Board of Foster Management Company, an investment
advisor, and general partner of various venture capital investment funds. He was
also the founder, Chairman of the Board and Chief Executive Officer of
RehabClinics, Inc., which was acquired by NovaCare in February 1994.
 
     TIMOTHY E. FOSTER has been Chief Executive Officer of the Company since May
1997. From October 1994 until May 1997 he was President and Chief Operating
Officer. He served as Senior Vice President, Finance and Administration and
Chief Financial Officer of NovaCare from November 1988 to October 1994,
Treasurer of NovaCare from March 1992 to October 1994, and has been a director
of NovaCare since December 1984. Mr. Foster currently serves as a Director of
Apogee, Inc., a national mental health services company, a position he has had
since February 1995.
 
     JAMES W. MCLANE has been President and Chief Operating Officer and a
director of the Company since May 1997. From 1991 to 1997, Mr. McLane served as
Chief Executive Officer of Aetna Health Plans and as Executive Vice President of
Aetna Life and Casualty. He is also a director of FemRx, a medical device
manufacturer.
 
     DARYL A. DIXON has been President and General Manager of NovaCare's
Contract Rehabilitation Division since January 1994. He joined NovaCare in
February 1992 as Regional Vice President in the Contract Rehabilitation Division
and was Vice President, Operations of the Contract Rehabilitation Division from
November 1992 until January 1994. From 1982 to 1992, he held various positions
at Manor HealthCare, Inc., a nursing home management company.
 
     RONALD G. HISCOCK has been President and General Manager of NovaCare's
Outpatient Division since February 1996 and had been President and General
Manager of NovaCare's Orthotics and Prosthetics Division from April 1995 to
February 1996. He joined NovaCare in June 1992 as the East Region President
 
                                       21
<PAGE>   24
 
for the Orthotics and Prosthetics Division and was the Division's Vice President
of Operations from July 1994 through March 1995.
 
     PETER D. BEWLEY has been Senior Vice President, General Counsel and
Secretary of NovaCare since May 1994. Prior to joining NovaCare Mr. Bewley was
Associate General Counsel at Johnson & Johnson, where he had been employed since
1977.
 
     ROBERT E. HEALY, JR. has been Senior Vice President, Finance and
Administration and Chief Financial Officer since December 1995. From January
1994 to December 1995, he was Vice President Chief Financial Officer of
NovaCare's Contract Rehabilitation Division. He served as Vice President Finance
and Chief Accounting Officer of the Company from March 1992 to January 1994.
 
     LAURENCE F. LANE has been Senior Vice President, Regulatory Affairs of
NovaCare since October 1994. From November 1986 to October 1994 he was Vice
President Regulatory Affairs.
 
     AVEN KERR has been Senior Vice President, Human Resources of NovaCare since
October 1996. From November 1995 to September 1996, she was Senior Vice
President Administration and Systems at United Healthcare. She was Senior Vice
President, Human Resources at MetraHealth from May 1995 to November 1995. Prior
to that, she was employed by Prudential Insurance Company for 27 years in
various positions, most recently as Senior Vice President, Central Atlantic
Operations.
 
     SUSAN J. CAMPBELL has been Vice President, Communications and Investor
Relations of NovaCare since April 1995. She joined NovaCare in March 1993 as
Director of Investor Relations and was Vice President, Investor Relations from
April 1994 to April 1995. Ms. Campbell was Vice President, Investor Relations,
First Fidelity Bancorporation from 1982 to 1993.
 
     RICHARD A. MCDONALD has been Vice President, Treasurer since August 1996
and was Director, Treasury Services from May 1995 until August 1996. Prior to
joining the Company, he was a financial consultant to Continental Medical
Systems, Inc. He served as an assistant treasurer with American Healthcare
Management from 1990 until 1994.
 
     BARRY E. SMITH has been Vice President, Controller and Chief Accounting
Officer of the Company since December 1995 and has been Vice President of
Finance of the Contract Rehabilitation Division since March 1995. He was Vice
President of Finance of the Medical Rehabilitation Hospital Division from
February 1994 through the sale date of the division, April 1995. From May 1992
through February 1994 he served in various positions in NovaCare's Corporate
Finance Department.
 
     JAMES T. WALMSLEY has been Vice President, Reimbursement of NovaCare since
January 1994 and Director of Reimbursement from April 1992 to January 1994.
 
     STEVEN M. WISE has been Vice President Information Systems and Chief
Information Officer since December 1995. He joined NovaCare in 1993 as Director,
Systems and Programming, for the Contract Rehabilitation Division. Prior to
joining NovaCare, he was employed at Ortho-McNeil Pharmaceutical Company where
he held various management positions in business systems development.
 
ITEM 2. PROPERTIES
 
     The Company's principal executive offices are located at 1016 West Ninth
Avenue, King of Prussia, Pennsylvania 19406 where NovaCare leases approximately
132,500 square feet. The lease for this office space expires in June 2005. In
addition, the Company leases other office space in various cities in the United
States for terms which typically are three years or less. See Note 8 of Notes to
the Company's Consolidated Financial Statements for information concerning the
Company's leases for its facilities. The Company does not anticipate that it
will experience any difficulty in renewing any such leases upon their expiration
or obtaining different space on comparable terms if such leases are not renewed.
The Company believes that these facilities are well maintained and are of
adequate size for present needs and planned expansion in the near future.
 
                                       22
<PAGE>   25
 
     NovaCare also has sublease agreements for approximately 24,748 square feet
of office space, expiring February 2003 with companies in which NovaCare's
Chairman of the Board is a Director and/or an Executive Officer.
 
ITEM 3. LEGAL PROCEEDINGS
 
     From time to time, NovaCare is party to certain claims, suits and
complaints which arise in the ordinary course of business. Currently, there are
no such claims, suits or complaints which, in the opinion of management, would
have a material adverse effect on the Company's business, financial condition,
results of operations and liquidity.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     None.
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     NovaCare's common stock is traded on the New York Stock Exchange (NYSE)
under the symbol NOV. On September 5, 1997, there were 1,817 holders of record
of common stock.
 
     The following table sets forth the high and low sales prices per share of
common stock as reported on the NYSE Composite Tape for the relevant periods.
 
<TABLE>
<CAPTION>
                                                                       COMMON STOCK
                                                                          PRICES
                                                                     -----------------
                                                                      HIGH       LOW
                                                                     ------     ------
        <S>                                                          <C>        <C>
        YEAR ENDED JUNE 30, 1997
          First Quarter............................................  $ 9.63     $ 6.88
          Second Quarter...........................................   11.25       8.13
          Third Quarter............................................   13.75       9.63
          Fourth Quarter...........................................   14.13      10.88
        YEAR ENDED JUNE 30, 1996
          First Quarter............................................  $ 9.50     $ 6.25
          Second Quarter...........................................    8.50       5.13
          Third Quarter............................................    8.25       5.25
          Fourth Quarter...........................................    7.63       6.25
</TABLE>
 
     With the exception of 2-for-1 stock splits of common stock effected in the
form of stock dividends in June 1987 and July 1991, no other dividends have been
paid or declared on common stock since NovaCare's initial public offering on
November 5, 1986. NovaCare does not expect to declare any cash dividends on
common stock in the foreseeable future.
 
                                       23
<PAGE>   26
 
ITEM 6. SELECTED FINANCIAL DATA
 
     The following selected financial data should be read in conjunction with
NovaCare's consolidated financial statements and the accompanying notes
presented elsewhere herein.
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                          FIVE YEAR FINANCIAL SUMMARY
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                              YEARS ENDED JUNE 30,
                                             ------------------------------------------------------
                                                1997        1996       1995       1994       1993
                                             ----------   --------   --------   --------   --------
<S>                                          <C>          <C>        <C>        <C>        <C>
STATEMENT OF OPERATIONS DATA:(1)
  Net revenues.............................  $1,066,451   $793,038   $905,359   $789,745   $582,342
  Gross profit.............................     260,086    208,082    256,240    255,511    186,265
  Income from operations...................      80,541     37,499    143,881    108,208     78,819
  Net interest (expense) income............     (13,504)    (7,537)   (17,893)   (11,773)    (2,841)
  Income before income taxes...............      66,801     29,866    125,584     95,892     75,542
  Income taxes.............................      27,891     14,585     63,660     37,678     27,906
  Net income...............................      38,910     15,281     61,924     58,214     47,636
  Net income applicable to common
     stock(2)..............................      38,910     15,281     61,924     58,214     47,585
  Net income per common share..............         .62        .24        .95        .90        .79
</TABLE>
 
<TABLE>
<CAPTION>
                                                                 AS OF JUNE 30,
                                             ------------------------------------------------------
                                                1997        1996       1995       1994       1993
                                             ----------   --------   --------   --------   --------
<S>                                          <C>          <C>        <C>        <C>        <C>
BALANCE SHEET DATA:
  Working capital..........................  $  173,576   $223,712   $255,126   $194,324   $265,908
  Total assets.............................   1,014,304    789,731    852,557    850,541    611,567
  Total indebtedness.......................     342,678    192,215    225,015    344,602    206,415
  Total liabilities(3).....................     506,298    305,337    364,922    434,837    282,587
  Shareholders' equity.....................     508,006    484,394    487,635    415,704    328,980
</TABLE>
 
---------------
(1) Certain amounts have been reclassified to conform with the fiscal 1997
    presentation.
 
(2) Gives effect to dividends, whether or not declared, on 10% mandatorily
    redeemable preferred stock issued by a consolidated subsidiary in fiscal
    1991 which was redeemed in fiscal 1993.
 
(3) Includes minority interests in consolidated subsidiaries.
 
                                       24
<PAGE>   27
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
OVERVIEW
 
     The Company has experienced significant growth in the recent year through
strategic acquisitions and growth in its existing businesses. During fiscal
1997, the Company purchased 52 outpatient businesses and 3 businesses which
provide occupational health services. Of the outpatient businesses acquired, 33
provide orthotic and prosthetic ("O&P") rehabilitation services and 19 provide
outpatient rehabilitation services. The Company entered into the professional
employer organization ("PEO") industry through the acquisition of one PEO
business in October 1996 and three in February 1997. PEOs, or employee service
companies, provide human resource and payroll management, workers compensation
risk management, benefits administration, unemployment service and human
resource consulting services principally to small to medium-sized businesses.
Effective January 25, 1997, employee services were also provided to the
rehabilitation services segment of the Company.
 
     During fiscal 1996, the Company acquired seven businesses which provide
outpatient rehabilitation services and six businesses which provide O & P
rehabilitation services. Nonrecurring charges in fiscal 1996 included a $13.4
million pretax restructuring charge and a $10.5 million pretax charge for a
change in estimate. Nonrecurring items in fiscal 1995 consisted of an $88.2
million pretax gain on the sale of the medical rehabilitation hospitals, a $29.9
million pretax restructuring charge, and a $1.0 million pretax charge relating
to the settlement of certain shareholder litigation.
 
     The following are the results of operations for fiscal years ended June 30,
1997, 1996 and 1995. The results of operations for fiscal 1996 and 1995 have
been reclassified to conform to the fiscal 1997 presentation. Other operating
expenses includes selling, general & administrative expenses, provision for
uncollectible accounts and amortization of excess cost of net assets acquired.
 
<TABLE>
<CAPTION>
                                                            FISCAL YEAR ENDED JUNE 30,
                                                        -----------------------------------
                                                          1997          1996         1995
                                                        ---------     --------     --------
    <S>                                                 <C>           <C>          <C>
    Net revenues
      Rehabilitation services.........................  $ 927,547     $793,038     $905,359
      Employee services...............................    394,193           --           --
      Elimination.....................................   (255,289)          --           --
                                                        ----------    --------     --------
      Total net revenues..............................  1,066,451      793,038      905,359
    Gross profit
      Rehabilitation services.........................    253,549      208,082      256,240
      Employee services...............................     12,238           --           --
      Elimination.....................................     (5,701)          --           --
                                                        ----------    --------     --------
      Total gross profit..............................    260,086      208,082      256,240
    Other operating expenses..........................    179,545      157,213      169,727
    Provision for restructure and other nonrecurring
      items...........................................         --       13,370      (57,368)
                                                        ----------    --------     --------
    Income from operations............................  $  80,541     $ 37,499     $143,881
                                                        ==========    ========     ========
</TABLE>
 
  Change in Estimate
 
     In the third quarter of fiscal 1996, the Company recorded a $10.5 million
charge to revenues to fully reflect payer allowances that had not been
sufficiently recognized by certain billing systems during the first three
quarters of fiscal 1996 and prior years. The Company has implemented a new
methodology for estimating allowances and commenced the implementation of a
fully integrated billing and allowance system. Systems implementation is
scheduled to be substantially completed in fiscal 1998.
 
                                       25
<PAGE>   28
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- (CONTINUED)
 
  Restructuring Charge
 
     The Company recorded provisions for restructure of $13.4 million and $29.9
million in fiscal 1996 and 1995, respectively. The 1996 and 1995 programs,
consisting of the consolidation and reorganization of the Company's outpatient
and O&P businesses, closing certain administrative offices, O&P branches and
outpatient rehabilitation centers in selected markets, and the consolidation of
certain finance and other administrative functions, are substantially complete.
The Company estimates that these plans would reduce or eliminate in the
aggregate approximately $30 million to $35 million of annual expenses.
 
     Of the total restructuring charges, $19.6 million related to amounts to be
paid in cash. The noncash portion of the charge related to the write-off of
certain assets, principally excess cost of net assets acquired, related to
facilities closed or to be closed.
 
  Sale of Medical Rehabilitation Hospitals
 
     Effective April 1, 1995, the Company sold its medical rehabilitation
hospitals in a transaction valued at $242.9 million. The transaction resulted in
a pretax gain on the sale of $88.2 million. The medical rehabilitation hospitals
contributed $110.6 million in net revenues, $31.3 million in gross profit and
$15.1 million in income from operations in fiscal 1995.
 
  Year Ended June 30, 1997 Compared With the Year Ended June 30, 1996
 
     Net revenues for the year ended June 30, 1997 increased from the prior year
by $273.4 million, or 34.5%, to $1.1 billion and gross profit increased $52.0
million, or 25.0%, to $260.1 million, primarily as a result of acquisitions,
internal growth and a prior year $10.5 million charge to revenues for a change
in estimate, as discussed further under "Operating Results by Business".
 
     Other operating expenses increased $22.3 million from $157.2 million for
the year ended June 30, 1996 to $179.5 million for the year ended June 30, 1997.
The increased costs are primarily associated with businesses acquired in fiscal
1997. As a percentage of net revenues, other operating expenses decreased from
19.8% to 16.8% for the same periods, respectively, principally as a result of
employee and facility cost savings from the productivity and cost reduction
programs initiated in fiscal 1996 and 1995.
 
     Depreciation expense increased to $24.4 million for the year ended June 30,
1997 from $23.3 million for the year ended June 30, 1996 primarily due to the
full year effect of assets acquired in fiscal 1996 and certain internally
developed software placed in service during fiscal 1997. Amortization expense
increased $3.6 million to $13.5 million from $9.9 million for the same periods,
respectively, as a result of businesses acquired in fiscal 1997 and the full
year effect of businesses acquired during fiscal 1996.
 
     Interest expense, net of investment income, increased $6.0 million compared
with the prior period principally as a result of decreased interest income due
to lower invested cash, and higher interest expense due to increased borrowings
in the fiscal 1997 compared with the fiscal 1996 as discussed under "Liquidity
and Capital Resources".
 
     Income tax expense as a percentage of pretax income decreased to 41.8% for
the year ended June 30, 1997 from 48.8% for the year ended June 30, 1996. The
decrease in the income tax rate resulted principally from the impact of
nondeductible amortization of excess cost of net assets acquired
("amortization") on lower income subject to income tax in fiscal 1996 as a
result of the provision for restructure and the charge to revenues. See Note 9
to the Consolidated Financial Statements for the reconciliation of expected tax
rate to actual tax expense.
 
                                       26
<PAGE>   29
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- (CONTINUED)
 
  Year Ended June 30, 1996 Compared to the Year Ended June 30, 1995
 
     Net revenues for fiscal 1996 decreased $112.3 million from fiscal 1995. The
decrease resulted principally from the inclusion of $110.6 million of net
revenues in fiscal 1995 from the medical rehabilitation hospitals sold in fiscal
1995 and the $10.5 million charge for the change in estimate in fiscal 1996.
 
     Gross profit decreased $48.2 million in fiscal 1996 compared to fiscal
1995. The decrease resulted principally from the inclusion of $31.3 million
gross profit in fiscal 1995 from the medical rehabilitation hospitals sold in
fiscal 1995 and the $10.5 million charge to revenues for the change in estimate
in fiscal 1996.
 
     See "Operating Results by Business -- Rehabilitation Services" below for a
further explanation of the comparison of net revenues and gross profit.
 
     Operating expenses in fiscal 1996 decreased $12.5 million compared to
fiscal 1995. The decrease resulted primarily from the inclusion of expenses of
$16.1 million from the medical rehabilitation hospitals sold in fiscal 1995,
coupled with expense savings from the cost reduction programs undertaken in
fiscal 1996 and 1995, which were offset, somewhat, by an increase in
depreciation.
 
     Depreciation expense increased to $23.3 million from $19.3 million for the
fiscal years 1996 and 1995, respectively. The increase was due primarily to the
full year effect of assets acquired in fiscal 1995 and certain internally
developed software, and other assets placed in service in fiscal 1996.
Amortization of excess cost of net assets acquired decreased by $1.1 million.
This decrease resulted from a reduction in the related assets being amortized
which were written off in the restructure charge.
 
     In fiscal 1996, the Company recorded a $13.4 million provision for
restructure pertaining to the consolidation and reorganization of its outpatient
businesses and certain administrative functions.
 
     Interest expense, net of interest income, decreased $10.4 million compared
with the prior period principally due to reduced amounts borrowed under the
Company's credit facility and increased cash invested, both as a result of the
sale of the medical rehabilitation hospitals.
 
     Income tax expense as a percentage of pretax income decreased to 48.8% for
the year ended June 30, 1996 from 50.7% for the previous year. The principal
reasons for the effective income tax rate being higher than the statutory
federal income tax rate were state income taxes, non-deductible nonrecurring
items and nondeductible amortization of excess cost of net assets acquired
("amortization"). See Note 9 to the Consolidated Financial Statements for the
reconciliation of expected tax expense to actual tax expense.
 
OPERATING RESULTS BY BUSINESS
 
  REHABILITATION SERVICES
 
     The following table displays the proforma results of operations,which have
been reclassified to conform to the fiscal 1997 presentation, for the Company's
rehabilitation services segment had the sale of the medical rehabilitation
hospitals occurred July 1, 1994 and excluding restructuring and other
nonrecurring charges:
 
<TABLE>
<CAPTION>
                                                                        PRO FORMA
                                                            ----------------------------------
                                                              1997       1996(1)        1995
                                                            --------     --------     --------
    <S>                                                     <C>          <C>          <C>
    Net revenues........................................    $927,547     $793,038     $794,716
    Gross profit........................................     253,549      208,082      224,957
    Gross profit %......................................        27.3%        26.2%        28.4%
</TABLE>
 
---------------
(1) Includes the $10.5 million charge for a change in estimate.
 
                                       27
<PAGE>   30
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- (CONTINUED)
 
  Year Ended June 30, 1997 Compared with the Year Ended June 30, 1996
 
     Net revenues for the year ended June 30, 1997 increased from the prior year
by $134.5 million, or 17.0%. Gross profit for the year ended June 30, 1997
increased from the prior year by $45.5 million, or 21.9%. Gross profit as a
percentage of net revenues increased from 26.2% for the year ended June 30, 1996
to 27.3% for the year ended June 30, 1997.
 
     The $134.5 million increase in net revenues resulted principally from: (i)
net revenues from businesses acquired, (ii) an increase in contract
rehabilitation net revenues resulting principally from new contract sales, (iii)
the $10.5 million prior year charge discussed previously, and (iv) an increase
in outpatient net revenues attributable to internal growth. These increases were
offset somewhat by a decrease in revenues attributable to outpatient facilities
closed or sold in fiscal 1997 and the full year effect of facilities closed,
sold or contributed to joint ventures in the prior year.
 
     The $45.5 million increase in gross profit was primarily due to: (i)
acquisitions in fiscal 1997 and the full year effect of acquisitions in fiscal
1996, (ii) new contracts, and (iii) an increase in productivity in the
outpatient and contract rehabilitation businesses. The increase of 1.1% in the
gross profit margin results principally from the increase in contract
rehabilitation and outpatient productivity, an increase in the outpatient gross
profit margin as a result of the consolidation and reorganization of certain
outpatient rehabilitation and orthotic and prosthetic operations commenced in
the third quarter of fiscal 1996 and the impact of the $10.5 million charge
discussed previously.
 
  Year Ended June 30, 1996 Compared with the Year Ended June 30, 1995
 
     Net revenues for the year ended June 30, 1996 decreased from the prior year
by $1.7 million to $793.0 million and gross profit decreased by $16.9 million,
or 7.5%, to $208.1 million. As previously described, net revenues and gross
profit were effected by a $10.5 million charge to net revenues for a change in
estimate. Excluding this charge, net revenues increased $8.8 million, or 1.1%,
gross profit decreased $6.4 million, or 2.8%, and gross profit margin decreased
to 27.6% from 28.4% in fiscal 1996 compared with fiscal 1995, respectively.
 
     The $8.8 million increase in net revenues in fiscal 1996 resulted
principally from: (i) an increase in contract rehabilitation pricing; (ii) an
increase in O&P net revenue per patient due to an increased mix of higher
revenue prosthetics; (iii) an increase in long-term care management and
consulting services; and (iv) the full year impact of the acquisition of 25
businesses in fiscal 1995, offset by a decrease in outpatient rehabilitation net
revenue per visit due to higher managed care contract mix.
 
     The $6.4 million decrease in gross profit and decrease in gross profit
margin in fiscal 1996 resulted principally from increased costs of competitive
compensation and benefits, and decreased productivity and pricing pressure in
outpatient rehabilitation services.
 
  EMPLOYEE SERVICES
 
  Year Ended June 30, 1997
 
     The Company's employee services segment provides human resource management
services to third party clients and the Company's rehabilitation services
segment. Inter-company activity is eliminated in consolidation.
 
     Net revenues from third party clients increased from $10.9 million in the
second quarter of fiscal year 1997 to $76.9 million in the fourth quarter of
fiscal year 1997. This increase is primarily attributable to an increase in the
weighted average number of worksite employees ("WSEs") from 1,757 to 16,656
during the same periods. The increases in WSEs is due principally to the
acquisition of three PEOs in the third quarter of
 
                                       28
<PAGE>   31
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- (CONTINUED)
 
fiscal 1997 with an aggregate 14,412 WSEs at the date of acquisition and an
approximate 16.7% internal growth in the number of WSEs since the acquisition
date (approximately a 40% annualized growth rate). Net revenues from employee
services provided to the Company's rehabilitation segment increased from $99.9
million in the third quarter of fiscal 1997 to $155.4 million in the fourth
quarter. The increase is due to a WSE increase from 15,546 to 16,061 and
approximately one month of additional service during the fourth quarter.
 
     Gross profit from third party clients increased from $0.8 million in the
second quarter to $3.2 million in the fourth quarter of fiscal year 1997. The
increase is attributable primarily to acquisitions and internal growth. Gross
profit pertaining to the Company's rehabilitation segment increased from $2.2
million in the third quarter to $3.5 million in the fourth quarter of fiscal
1997 due to the increased WSEs and the additional month of service.
 
     Overall, gross profit as a percentage of net revenues declined from 7.7%
during the second quarter of fiscal 1997 to 2.9% for the fourth quarter of
fiscal 1997. The primary reasons for the decrease in the gross profit percentage
are the increased salaries, wages and employment taxes per WSE, which increased
revenues but not gross profit dollars, and the relative impact of services
provided to the Company's rehabilitation segment, which has a lower gross profit
percentage (2.0%) due to a more highly compensated employee population.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     At June 30, 1997 cash and cash equivalents totaled $22.7 million, a
decrease of $73.0 million from $95.7 million at June 30, 1996. Cash generated
from operations decreased to $47.2 million in 1997 from $57.7 million in fiscal
1996, which was an increase from the $43.6 million generated in fiscal 1995. The
$10.5 million decrease in cash flow from operating activities from fiscal 1996
to 1997 resulted principally from a decrease in cash flows from accounts and
notes receivable of $41.2 million offset, somewhat, by an increase in cash flows
from net income of $23.6 million and $8.2 million of non-cash charges consisting
of depreciation, amortization and provision for doubtful accounts.
 
     The $14.1 million increase in cash flows from operating activities from
fiscal 1995 to 1996 resulted principally from the $9.0 million use of cash in
fiscal 1995 by the medical rehabilitation hospitals prior to their sale and the
following items (each before the effect on cash flows of the sale of the medical
rehabilitation hospitals and nonrecurring items): (i) an $11.6 million increase
in depreciation and amortization, non-cash charges, (ii) a $16.1 million
increase in income taxes due to the timing of payments for income taxes in
fiscal 1996 compared with fiscal 1995, (iii) an $11.4 million decrease in
accounts payable and accrued expenses due primarily to the timing of
compensation related expenses, and (iv) a $6.3 million decrease in net income.
 
     Investing activities, net of the effects of the sale of the medical
rehabilitation operations and the proceeds from the sale of marketable
securities of $88.2 million in fiscal 1995, used $187.8 million of cash in
fiscal 1997 compared to $51.7 million and $106.8 million in fiscal 1996 and
1995, respectively. Cash paid for acquisitions increased to $164.4 in fiscal
1997 compared to $20.8 million in fiscal 1996 which was a decline from the $71.8
million paid in fiscal 1995. Capital expenditures remained relatively constant
during the three year period ended June 30, 1997 at $21.7 million, $26.6
million, and $29.5 million, respectively, as the Company continued to invest in
internally and externally developed software and equipment needed for
technological efficiency in clinical and administrative activities in support of
clinical programs and outcomes, cost reduction initiatives and future growth
plans.
 
     The Company's major financing activities consisted of borrowing, net of
repayment, $87.0 million in fiscal 1997, whereas the Company repaid debt, net of
borrowings, of $33.6 million and $113.1 million in fiscal 1996 and 1995,
respectively. The net borrowing increase in fiscal 1997 was used principally to
fund acquisition activity. The proceeds from the sale of the medical
rehabilitation hospitals, cash generated from operations and excess cash, were
used to repay debt in fiscal 1996 and 1995.
 
                                       29
<PAGE>   32
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- (CONTINUED)
 
     The Company amended its bank credit facility in fiscal 1997 to extend the
term of the agreement from November 1997 to November 1999 and to increase the
amount available to $190.0 million. As of June 30, 1997, $72.7 million of the
credit facility was available after reduction of borrowings and letters of
credit of $7.7 million. The Company is presently renegotiating its credit
facility to further increase the amount available.
 
     The Company's growth strategy contemplates expansion of the outpatient,
occupational health and employee services businesses, and affiliation with
health care systems of providers and payers in target markets principally
through acquisitions and start-ups. Given the Company's cash position of $22.7
million at June 30, 1997 and debt capacity as suggested by its favorable debt to
total capital ratio of 40.3%, it is anticipated that the Company will take
advantage of its underleveraged position and ability to borrow. Cash payments
for acquired businesses under this strategy are expected to be approximately
$160 million in fiscal 1998. Capital expenditures are expected to be
approximately $35 million in fiscal 1998 as the Company acquires property and
equipment for the establishment of start-up outpatient and orthotic and
prosthetic facilities in selected markets and continues to invest in systems to
enhance clinical productivity, outcomes measurement and administrative
efficiencies.
 
     The Company believes that the cash flows generated by the Company's
operations together with its existing cash and availability of credit will be
sufficient to meet the Company's cash needs during fiscal 1998.
 
  Inflation
 
     A significant portion of the Company's operating expenses are subject to
inflationary increases, particularly therapist salary increases, which
historically have exceeded other medical industry salary rate increases due to
the existing supply shortage of therapists. The Company has historically been
unable to partially offset inflationary increases through charge increases, but
has somewhat mitigated the effect by expanding services and increasing operating
efficiencies. In the existing regulatory environment and to the extent that
inflation occurs in the future, it is uncertain whether the Company will be able
to pass on the increased costs associated with providing health care services to
customers insured by government or managed care payers. However, management
believes that the Company will be able to somewhat offset this potential impact
through business expansion and increasing operating efficiencies.
 
RECENTLY ISSUED ACCOUNTING STANDARDS
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities" ("SFAS 125") as amended
by the December 1996 issuance of Statement of Financial Accounting Standards No.
127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125"
("SFAS 127"). SFAS 125, as amended, provides accounting and reporting standards
for transfers and servicing of financial assets and extinguishments of
liabilities. Management does not believe the adoption of SFAS 125, as amended,
will have a material effect on the Company's financial position or results of
operations.
 
     In February 1997, the Financial Accounting Standards Board issued
Statements of Financial Accounting Standards No. 128, "Earnings Per Share"
("SFAS 128") which the Company is required to adopt no later than the second
quarter of fiscal year 1998. SFAS 128 established accounting standards for
computing and presenting earnings per share by replacing the presentation of
weighted shares outstanding, inclusive of common stock equivalents, with a dual
presentation of basic earnings per share which excludes dilution and diluted
earnings per share which includes the dilutive effect of all potentially
exercisable or convertible stock. Once adopted, SFAS 128 requires restatement of
all prior period earnings per share data. See Note 1 to the Consolidated
Financial Statements for the effect of adopting SFAS 128.
 
                                       30
<PAGE>   33
 
                        NOVACARE, INC. AND SUBSIDIARIES
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- (CONTINUED)
 
CAUTIONARY STATEMENT
 
     Except for historical information, matters discussed above are
forward-looking statements that are based on management's estimates, assumptions
and projections. Important factors that could cause results to differ materially
from those expected by management include the timing and nature of reimbursement
changes (including imposition of, and changes in, salary equivalency rates for
Medicare, changes in workers' compensation and other governmental rate and
reimbursement system changes), the number and productivity of clinicians,
decisions by chain customers as to whether to take therapy and other services
in-house, pricing of managed care and other third party contracts, the direction
and success of competitors, management retention and development, management's
success integrating acquired businesses and in developing and introducing new
products and lines of business, adverse Internal Revenue Service rulings with
respect to the employer status of PEOs, state legislative and regulatory efforts
to control PEOs, adverse uninsured health or workers' compensation expenses in
the PEO, and unanticipated market changes.
 
                                       31
<PAGE>   34
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                           AS OF JUNE 30,
                                                                       -----------------------
                                                                          1997          1996
                                                                       ----------     --------
<S>                                                                    <C>            <C>
ASSETS
Current assets:
  Cash and cash equivalents..........................................  $   22,716     $ 95,724
  Accounts receivable, net of allowance in 1997 and 1996 of $33,263
     and $18,995, respectively.......................................     256,477      192,636
  Inventories........................................................      18,450       13,948
  Deferred income taxes..............................................      13,939       14,875
  Other current assets...............................................      18,313       14,976
                                                                       ----------     --------
          Total current assets.......................................     329,895      332,159
Property and equipment, net..........................................      69,740       63,319
Excess cost of net assets acquired, net..............................     568,027      354,117
Investment in joint ventures.........................................      12,719       11,984
Deferred income taxes................................................       2,570        2,332
Other assets, net....................................................      31,353       25,820
                                                                       ----------     --------
                                                                       $1,014,304     $789,731
                                                                       ==========     ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Current portion of financing arrangements..........................  $   15,978     $  8,173
  Accounts payable and accrued expenses..............................     135,272       93,854
  Income taxes payable...............................................       5,069        6,420
                                                                       ----------     --------
          Total current liabilities..................................     156,319      108,447
Financing arrangements, net of current portion.......................     326,700      184,042
Deferred income taxes................................................      14,779        9,625
Other................................................................       4,851        2,451
                                                                       ----------     --------
          Total liabilities..........................................     502,649      304,565
                                                                       ----------     --------
Minority interests in consolidated subsidiaries......................       3,649          772
Commitments and contingencies........................................          --           --
Shareholders' equity:
  Common stock, $.01 par value; authorized 200,000 shares,
     issued 66,630 shares in 1997 and 66,091 shares in 1996..........         666          661
  Additional paid-in capital.........................................     259,915      253,918
  Retained earnings..................................................     292,340      253,430
                                                                       ----------     --------
                                                                          552,921      508,009
  Less:  Common stock in treasury (at cost), 5,590 shares in 1997
            and 3,190 shares in 1996.................................     (44,915)     (23,465)
          Deferred compensation......................................          --         (150)
                                                                       ----------     --------
          Total shareholders' equity.................................     508,006      484,394
                                                                       ----------     --------
                                                                       $1,014,304     $789,731
                                                                       ==========     ========
</TABLE>
 
        The accompanying Notes to Consolidated Financial Statements are
                     an integral part of these statements.
 
                                       32
<PAGE>   35
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                FOR THE YEARS ENDED JUNE 30,
                                                            ------------------------------------
                                                               1997          1996         1995
                                                            ----------     --------     --------
<S>                                                         <C>            <C>          <C>
Net revenues..............................................  $1,066,451     $793,038     $905,359
Cost of services..........................................     806,365      584,956      649,119
                                                            ----------     --------     --------
     Gross profit.........................................     260,086      208,082      256,240
Selling, general and administrative expenses..............     146,289      130,980      142,872
Provision for uncollectible accounts......................      19,708       16,359       15,918
Amortization of excess cost of net assets acquired........      13,548        9,874       10,937
Provision for restructure and other nonrecurring items....          --       13,370      (57,368)
                                                            ----------     --------     --------
     Income from operations...............................      80,541       37,499      143,881
Investment income.........................................       1,740        4,999        5,405
Interest expense..........................................     (15,244)     (12,536)     (23,298)
Minority interest.........................................        (236)         (96)        (404)
                                                            ----------     --------     --------
     Income before income taxes...........................      66,801       29,866      125,584
Income taxes..............................................      27,891       14,585       63,660
                                                            ----------     --------     --------
     Net income...........................................  $   38,910     $ 15,281     $ 61,924
                                                            ==========     ========     ========
     Net income per common share..........................  $      .62     $    .24     $    .95
                                                            ==========     ========     ========
     Weighted average number of common shares
       outstanding........................................      63,081       64,325       65,163
                                                            ==========     ========     ========
</TABLE>
 
        The accompanying Notes to Consolidated Financial Statements are
                     an integral part of these statements.
 
                                       33
<PAGE>   36
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                              COMMON
                                          SHARES ISSUED       STOCK                 ADDITIONAL              DEFERRED
                                        -----------------     ($.01      TREASURY    PAID-IN     RETAINED   COMPEN-    VALUATION
                                        COMMON   TREASURY   PAR VALUE)    STOCK      CAPITAL     EARNINGS    SATION    ALLOWANCE
                                        ------   --------   ----------   --------   ----------   --------   --------   ---------
<S>                                     <C>      <C>        <C>          <C>        <C>          <C>        <C>        <C>
Balance at June 30, 1994..............  64,228       (17)      $643      $   (305)   $240,619    $176,225    $ (662)     $(816)
Issued in connection with employee
  benefit plans.......................    302         52          4           453       3,497          --        --         --
Issued in connection with
  acquisitions........................    946         29          9           250       6,741          --        --         --
Reversal of valuation allowance.......     --         --         --            --          --          --        --        816
Repurchase of common stock............     --       (251)        --        (2,012)         --          --        --         --
Amortization of deferred
  compensation........................     --         --         --            --          --          --       249         --
Net income............................     --         --         --            --          --      61,924        --         --
                                        ------    ------       ----      --------    --------    --------     -----      -----
Balance at June 30, 1995..............  65,476      (187)       656        (1,614)    250,857     238,149      (413)        --
Issued in connection with employee
  benefit plans.......................    199        198          1         1,624       1,336          --        --         --
Issued in connection with
  acquisitions........................    416        203          4         1,478       1,725          --        --         --
Repurchase of common stock............     --     (3,404)        --       (24,953)         --          --        --         --
Amortization of deferred
  compensation........................     --         --         --            --          --          --       263         --
Net income............................     --         --         --            --          --      15,281        --         --
                                        ------    ------       ----      --------    --------    --------     -----      -----
Balance at June 30, 1996..............  66,091    (3,190)       661       (23,465)    253,918     253,430      (150)        --
ISSUED IN CONNECTION WITH EMPLOYEE
  BENEFIT PLANS.......................    539         17          5            11       4,284          --        --         --
ISSUED IN CONNECTION WITH
  ACQUISITIONS........................     --        344         --         2,474       1,713          --        --         --
REPURCHASE OF COMMON STOCK............     --     (2,761)        --       (23,935)         --          --        --         --
AMORTIZATION OF DEFERRED
  COMPENSATION........................     --         --         --            --          --          --       150         --
NET INCOME............................     --         --         --            --          --      38,910        --         --
                                        ------    ------       ----      --------    --------    --------     -----      -----
BALANCE AT JUNE 30, 1997..............  66,630    (5,590)      $666      $(44,915)   $259,915    $292,340        --         --
                                        ======    ======       ====      ========    ========    ========     =====      =====
</TABLE>
 
        The accompanying Notes to Consolidated Financial Statements are
                     an integral part of these statements.
 
                                       34
<PAGE>   37
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                         FOR THE YEARS ENDED JUNE 30,
                                                                     ------------------------------------
                                                                       1997          1996         1995
                                                                     ---------     --------     ---------
<S>                                                                  <C>           <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.........................................................  $  38,910     $ 15,281     $  61,924
Adjustments to reconcile net income to net cash flows from
  operating activities:
  Depreciation and amortization....................................     37,978       33,159        30,190
  Minority interest................................................        236           96           404
  Provision for uncollectible accounts.............................     19,708       16,359        15,918
  Deferred income taxes............................................      6,017        3,631        (1,525)
  Noncash portion of nonrecurring items............................         --        8,256        15,415
  Gain on sale of medical rehabilitation hospitals.................         --           --       (88,243)
  Changes in assets and liabilities, net of effects from
    acquisitions:
    Accounts and notes receivable..................................    (53,844)     (12,676)      (31,164)
    Inventories....................................................      2,502       (2,039)       (2,875)
    Other current assets...........................................     (1,434)          10         1,388
    Accounts payable and accrued expenses..........................       (725)      (6,152)       10,279
    Income taxes payable...........................................        110        1,553        28,982
    Other, net.....................................................     (2,217)         220         2,925
                                                                      --------     ---------    ---------
    Net cash flows provided by operating activities................     47,241       57,698        43,618
                                                                      --------     ---------    ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Payments for businesses acquired, net of cash acquired.............   (164,370)     (20,764)      (71,759)
Net additions to property and equipment............................    (21,653)     (26,621)      (29,529)
Net (payment for) proceeds from sale of medical rehabilitation
  hospitals........................................................         --      (13,208)      206,838
Proceeds from sales of investments.................................         --           --        88,151
Other, net.........................................................     (1,752)      (4,326)       (5,513)
                                                                      --------     ---------    ---------
    Net cash flows (used in) provided by investing activities......   (187,775)     (64,919)      188,188
                                                                      --------     ---------    ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt and credit arrangements...............    263,200          133        74,077
Payment of long-term debt and credit arrangements..................   (176,174)     (33,769)     (187,206)
Proceeds from common stock issued..................................      3,750        2,898         3,947
Payment for purchase of treasury stock.............................    (23,250)     (24,953)       (2,012)
                                                                      --------     ---------    ---------
    Net cash flows provided by (used in) financing activities......     67,526      (55,691)     (111,194)
                                                                      --------     ---------    ---------
Net (decrease) increase in cash and cash equivalents...............    (73,008)     (62,912)      120,612
Cash and cash equivalents, beginning of year.......................     95,724      158,636        38,024
                                                                      --------     ---------    ---------
Cash and cash equivalents, end of year.............................  $  22,716     $ 95,724     $ 158,636
                                                                      ========     =========    =========
</TABLE>
 
        The accompanying Notes to Consolidated Financial Statements are
                     an integral part of these statements.
 
                                       35
<PAGE>   38
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
     Nature of Operations:  NovaCare, Inc. is a national leader of physical
rehabilitation services and employee services. NovaCare's comprehensive medical
rehabilitation services include (i) providing rehabilitation therapy, subacute
and rehabilitation program consulting and management services on a contract
basis to health care institutions, primarily long-term care facilities, and (ii)
providing outpatient, orthotic and prosthetic ("O&P") and occupational health
rehabilitation services through a national network of patient care centers and
integrated delivery systems. The Company operated medical rehabilitation
hospitals until April 1, 1995, the effective date of the sale of such hospitals.
For the fiscal year ended June 30, 1995, the medical rehabilitation hospitals
represented 12% of the Company's consolidated net revenues.
 
     Employee services are generally provided to small and medium-sized
businesses and are comprehensive, fully integrated outsourcing solutions to
human resource management, including payroll management, workers' compensation,
risk management, benefits administration, unemployment services and human
resource consulting services.
 
     Principles of Consolidation:  The Consolidated Financial Statements include
the accounts of NovaCare, Inc., its majority-owned subsidiaries and companies
effectively controlled through management agreements (collectively, "NovaCare"
or the "Company"). Investments in 20% or more of the voting stock of an
affiliate are accounted for under the equity method. All significant
intercompany accounts and transactions have been eliminated.
 
     Reclassifications:  Certain amounts in the fiscal 1996 and 1995
consolidated financial statements have been reclassified to conform with the
fiscal 1997 presentation.
 
     Use of Estimates:  The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
In 1996, the Company recorded a $10.5 million charge to net revenues to reflect
payer allowances that had not been sufficiently recognized by certain billing
systems.
 
     Cash and Cash Equivalents:  The Company considers its holdings of highly
liquid debt and money-market instruments to be cash equivalents if the
securities mature within 90 days from the date of acquisition. These investments
are carried at cost, which approximates fair value.
 
     Net Revenues:  Rehabilitation services net revenues are reported at the net
realizable amounts from customers and third party payers. Net revenues generated
directly from Medicare and Medicaid reimbursement programs represented 12%, 12%
and 18% of the Company's consolidated net revenues for fiscal 1997, 1996, and
1995, respectively. Settlement amounts due to or receivable from Medicare and
Medicaid programs are determined by fiscal intermediaries. Management believes
that adequate provision has been made in the consolidated financial statements
for potential adjustments resulting from such determinations.
 
     Employee services revenues and related costs of wages, salaries, and
employment taxes pertaining to worksite employees are recognized in the period
in which the employee performs the service. Because the Company is at risk for
all of its direct costs, independently of whether payment is received from its
clients, and consistent with industry practice, all amounts billed to clients
for gross salaries and wages, related employment taxes, and health care and
workers' compensation coverage are recognized as revenue by the Company. The
Company establishes an allowance for doubtful accounts for both related and
third party accounts receivable based on prior experience.
 
                                       36
<PAGE>   39
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
     Inventories:  Inventories consist of customized orthotic and prosthetic
merchandise held for sale, work in process and raw materials and are carried at
the lower of cost or market. Cost of inventories is determined by the first-in,
first-out method.
 
     Property and Equipment:  Property and equipment are stated at cost.
Depreciation is provided on a straight-line basis over the estimated useful
lives of the assets, which principally range from three to seven years for
property and equipment and 30 to 40 years for buildings. Assets under capital
leases and leasehold improvements are amortized over the lesser of the lease
term or the asset's estimated useful life. Property and equipment also include
external and incremental internal costs incurred to develop major business
systems. Capitalized software costs are amortized on a straight-line basis over
three to five years.
 
     Excess Cost of Net Assets Acquired:  Assets and liabilities acquired in
connection with business combinations accounted for under the purchase method
are recorded at their respective fair values. Deferred taxes have been recorded
to the extent of the difference between the fair value and the tax basis of the
assets acquired and liabilities assumed. The excess of the purchase price over
the fair value of net assets acquired, including the recognition of applicable
deferred taxes, consists of non-compete agreements, customers lists, assembled
workforce and goodwill and is amortized on a straight-line basis over the
estimated useful lives of the assets which range from five to 40 years. The
Company performs a periodic assessment of the recoverability of goodwill based
on estimated future cash flows.
 
     Other Assets:  Other assets consist principally of investments in
affordable income housing partnerships, executive savings plan assets and
miscellaneous receivables. Investments in affordable income housing partnerships
are recorded at cost and are subject to an annual assessment as to carrying
value. The executive savings plan is a qualified savings plan offered to Company
executives. Contributions made to the fund by eligible employees are partially
matched by the Company. Withdrawals from the fund by employees are limited to
events specified by the plan document.
 
     Workers' Compensation:  The Company is contractually obligated to provide
workers' compensation coverage for its employees and co-employees. The Company
accomplishes this through a combination of various commercial insurance policies
and self insurance programs. The Company records estimated accruals for workers
compensation and health care claims, including estimates for incurred but not
reported claims, based upon review of the claims activity and past experience.
Management believes any differences which may arise between actual settlement of
claims and reserves at June 30, 1997 would not have a material impact on the
Company's financial position.
 
     On July 1, 1997, the Company entered into a three-year contract with a
commercial insurance company for workers' compensation coverage. Under this
program, the Company's rehabilitation segment worksite employees will continue
to be covered under a self insurance program. Third party worksite employees
will be covered under a fixed cost insurance program, which is subject to
certain per incident and aggregate deductibles.
 
     Income Taxes:  The Company records deferred tax assets and liabilities for
the expected future tax consequences of events that have been recognized in the
Company's financial statements or tax returns.
 
     Net Income Per Common Share:  Net income per common share has been computed
by dividing net income applicable to common stock by the weighted average number
of common shares outstanding during the year, giving effect to dilutive stock
options.
 
     Recently Issued Accounting Standards:  In June, 1996, the Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No.125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS 125") as amended by the December 1996
 
                                       37
<PAGE>   40
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
issuance of Statement of Financial Accounting Standards No. 127, "Deferral of
the Effective Date of Certain Provisions of SFAS No. 125" ("SFAS 127"). SFAS
125, as amended, provides accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities. Management
does not believe the adoption of SFAS 125, as amended, will have a material
effect on the Company's financial position or results of operations.
 
     In February 1997, the Financial Accounting Standards Board issued
Statements of Financial Accounting Standards No. 128, "Earnings Per Share"
("SFAS 128") which the Company is required to adopt no later than the second
quarter of fiscal year 1998. SFAS 128 establishes accounting standards for
computing and presenting earnings per share by replacing the presentation of
weighted shares outstanding, inclusive of common stock equivalents, with a dual
presentation of basic earnings per share which excludes dilution ("earnings per
share") and diluted earnings per share which includes the dilutive effect of all
potentially exercisable or convertible stock ("earnings per share assuming
dilution"). Once adopted, SFAS 128 requires restatement of all prior period
earnings per share data.
 
     The following represents the pro forma earnings per share which would be
required with the adoption of SFAS 128 for the three years ended June 30:
 
<TABLE>
<CAPTION>
                                                                           PRO FORMA
                                                                     ----------------------
                                                                     1997     1996     1995
                                                                     ----     ----     ----
    <S>                                                              <C>      <C>      <C>
    Earnings per share.............................................  $.64     $.24     $.96
    Earnings per share assuming dilution...........................   .62      .23      .93
</TABLE>
 
     While the effect of adopting SFAS 128 for fiscal years ended June 30, 1997,
1996 and 1995 is not material, Management believes that the effect to the first
quarter of fiscal 1998, once restated, may be material depending upon changes in
the Company's stock price.
 
2.   PROVISION FOR RESTRUCTURE AND OTHER NONRECURRING ITEMS
 
     The following table sets forth the Company's provision for restructure and
other nonrecurring items for the two years in the period ended June 30, 1996.
There were no nonrecurring items in fiscal 1997.
 
<TABLE>
<CAPTION>
                                                                       1996         1995
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Productivity and cost reduction programs:
      Employee severance costs.....................................  $  2,931     $  7,042
      Lease terminations...........................................     4,032        6,847
      Asset write-offs, net of estimated sale proceeds.............     5,965       15,415
      Other........................................................       442          571
    Gain on sale of medical rehabilitation hospitals...............        --      (88,243)
    Settlement of shareholder litigation...........................        --        1,000
                                                                     --------     --------
                                                                     $ 13,370     $(57,368)
                                                                     ========     ========
</TABLE>
 
     At June 30, 1997, approximately $5,286 remained accrued for the
productivity and cost reduction programs initiated in fiscal 1996 and 1995. The
1996 productivity and cost reduction programs pertained to the consolidation and
reorganization of the Company's outpatient and O&P operations and certain
administrative functions. The 1995 program consisted of closing certain contract
rehabilitation offices, O&P branches, and outpatient centers in selected markets
and the consolidation of certain finance and other administrative
 
                                       38
<PAGE>   41
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
functions. These programs are substantially complete. Of the amount accrued,
approximately $4,232 relates to the fiscal 1996 provision for restructure. The
remainder relates to the fiscal 1995 provision for restructure. The amounts
accrued at June 30, 1997, for both programs combined, relate primarily to lease
obligations on facilities which have been closed and the costs associated with
the closure of certain facilities which were sold in conjunction with the
restructure.
 
     Effective April 1, 1995, the Company sold its medical rehabilitation
hospitals for $242,888 which consisted of cash of $232,394, debt of $19,156, and
cash assumed by the purchaser of $8,662, respectively. Of the cash portion of
the purchase price, $16,894 was unpaid at June 30, 1995 and was included as a
component of other current assets. Substantially all of this amount was received
in July 1995. Had the sale of the medical rehabilitation hospitals taken place
on July 1, 1994, pro forma unaudited net revenues for the fiscal year ended June
30, 1995 would have been $794,716 and pro forma unaudited income from operations
would have been $40,504.
 
3.   ACQUISITION AND JOINT VENTURE TRANSACTIONS
 
     During the year ended June 30, 1997, the Company acquired 52 outpatient
businesses, including 33 which provide O&P rehabilitation services, and 19 which
provide outpatient rehabilitation services. The Company also acquired three
businesses, which provide occupational health services, and four professional
employer organizations ("PEO"). During fiscal year 1996, the Company acquired
seven businesses which provide outpatient rehabilitation services and six
businesses which provide orthotic and prosthetic rehabilitation services.
 
     The Company entered into two joint ventures in fiscal 1996. The carrying
value of these investments is $12,719 and $11,984 at June 30, 1997 and 1996,
respectively. The Company accounts for investments in joint ventures by the
equity method.
 
     The following unaudited pro forma consolidated results of operations of the
Company give effect to each of the acquisitions as if they occurred on July 1,
1995:
 
<TABLE>
<CAPTION>
                                                                    YEARS ENDED JUNE 30,
                                                                  -------------------------
                                                                     1997           1996
                                                                  ----------     ----------
    <S>                                                           <C>            <C>
    Net revenues................................................  $1,276,251     $1,217,419
    Net income..................................................      43,057         27,833
    Net income per common share.................................  $      .68     $      .43
</TABLE>
 
     The above pro forma information is not necessarily indicative of the
results of operations that would have occurred had the acquisition been made as
of July 1, 1995, or the results which may occur in the future.
 
     Information with respect to businesses acquired in purchase transactions
was as follows (the allocation for fiscal 1997 acquisitions is preliminary):
 
<TABLE>
<CAPTION>
                                                                        AS OF JUNE 30,
                                                                     ---------------------
                                                                       1997         1996
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Excess cost of net assets acquired.............................  $618,781     $391,324
    Less: accumulated amortization.................................   (50,754)     (37,207)
                                                                     --------     --------
                                                                     $568,027     $354,117
                                                                     ========     ========
</TABLE>
 
                                       39
<PAGE>   42
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                          YEARS ENDED
                                                                           JUNE 30,
                                                                     ---------------------
                                                                       1997         1996
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Cash paid (net of cash acquired).............................    $149,147     $  5,850
    Deferred purchase price obligations..........................      19,294           --
    Notes issued.................................................      44,275          990
    Other consideration..........................................       4,781           19
                                                                     --------     --------
                                                                      217,497        6,859
    Liabilities assumed..........................................      11,685          617
                                                                     --------     --------
                                                                      229,182        7,476
    Fair value of assets acquired, principally accounts
      receivable and property and equipment......................      19,501        1,430
                                                                     --------     --------
      Cost in excess of fair value of net assets acquired........    $209,681     $  6,046
                                                                     ========     ========
</TABLE>
 
     Certain purchase agreements require additional payments if specific
financial targets and non-financial conditions are met. Aggregate contingent
payments in connection with these acquisitions at June 30, 1997 of approximately
$42,112 in cash and 162 shares of common stock have not been included in the
initial determination of cost of the businesses acquired since the amount of
such contingent consideration, if any, is not presently determinable. During the
fiscal years ended June 30, 1997, 1996 and 1995, the Company paid $15,223,
$14,914 and $10,830, respectively, in cash and issued 344, 619 and 975 shares of
common stock, respectively, in connection with businesses acquired in prior
years.
 
     Deferred purchase price obligations represent guaranteed purchase price
amounts due to former owners of four businesses acquired. Obligations of $19,233
remained accrued at June 30, 1997, and are included in accounts payable and
accrued expenses. Approximately $17,500 of the total amount, is due upon the
earlier of the initial public offering of a NovaCare, Inc. subsidiary's,
NovaCare Employee Services, Inc., common stock or December 31, 1997.
 
4.   INVENTORIES
 
     Inventories consisted of the following:
 
<TABLE>
<CAPTION>
                                                                        AS OF JUNE 30,
                                                                     ---------------------
                                                                       1997         1996
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Materials and supplies.......................................    $ 12,569     $  9,730
    Work in process..............................................       4,509        3,355
    Finished goods...............................................       1,372          863
                                                                     --------     --------
                                                                     $ 18,450     $ 13,948
                                                                     ========     ========
</TABLE>
 
                                       40
<PAGE>   43
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
5.   PROPERTY AND EQUIPMENT
 
     The components of property and equipment were as follows:
 
<TABLE>
<CAPTION>
                                                                         AS OF JUNE 30,
                                                                      --------------------
                                                                        1997        1996
                                                                      --------     -------
    <S>                                                               <C>          <C>
    Land and buildings..............................................  $  3,983     $ 3,573
    Property, equipment and furniture...............................    84,733      65,401
    Capitalized software............................................    31,792      31,515
    Leasehold improvements..........................................    20,559      15,124
                                                                       -------     -------
                                                                       141,067     115,613
    Less: accumulated depreciation and amortization.................   (71,327)    (52,294)
                                                                       -------     -------
                                                                      $ 69,740     $63,319
                                                                       =======     =======
</TABLE>
 
     Depreciation expense, including depreciation of property under capital
lease, for fiscal 1997, 1996, 1995 was $24,430, $23,285, and $19,253,
respectively.
 
6.   ACCOUNTS PAYABLE AND ACCRUED EXPENSES
 
     Accounts payable and accrued expenses are summarized as follows:
 
<TABLE>
<CAPTION>
                                                                         AS OF JUNE 30,
                                                                      --------------------
                                                                        1997        1996
                                                                      --------     -------
    <S>                                                               <C>          <C>
    Accounts payable................................................  $ 13,647     $ 8,026
    Accrued compensation and benefits...............................    65,564      44,610
    Deferred and contingent purchase price obligations (Note 3).....    25,624          --
    Accrued workers' compensation and health claims.................     8,471       6,862
    Accrued costs of productivity and cost improvement programs
      (Note 2)......................................................     5,286       8,241
    Accrued interest................................................     1,002       4,868
    Other...........................................................    15,678      21,247
                                                                      --------     -------
                                                                      $135,272     $93,854
                                                                      ========     =======
</TABLE>
 
     The Company is self-insured for certain health benefits up to $150 per
individual per year. The Company expensed amounts for estimated losses occurring
from both asserted and unasserted claims. The estimate of the liability for
unasserted claims arising from unreported incidents is based on an analysis of
historical claims rates.
 
                                       41
<PAGE>   44
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
7.   FINANCING ARRANGEMENTS
 
     Financing arrangements consisted of the following:
 
<TABLE>
<CAPTION>
                                                                        AS OF JUNE 30,
                                                                     ---------------------
                                                                       1997         1996
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Convertible subordinated debentures (5.5%), due January 2000...  $175,000     $175,000
    $190,000 revolving credit facility (EuroDollar rate plus 0.5%
      to 1.125%), due November 28, 1999............................   109,600           --
    Subordinated promissory notes (5% to 10%), payable through
      2007.........................................................    56,859       15,516
    Notes (7.0% to 7.5%), payable through November 2000............       456          172
    Capitalized lease obligations, payable through 2016............       763        1,527
                                                                     --------     --------
                                                                      342,678      192,215
    Less: current portion..........................................    15,978        8,173
                                                                     --------     --------
                                                                     $326,700     $184,042
                                                                     ========     ========
</TABLE>
 
     The Company established a revolving credit facility with a syndicate of
lenders in fiscal 1996, which is collateralized by substantially all of the
Company's subsidiaries' common stock. During fiscal 1997, the credit agreement
was amended to extend the term of the agreement from November 1997 to November
1999 and to increase the available line of credit from $150,000 to $190,000. As
of June 30, 1997, $72,737 of the line of credit was available after reduction
for borrowings and letters of credit totaling $7,663. The revolving credit
facility arrangement requires the maintenance of minimum working capital and net
worth amounts as well as certain financial ratios. At June 30, 1997, the Company
was in compliance with these requirements. The Company is charged a commitment
fee of .25% per annum on the average daily available balance. The weighted
average borrowing rate for fiscal 1997 was 6.94%.
 
     The Company has issued $175,000 of convertible subordinated debentures due
January 15, 2000, priced at par to yield 5.5%. The debentures are convertible,
at the option of the holder, into shares of the Company's common stock at a
conversion price of $26.65 per share. The debentures are redeemable, in whole or
in part, at the option of the Company. There is no sinking fund applicable to
the debentures.
 
     The fair value of the Company's convertible subordinated debentures based
on quoted market prices at June 30, 1997 and 1996 was $164,500 and $154,875,
respectively. The estimated fair value of all other debt and financing
arrangements approximates carrying value.
 
     At June 30, 1997, aggregate annual maturities of financing arrangements
were as follows for the next five fiscal years and thereafter:
 
<TABLE>
<CAPTION>
        FISCAL YEAR
        -----------
        <S>                                                                 <C>
        1998..............................................................  $ 15,978
        1999..............................................................    13,820
        2000..............................................................   295,875
        2001..............................................................     8,314
        2002..............................................................     5,609
        Thereafter........................................................     3,082
                                                                            --------
                                                                            $342,678
                                                                            ========
</TABLE>
 
     Interest paid on debt during fiscal 1997, 1996 and 1995 amounted to
$18,120, $11,730 and $20,377, respectively.
 
                                       42
<PAGE>   45
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
8.   LEASES
 
     The Company is obligated under capital leases for office space and office,
transportation and therapy equipment. All other capital leases expire over the
next five years.
 
     Included in property and equipment in the accompanying Consolidated Balance
Sheets are the following assets held under capital leases:
 
<TABLE>
<CAPTION>
                                                                     AS OF JUNE 30,
                                                                   -------------------
                                                                    1997        1996
                                                                   -------     -------
        <S>                                                        <C>         <C>
        Property and equipment...................................  $ 3,316     $ 3,196
        Less: accumulated amortization...........................   (2,497)     (1,605)
                                                                   -------     -------
                                                                   $   819     $ 1,591
                                                                   =======     =======
</TABLE>
 
     The Company also rents office space and office, transportation and therapy
equipment under non-cancelable operating leases. In an effort to leverage its
purchasing power with lessors, the Company has leased and concurrently subleased
certain office space to companies which are controlled by the Company's
Chairman. The Company is fully reimbursed for its lease costs for the
aforementioned office space under non-cancelable sublease agreements.
 
     Future minimum lease commitments for all non-cancelable leases as of June
30, 1997 are as follows:
 
<TABLE>
<CAPTION>
                                                               CAPITAL   OPERATING    SUB-LEASE
                           FISCAL YEAR                         LEASES     LEASES     RECEIVABLES
    ---------------------------------------------------------  -------   ---------   -----------
    <S>                                                        <C>       <C>         <C>
    1998.....................................................  $   518    $27,965      $ 1,135
    1999.....................................................      172     23,725          731
    2000.....................................................       34     18,202          395
    2001.....................................................       17     12,856          175
    2002.....................................................        9      8,173          142
    Thereafter...............................................      123      7,393           83
                                                               -------    -------     --------
    Total minimum lease payments.............................      873    $98,314      $ 2,661
                                                                          =======     ========
    Less: amount representing interest.......................     (110)
                                                               -------
    Present value of minimum payments under capital lease
      obligations............................................  $   763
                                                               =======
</TABLE>
 
                                       43
<PAGE>   46
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
9.   INCOME TAXES
 
     The components of income tax expense were as follows:
 
<TABLE>
<CAPTION>
                                                                   YEARS ENDED JUNE 30,
                                                                ---------------------------
                                                                 1997      1996      1995
                                                                -------   -------   -------
    <S>                                                         <C>       <C>       <C>
    Current:
      Federal.................................................  $17,757   $ 8,048   $53,258
      State...................................................    4,117     2,906    11,927
                                                                -------   -------   -------
                                                                 21,874    10,954    65,185
                                                                -------   -------   -------
    Deferred:
      Federal.................................................    5,470     3,301    (1,182)
      State...................................................      547       330      (343)
                                                                -------   -------   -------
                                                                  6,017     3,631    (1,525)
                                                                -------   -------   -------
                                                                $27,891   $14,585   $63,660
                                                                =======   =======   =======
</TABLE>
 
     The components of net deferred tax assets as of June 30, 1997 and 1996 were
as follows:
 
<TABLE>
<CAPTION>
                                                                          1997      1996
                                                                        --------   -------
    <S>                                                                 <C>        <C>
    Accruals and reserves not currently deductible for tax purposes...  $ 12,557   $10,484
    Restructuring reserve.............................................     3,232     6,043
    Other.............................................................       720       680
                                                                        ---------  --------
      Gross deferred tax assets.......................................    16,509    17,207
                                                                        ---------  --------
    Expenses capitalized for financial statement purposes.............    (9,828)   (6,274)
    Depreciation and capital leases...................................    (3,586)   (2,589)
    Other, net........................................................    (1,365)     (762)
                                                                        ---------  --------
      Gross deferred tax liabilities..................................   (14,779)   (9,625)
                                                                        ---------  --------
      Net deferred tax asset..........................................  $  1,730   $ 7,582
                                                                        =========  ========
</TABLE>
 
     The reconciliation of the expected tax expense (computed by applying the
federal statutory tax rate to income before income taxes) to actual tax expense
was as follows:
 
<TABLE>
<CAPTION>
                                                                   YEARS ENDED JUNE 30,
                                                                ---------------------------
                                                                 1997      1996      1995
                                                                -------   -------   -------
    <S>                                                         <C>       <C>       <C>
    Expected federal income tax expense.......................  $23,380   $10,453   $43,954
    State income taxes, less federal benefit..................    3,244     2,108     7,530
    Non-deductible nonrecurring items.........................      549     1,027     9,178
    Non-deductible amortization of excess cost of net assets
      acquired................................................    2,974     2,011     2,370
    Dividend exclusion and non-taxable interest income........       59      (395)     (401)
    Other, net................................................   (2,315)     (619)    1,029
                                                                -------   -------   -------
                                                                $27,891   $14,585   $63,660
                                                                =======   =======   =======
</TABLE>
 
     Income taxes paid during fiscal 1997, 1996 and 1995 amounted to $21,981,
$38,699 and $37,604, respectively.
 
                                       44
<PAGE>   47
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
10. MINORITY INTEREST
 
     Minority interest resulted from investments in the following entities:
 
<TABLE>
<CAPTION>
                                                                             AS OF JUNE
                                                                                 30,
                                                                            -------------
                                                                             1997    1996
                                                                            ------   ----
    <S>                                                                     <C>      <C>
      NovaCare Employee Services, Inc.....................................  $3,334     --
      All other entities..................................................     315    772
                                                                            ------  -----
                                                                            $3,649   $772
                                                                            ======  =====
</TABLE>
 
     During fiscal 1997, one of the Company's consolidated subsidiaries,
NovaCare Employee Services, Inc., issued equity instruments on its own behalf.
The Company recognizes a minority interest liability for NovaCare Employee
Services, Inc. equity issued to third party investors plus the portion of
NovaCare Employee Services, Inc.'s net income attributable to those investors.
 
11. BENEFIT PLANS
 
  Stock Option Plan:
 
     The Company's stock option plan, as amended, provides for issuance of
options to purchase up to 5,800 shares of common stock to employees, officers
and directors. Under the plan, substantially all options are granted for a term
of up to 10 years at prices equal to the fair market value at the date of grant.
 
     In May 1996, the Board approved an option exchange whereby option holders
were allowed to acquire new options to purchase shares of common stock in
exchange for the surrender by such option holders of certain existing options
under the plan. The exchange formula took into account the vesting schedule and
exercise price of the surrendered options. Under the exchange program, 1,157
options were surrendered and 888 new options were granted. The options granted
as a result of the exchange vest over 5 years, although vesting can be
accelerated if the Company's stock price achieves certain levels.
 
     The following summarizes the activity of the stock option plan:
 
<TABLE>
<CAPTION>
                                                            YEARS ENDED JUNE 30,
                                               ----------------------------------------------
                                                   1997             1996             1995
                                               ------------     ------------     ------------
    <S>                                        <C>              <C>              <C>
    Options:
      Outstanding at beginning of year.......         3,188            2,649            2,771
      Granted................................           551            2,592            1,162
      Exercised..............................          (364)             (71)             (77)
      Canceled...............................          (475)          (1,982)          (1,207)
                                                -----------      -----------      -----------
      Outstanding at end of year.............         2,900            3,188            2,649
                                                ===========      ===========      ===========
    Option price per share ranges:
      Outstanding at beginning of year.......  $ .09-$20.58     $ .09-$21.00     $ .09-$23.50
      Granted................................   7.38- 13.38      5.75-  7.50      7.25- 13.00
      Exercised..............................    .09- 10.63       .09-  9.13       .09- 14.38
      Canceled...............................   2.00- 16.50       .12- 20.58       .12- 20.58
      Outstanding at end of year.............  $ .09-$20.58     $ .12-$20.58     $ .09-$21.00
    Options exercisable at end of year.......         1,464              363            1,109
    Exercisable option price ranges..........  $ .09-$20.58     $ .09-$20.58     $ .09-$21.00
    Options available for grant at end of
      year under stock option plan...........         1,034              982            1,601
</TABLE>
 
                                       45
<PAGE>   48
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
  Other Stock Option Awards:
 
     During 1997, the Board decided, subject to shareholder approval, to grant
to the President of the Company 850 options to purchase the Company's common
stock at an exercise price equal to the fair market value on the grant date.
 
     During May 1996, the Board also decided, subject to shareholder approval,
to offer certain officers of the Company a modified exchange. Under the modified
exchange, the Chairman received fewer options than would have been warranted
under the Black-Scholes formula while the Chief Executive Officer was offered an
exchange and additional options, resulting in a net reduction of outstanding
options of 909. The new options were at the same price and with the same vesting
term as the options issued pursuant to the exchange described above, except that
3,317 options of the 3,500 total options issued have a seven year term.
 
     The following summarizes the other stock option award activity:
 
<TABLE>
<CAPTION>
                                                            YEAR ENDED JUNE 30,
                                              -----------------------------------------------
                                                  1997             1996              1995
                                              ------------     -------------     ------------
    <S>                                       <C>              <C>               <C>
    Options:
      Outstanding at beginning of year......         3,554             4,704            4,708
      Granted...............................           850             3,500               --
      Exercised.............................            --                --               (4)
      Canceled..............................            --            (4,650)              --
                                              ------------     -------------     ------------
      Outstanding at end of year............         4,404             3,554            4,704
                                              ============     =============     ============
    Option price per share:
      Outstanding at beginning of year......  $ 2.25-$6.88     $ 2.25-$19.50     $2.25-$19.50
      Granted...............................         10.88              6.88               --
      Exercised.............................            --                --             2.25
      Canceled..............................            --       10.44-19.50               --
      Outstanding at end of year............  $2.25-$10.88     $  2.25-$6.88     $2.25-$19.50
    Options exercisable at end of year......         2,254                54            1,914
    Exercisable option price ranges.........  $2.25-$10.88     $  2.25-$4.88     $2.25-$19.50
</TABLE>
 
     The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123") and applies Accounting
Principles Board Opinion No. 25 and related interpretations in accounting for
the plans. The table below sets forth the proforma information as if the Company
had adopted the compensation recognition provisions of SFAS 123:
 
<TABLE>
<CAPTION>
                                                  1997             1996
                                              ------------     -------------
    <S>                                       <C>              <C>               <C>
    Decrease to:
      Net income............................        $5,268            $1,585
      Net income per common share...........        $  .08            $  .02
    Assumptions:
      Expected life (years).................           1.6               1.6
      Risk-free interest rate...............     4.2%-7.8%         4.2%-7.8%
      Volatility............................        43.93%            59.01%
      Dividend yield........................           N/A               N/A
</TABLE>
 
                                       46
<PAGE>   49
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
     The weighted average fair value per share of the stock options, calculated
using the Black-Scholes option pricing model, granted during the fiscal year
ended June 30, 1997 and 1996 is $10.59 and $6.76, respectively. The remaining
contractual life of all options granted as of June 30, 1997 is 7.29 years.
 
  Deferred Compensation:
 
     Deferred compensation represents common stock issued to certain key
employees wherein the recipient becomes fully vested at the end of a five-year
period. Compensation expense is charged to income over the vesting period.
 
  Retirement Plans:
 
     The Company has defined contribution 401(k) plans covering substantially
all of its employees. Company contributions for fiscal 1997, 1996 and 1995 were
$3,916, $3,634, and $3,878, respectively. The Company established a
non-qualified supplemental benefit plan covering certain key employees. The
Company's matching contribution was $224, $582 and $302 for fiscal 1997, 1996
and 1995, respectively.
 
12. FINANCIAL DATA BY BUSINESS SEGMENT
 
     Beginning in the second quarter of fiscal 1997, the Company operates in two
service industries, rehabilitation services and employee services as described
in Note 1 -- Nature of Operations.
 
     Income from operations by business segment is total net revenues less
operating expenses. In computing operating profit by business segment, none of
the following items has been added or deducted: other income, interest expense
or income taxes. Identifiable assets by segment are those assets that are used
in the Company's operations in each industry.
 
     Employee services revenues and the related costs of wages, salaries, and
employment taxes pertaining to worksite employees are recognized in the period
in which the employee performs the services. Because the Company is at risk for
all of its direct costs, independently of whether payment is received from its
clients, and consistent with industry practice, all amounts billed to clients
for gross salaries and wages, related employment taxes, and health care and
workers' compensation coverage are recognized as revenue by the Company.
 
     The Company's rehabilitation services segment is a client of the employee
services segment, resulting in the net revenues and asset eliminations.
 
                                       47
<PAGE>   50
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
     Operating results and other financial data are presented for the principal
business segments of the Company as follows:
 
<TABLE>
<CAPTION>
                                             REHABILITATION     EMPLOYEE
                                                SERVICES        SERVICES     ELIMINATION     CONSOLIDATED
                                             --------------     --------     -----------     ------------
<S>                                          <C>                <C>          <C>             <C>
YEAR ENDED JUNE 30, 1997:
  Net revenues.............................     $927,547        $394,193      $ (255,289)     $ 1,066,451
  Income from operations...................       77,610           2,931              --           80,541
  Depreciation expense.....................       24,265             165              --           24,430
  Net capital expenditures.................       21,324             329              --           21,653
AS OF JUNE 30, 1997
  Assets...................................     $945,653        $ 95,998      $  (27,347)     $ 1,014,304
</TABLE>
 
13. COMMITMENTS AND CONTINGENCIES
 
     The Company is subject to legal proceedings and claims which arise in the
ordinary course of its business. In the opinion of Management, the amount of
ultimate liability, if any, with respect to these actions will not have a
materially adverse effect on the financial position or results of operations of
the Company.
 
14. SHAREHOLDER RIGHTS PLAN
 
     Under the terms of a Shareholder Rights Plan adopted in 1995, the Company's
Board of Directors declared a dividend distribution of one right for each
outstanding common share. The rights may not be exercised or traded apart from
the common shares to which they are attached until 10 days after a person or
group has acquired, obtained the right to acquire, or commenced a tender offer
for, at least 20% of the Company's outstanding common shares. In such event,
each right will become exercisable for one common share at a price of $27. If a
person or group acquires, or obtains the right to acquire, 20% or more of the
Company's outstanding common shares, each right will become exercisable for
common shares worth $54 and the rights held by the acquiror will become null and
void. If the Company is involved in a merger and its common shares are changed
or exchanged, or if more than 50% of its assets or earnings power is sold or
transferred, each right will become exercisable for common stock of the acquiror
worth $54. The rights will expire on March 20, 2000 unless earlier redeemed by
the Company for $.001 per right. Subject to its right to extend the redemption
period, the Company may redeem the rights at any time until any person or group
has acquired, or obtained the right to acquire, at least 20% of the Company's
outstanding common shares.
 
15. SUBSEQUENT EVENTS
 
     One of the Company's subsidiaries, NovaCare Employee Services, Inc.
("NCES") plans to file a registration statement with the Securities and Exchange
Commission to register for the sale of up to 4,500 shares of its common stock.
NCES intends to use the net proceeds of the offering to satisfy $17,500 of
deferred purchase price obligations incurred in connection with NCES
acquisitions. The remaining net proceeds will be used for expansion of the NCES
operations, including further penetration of existing markets, and as
opportunities arise, to expand the NCES's client base in new or existing markets
through acquisitions, and to pay down debt under the Company's credit facility.
 
                                       48
<PAGE>   51
 
                        NOVACARE, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                                 JUNE 30, 1997
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
16. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
 
<TABLE>
<CAPTION>
                                                   FOURTH       THIRD        SECOND       FIRST
                                                  QUARTER      QUARTER      QUARTER      QUARTER
                                                  --------     --------     --------     --------
<S>                                               <C>          <C>          <C>          <C>
YEAR ENDED JUNE 30, 1997:
  Net revenues................................    $331,555     $290,454     $235,012     $209,430
  Gross profit................................      73,957       69,439       60,911       55,779
  Income from operations......................      25,506       21,222       18,795       15,018
  Net income..................................      12,057       10,093        9,216        7,544
  Net income per common share.................    $    .19     $    .16     $    .15     $    .12
YEAR ENDED JUNE 30, 1996:
  Net revenues................................    $202,551     $191,393     $200,957     $198,137
  Gross profit................................      55,018       42,972       55,209       54,883
  Income from operations......................      16,428       (9,549)      15,123       15,497
  Net income (loss)...........................       8,411       (8,580)       7,447        8,003
  Net income (loss) per common share..........    $    .13     $   (.13)    $    .12     $    .12
</TABLE>
 
     Results from the third quarter of fiscal 1996 included a $13,370 provision
for restructure and a $10,462 charge to fully reflect payer allowances that had
not been sufficiently recognized by certain billing systems.
 
                                       49
<PAGE>   52
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Shareholders of
  NovaCare, Inc.
 
     In our opinion, the consolidated financial statements listed under Item
14(a)(1) and (2) on page 51 present fairly, in all material respects, the
financial position of NovaCare, Inc. and its subsidiaries at June 30, 1997 and
1996, and the results of their operations and their cash flows for each of the
three years in the period ended June 30, 1997, in conformity with generally
accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
 
PRICE WATERHOUSE LLP
 
Philadelphia, PA
July 31, 1997
 
                                       50
<PAGE>   53
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURES
 
     The Registrant has had no changes in or disagreements with accountants on
accounting and financial disclosure of the type referred to in Item 304 of
Regulation S-K.
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     For information concerning this item, see "Item 1 -- Business -- Executive
Officers of the Registrant" and the table and text under the caption "Name of
Nominee and Biographical Information" and "Section 16(a) Beneficial Ownership
Reporting Compliance" of the Proxy Statement to be filed with respect to the
1997 annual meeting of shareholders to be held on October 30, 1997 (the "Proxy
Statement"), which information is incorporated herein by reference.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     For information concerning this item, see the table and text under the
captions "Compensation of Executive Officers of the Company", "Compensation of
Directors of NovaCare", "Compensation Committee Interlocks and Insider
Participation" and "Employment Agreements" of the Proxy Statement, which
information is incorporated herein by reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     For information concerning this item, see the table and text under the
captions "Shares of Common Stock Owned Beneficially as of August 31, 1997" and
"Information Concerning Certain Stockholders" of the Proxy Statement, which
information is incorporated herein by reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     For information concerning this item, see the text under the caption
"Certain Transactions" of the Proxy Statement, which information is incorporated
herein by reference.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
     (a) The following documents are filed as part of this report:
 
<TABLE>
<CAPTION>
                                                                                        PAGE
                                                                                       NUMBER
                                                                                       ------
    <S>       <C>                                                                      <C>
         (1)  FINANCIAL STATEMENTS:
              Consolidated Balance Sheets at June 30, 1997 and 1996................       32
              Consolidated Statements of Operations for the three years ended June
              30, 1997.............................................................       33
              Consolidated Statements of Changes in Shareholders' Equity for the
              three years ended June 30, 1997......................................       34
              Consolidated Statements of Cash Flows for the three years ended June
              30, 1997.............................................................       35
              Notes to Consolidated Financial Statements...........................       36
              Report of Independent Accountants....................................       50
         (2)  FINANCIAL STATEMENT SCHEDULES:
              II -- Valuation and Qualifying Accounts for each of the three years
              in the period ended June 30, 1997....................................       53
         (3)  EXHIBITS (NUMBERED IN ACCORDANCE WITH ITEM 601 OF REGULATION S-K):
              The exhibits required to be filed are listed in the index to
              exhibits.............................................................       54
</TABLE>
 
     (b) Current Reports on Form 8-K: (None)
 
                                       51
<PAGE>   54
 
                               POWER OF ATTORNEY
 
     The Registrant and each person whose signature appears below hereby appoint
John H. Foster and Timothy E. Foster as attorneys-in-fact with full power of
substitution, severally, to execute in the name and on behalf of the Registrant
and each such person, individually and in each capacity stated below, one or
more amendments to the annual report which amendments may make such changes in
the report as the attorney-in-fact acting in the premises deems appropriate and
to file any such amendment to the report with the Securities and Exchange
Commission.
                            ------------------------
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
 
                                          NOVACARE, INC.
 
                                          By:   /s/ ROBERT E. HEALY, JR.
                                            ------------------------------------
                                                   (ROBERT E. HEALY, JR.,
                                             SENIOR VICE PRESIDENT, FINANCE AND
                                                        ADMINISTRATION
                                                AND CHIEF FINANCIAL 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
-----------------------------------------------  ------------------------------------  -------------------
<C>                                              <S>                                   <C>
 
              /s/ JOHN H. FOSTER                 Chairman of the Board and Director    September 19, 1997
-----------------------------------------------
               (JOHN H. FOSTER)
             /s/ TIMOTHY E. FOSTER               Chief Executive Officer and Director  September 19, 1997
-----------------------------------------------
              (TIMOTHY E. FOSTER)
 
              /s/ JAMES W. MCLANE                President, Chief Operating Officer    September 19, 1997
-----------------------------------------------  and Director
               (JAMES W. MCLANE)
 
           /s/ ROBERT E. HEALY, JR.              Senior Vice President, Finance and    September 19, 1997
-----------------------------------------------  Administration and Chief Financial
            (ROBERT E. HEALY, JR.)               Officer
 
              /s/ BARRY E. SMITH                 Vice President, Controller and Chief  September 19, 1997
-----------------------------------------------  Accounting Officer
               (BARRY E. SMITH)
 
             /s/ E. MARTIN GIBSON                Director                              September 19, 1997
-----------------------------------------------
              (E. MARTIN GIBSON)
 
             /s/ SIRI S. MARSHALL                Director                              September 19, 1997
-----------------------------------------------
              (SIRI S. MARSHALL)
 
             /s/ STEPHEN E. O'NEIL               Director                              September 19, 1997
-----------------------------------------------
              (STEPHEN E. O'NEIL)
 
             /s/ GEORGE W. SIGULER               Director                              September 19, 1997
-----------------------------------------------
              (GEORGE W. SIGULER)
 
           /s/ ROBERT G. STONE, JR.              Director                              September 19, 1997
-----------------------------------------------
            (ROBERT G. STONE, JR.)
 
         /s/ DANIEL C. TOSTESON, M.D.            Director                              September 19, 1997
-----------------------------------------------
          (DANIEL C. TOSTESON, M.D.)
</TABLE>
 
                                       52
<PAGE>   55
 
                                                                     SCHEDULE II
 
                                 NOVACARE, INC.
 
                       VALUATION AND QUALIFYING ACCOUNTS
                    YEARS ENDED JUNE 30, 1996, 1995 AND 1994
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                             BALANCE AT   CHARGED TO                              BALANCE
                                             BEGINNING    COSTS AND                               AT END
               DESCRIPTION                   OF PERIOD     EXPENSES    OTHER      DEDUCTIONS     OF PERIOD
-----------------------------------------    ----------   ----------   ------     ----------     ---------
<S>                                          <C>          <C>          <C>        <C>            <C>
Year ended June 30, 1997:
  Allowance for uncollectible accounts...     $ 12,751       19,708    11,295(1)    (13,207)      $ 30,547
  Allowance for Medicare denials and
     other allowances....................     $  6,244           --     8,270(2)    (11,798)      $  2,716
Year ended June 30, 1996:
  Allowance for uncollectible accounts...     $ 16,023       16,359     1,187(1)    (20,818)      $ 12,751
  Allowance for Medicare denials and
     other allowances....................     $  3,695           --     9,018(2)     (6,469)      $  6,244
Year ended June 30, 1995:
  Allowance for uncollectible accounts...     $ 17,692       15,918       643(1)    (18,230)      $ 16,023
  Allowance for Medicare denials and
     other allowances....................     $ 15,039           --     5,887(2)    (17,231)      $  3,695
</TABLE>
 
---------------
(1) Allowances for doubtful accounts related to acquired receivables.
 
(2) Charged against net revenues.
 
                                       53
<PAGE>   56
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT                                                                                PAGE
NUMBER                              EXHIBIT DESCRIPTION                               NUMBER
-------   -----------------------------------------------------------------------   -----------
<S>       <C>                                                                       <C>
 3(a)*    Certificate of Incorporation of the Company, as amended to date               --
          (incorporated by reference to Exhibit 3(a) to the Company's Quarterly
          Report on Form 10-Q for the quarter ended March 31, 1992).
 3(b)     By-laws of the Company, as amended to date (incorporated by reference         --
          to Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the
          quarter ended September 30, 1995).
 4(a)     Stock Option Plan, as amended to date.
 4(b)*    Form of Indenture dated as of January 15, 1993 between the Company and        --
          Pittsburgh National Bank relating to 5 1/2% Convertible Subordinated
          Debentures Due 2000 (incorporated by reference to Exhibit 4 to
          Registration Statement on Form S-3 No. 33-55710).
 4(c)     Rights Agreement dated as of March 9, 1995 by and between NovaCare,           --
          Inc. and American Stock Transfer & Trust Company, as Rights Agent
          (incorporated by reference to Exhibit 99(a) to the Company's current
          report on Form 8-K dated March 14, 1995).
10(a)     (i) Employment Agreement dated as of July 1, 1994 between the Company         --
          and John H. Foster (incorporated by reference to Exhibit 10(b) to the
          Company's Quarterly Report on Form 10-Q for the quarter ended March 31,
          1995).
          (ii) Amendment dated February 2, 1995 to the employment agreement dated       --
          as of July 1, 1994 between the Company and John H. Foster (incorporated
          by reference to Exhibit 10(b) to the Company's Quarterly Report on Form
          10-Q for the quarter ended March 31, 1995).
10(b)     Employment Agreement dated as of January 6, 1995 between the Company          --
          and Daryl A. Dixon and Promissory Note of Daryl A. Dixon in favor of
          the Company dated January 6, 1995 (incorporated by reference to Exhibit
          10(i) to the Company's Annual Report on Form 10-K for the year ended
          June 30, 1995).
10(c)     Employment agreement dated as of January 24, 1996 between the Company         --
          and Ronald G. Hiscock (incorporated by reference to Exhibit 10 to the
          Company's Quarterly Report on Form 10-Q for the quarter ended March 31,
          1996).
10(d)     Employment agreement dated as of March 17, 1995 between the Company and       --
          Robert E. Healy, Jr. (incorporated by reference to Exhibit 10(i) to the
          Company's Annual Report on Form 10-K for the year ended June 30, 1996).
10(e)     Employment Agreement dated as of July 1, 1996 between the Company and
          Timothy E. Foster.
10(f)     Employment agreement dated as of October 9, 1996 between the Company          --
          and Barry E. Smith (incorporated by reference to Exhibit 10(c) to the
          Company's Quarterly Report on Form 10-Q for the quarter ended December
          31, 1997).
10(g)     Employment agreement dated as of October 16, 1996 between the Company         --
          and Aven Kerr (incorporated by reference to Exhibit 10(b) to the
          Company's Quarterly Report on Form 10-Q for the quarter ended December
          31, 1996).
10(h)     Employment Agreement dated as of April 14, 1997 between the Company and       --
          James W. McLane (incorporated by reference to Exhibit 10(a) to the
          Company's Quarterly Report on Form 10-Q for the quarter ended March 31,
          1997).
10(i)     Stock Purchase Agreement dated as of May 1, 1997 between NovaCare
          Employee Services, Inc. and James W. McLane.
</TABLE>
 
                                       54
<PAGE>   57
 
<TABLE>
<CAPTION>
EXHIBIT                                                                                PAGE
NUMBER                              EXHIBIT DESCRIPTION                               NUMBER
-------   -----------------------------------------------------------------------   -----------
<S>       <C>                                                                       <C>
10(j)     (i) Revolving Credit Facility Agreement dated as of May 27, 1994 by and       --
          among NovaCare and certain of its subsidiaries and PNC Bank, First
          Union National Bank of North Carolina, Mellon Bank, N.A., Nations Bank
          of North Carolina, N.A., CoreStates Bank, N.A., and National
          Westminster Bank, N.A. (incorporated by reference to Exhibit 10(g) to
          the Company's Quarterly Report on Form 10-Q for the quarter ended March
          31, 1994).
          (ii) Revolving Credit Facility Credit Agreement First Amendment dated         --
          as of September 20, 1994 by and among NovaCare and certain of its
          subsidiaries and PNC Bank, N.A., First Union National Bank of North
          Carolina, Mellon Bank, N.A., Nations Bank of North Carolina, N.A.,
          CoreStates Bank, N.A., and National Westminster Bank, N.A.
          (incorporated by reference to Exhibit 10(a) to the Company's Quarterly
          Report on Form 10-Q for the quarter ended December 31, 1994).
          (iii) Revolving Credit Facility Agreement Second Amendment dated as of        --
          November 28, 1994 by and among NovaCare and certain of its subsidiaries
          and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nations Bank of North Carolina, N.A., CoreStates Bank,
          N.A., National Westminster Bank, N.A., and Fleet Bank of Massachusetts,
          N.A. (incorporated by reference to Exhibit 10(b) to the Company's
          Quarterly Report on Form 10-Q for the quarter ended December 31, 1994).
          (iv) Revolving Credit Facility Agreement Third Amendment dated as of          --
          May 15, 1995 by and among NovaCare and certain of its subsidiaries and
          PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A.,
          NatWest Bank, N.A., and Fleet Bank of Massachusetts, N.A. (incorporated
          by reference to Exhibit 10 (a) to the Company's Quarterly Report on
          Form 10-Q for the quarter ended September 30, 1995).
          (v) Revolving Credit Facility Agreement Fourth Amendment dated as of          --
          May 19, 1995 by and among NovaCare and certain of its subsidiaries and
          PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A.,
          NatWest Bank, N.A., and Fleet Bank of Massachusetts (incorporated by
          reference to Exhibit 10 (a) to the Company's Quarterly Report on Form
          10-Q for the quarter ended September 30, 1995).
          (vi) Revolving Credit Facility Agreement Fifth Amendment dated as of          --
          June 30, 1996 by and among NovaCare and certain of its subsidiaries and
          PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates Bank, N.A., and
          Fleet Bank of Massachusetts. (incorporated by reference to Exhibit
          10(j)(vi) to the Company's Annual Report on Form 10-K for the year
          ended June 30, 1996).
          (vii) Revolving Credit Facility Agreement Sixth Amendment dated as of         --
          June 30, 1996 by and among NovaCare and certain of its subsidiaries and
          PNC Bank, N.A., CoreStates Bank, N.A., First Union National Bank of
          North Carolina, Fleet Bank of Massachusetts, N.A., Mellon Bank, N.A.
          and Nationsbank, N.A. (incorporated by reference to Exhibit 10(j)(vii)
          to the Company's Annual Report on Form 10-K for the year ended June 30,
          1996).
          (viii) Revolving Credit Facility Agreement Seventh Amendment dated as         --
          of November 4, 1996 by and among NovaCare and certain of its
          subsidiaries and PNC Bank, N.A., First Union National Bank of North
          Carolina, Mellon Bank, N.A., Nationsbank, N.A. (Carolina), CoreStates
          Bank, N.A., and Fleet Bank of Massachusetts, N.A. (incorporated by
          reference to Exhibit 10(a) to the Company's Quarterly Report on Form
          10-Q for the quarter ended September 30, 1996).
          (ix) Revolving Credit Facility Agreement Eighth Amendment dated as of
          January 30, 1997 by and among NovaCare and certain of its subsidiaries
          and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet Bank of
          Massachusetts, N.A., The Bank of New York, and SunTrust Bank (Central
          Florida), N.A.
</TABLE>
 
                                       55
<PAGE>   58
 
<TABLE>
<CAPTION>
EXHIBIT                                                                                PAGE
NUMBER                              EXHIBIT DESCRIPTION                               NUMBER
-------   -----------------------------------------------------------------------   -----------
<S>       <C>                                                                       <C>
          (x) Revolving Credit Facility Agreement Ninth Amendment dated as of
          January 30, 1997 by and among NovaCare and certain of its subsidiaries
          and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet Bank of
          Massachusetts, N.A., The Bank of New York, and SunTrust Bank (Central
          Florida), N.A.
          (xi) Revolving Credit Facility Agreement Tenth Amendment dated as of
          March 31, 1997 by and among NovaCare and certain of its subsidiaries
          and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet National
          Bank, The Bank of New York, and SunTrust Bank (Central Florida), N.A.
          (xii) Revolving Credit Facility Agreement Eleventh Amendment dated as
          of June 27, 1997 by and among NovaCare and certain of its subsidiaries
          and PNC Bank, N.A., First Union National Bank of North Carolina, Mellon
          Bank, N.A., Nationsbank, N.A., CoreStates Bank, N.A., Fleet National
          Bank, The Bank of New York, SunTrust Bank (Central Florida), N.A., and
          Bank One (Kentucky), N.A.
10(k)     Supplemental Benefits Plan as amended to date.
13        Annual Report to Shareholders for the fiscal year ended June 30, 1997.
21        Subsidiaries of the Company.
23        Consent of Independent Accountants.
24        Power of Attorney (see "Power of Attorney" in Form 10-K).                     --
27        Financial Data Schedules.
</TABLE>
 
     Copies of the exhibits filed with this Annual Report on Form 10-K or
incorporated by reference herein do not accompany copies hereof for distribution
to shareholders of the Company. The Company will furnish a copy of any of such
exhibits to any stockholder requesting the same.
 
     Exhibits denoted by an asterisk were filed prior to the Company's adoption
of filing via EDGAR.
 
                                       56