
<PAGE>   1





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

                                  FORM 10-QSB

(MARK ONE)

   X             QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
 -----                    SECURITIES EXCHANGE ACT 1934
                  FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1996


                 TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
 -----                    SECURITIES EXCHANGE ACT 1934
            FOR THE TRANSITION PERIOD FROM              TO          
                                           ------------    ---------

COMMISSION FILE NUMBER 0-10521

                              QUEST MEDICAL, INC.
       (Exact name of Small Business Issuer as specified in its charter)


               TEXAS                                    75-1646002
  -------------------------------                   ------------------
  (State or other jurisdiction of                   (I.R.S. Employer 
  incorporation or organization)                    Identification No.)

                   ONE ALLENTOWN PARKWAY, ALLEN, TEXAS 75002
                  --------------------------------------------
                    (Address of principal executive offices)
                                   (Zip Code)

                                 (214) 390-9800
               -------------------------------------------------
                (Issuer's Telephone Number, including area code)

Check whether the issuer: (1) filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days.  
YES X   NO
   ---    ---

State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date:

                                                NUMBER OF SHARES OUTSTANDING AT
     TITLE OF EACH CLASS                                   JULY 26, 1996
- ----------------------------                    --------------------------------
COMMON STOCK, $.05 PAR VALUE                                 8,283,885
<PAGE>   2




                     QUEST MEDICAL, INC. AND SUBSIDIARIES


                              TABLE OF CONTENTS



<TABLE>
         <S>                                                                         <C>
         PART I. FINANCIAL INFORMATION                                               2

                 Consolidated Balance Sheets
                          June 30, 1996 and December 31, 1995                      3-4


                 Consolidated Statements of Operations
                          For the Three Months and Six Months
                          ended June 30, 1996 and 1995                               5


                 Consolidated Statements of Cash Flows
                          For the Six Months ended
                          June 30, 1996 and 1995                                     6


                 Consolidated Statements of Stockholders'
                          Equity                                                     7


                 Notes to Condensed Consolidated
                          Financial Statements                                    8-15


                 Management's Discussion and Analysis of
                          Financial Condition and Results of
                          Operations                                             16-21


         PART II.         OTHER INFORMATION                                      22-23

                          Item 4. Submission of Matters to a
                                  Vote of Security Holders                          22


                          Item 6. Exhibits and Reports on
                                  Form 8-K                                          23

         SIGNATURES                                                                 24
</TABLE>





                                       1
<PAGE>   3





                                    PART I


                             FINANCIAL INFORMATION





                                       2
<PAGE>   4



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                      JUNE 30, 1996 AND DECEMBER 31, 1995

<TABLE>
<CAPTION>
                                                                                 JUNE 30,             DECEMBER 31,
                                                                                   1996                  1995
 ASSETS                                                                        (UNAUDITED)
 ------                                                                      ----------------      -----------------
 <S>                                                                            <C>                    <C>
 Current assets:
  Cash and cash equivalents                                                     $   337,928             $ 1,325,630
  Marketable securities                                                           2,336,544               2,588,547
  Receivables:                                                          
      Trade accounts, less allowance for doubtful accounts of               
         $114,337 in 1996 and $114,337 in 1995                                    5,172,416               4,955,235
   Interest and other                                                               232,965                 128,492
                                                                                -----------             -----------
                                                                                
    Total receivables                                                             5,405,381               5,083,727
                                                                                -----------             -----------
                                                                                
  Inventories:                                                          
      Raw materials                                                               2,509,862              2,743,702
      Work-in-process                                                             2,169,201              1,077,529
      Finished goods                                                              2,246,172              2,285,961
                                                                                -----------            -----------
                                                                                
    Total inventories                                                             6,925,235              6,107,192
                                                                                -----------            -----------
                                                                                
  Deferred income taxes                                                             446,346                356,703
  Prepaid expenses and other current assets                                       1,195,420              1,226,268
                                                                                -----------            -----------
                                                                                
    Total current assets                                                         16,646,854             16,688,067
                                                                                -----------            -----------
                                                                                
 Property, plant and equipment:                                                 
  Land                                                                            1,930,289              1,930,289
  Building and improvements                                                       5,298,224              5,271,718
  Furniture and fixtures                                                          3,453,425              2,964,471
  Machinery and equipment                                                         4,404,521              3,879,802
                                                                                -----------            -----------
                                                                                 15,086,459             14,046,280
                                                                                
  Less accumulated depreciation and amortization                                  4,273,312              3,784,510
                                                                                -----------            -----------
                                                                                
    Net property, plant and equipment                                            10,813,147             10,261,770
                                                                                -----------            -----------
                                                                                
 Cost in excess of net assets acquired, net of                                  
   accumulated amortization of $571,212 in 1996                          
   and $340,300 in 1995                                                           9,569,047              9,546,298
 Patents, net of accumulated amortization of                                    
   $1,199,210 in 1996 and $1,086,433 in 1995                                      1,176,189              1,288,966
 Purchased technology from acquisitions, net of                                
   accumulated amortization of $572,166 in 1996                           
   and $413,558 in 1995                                                           4,125,834              4,284,442
 Tradenames, net of accumulated amortization                                    
   of $156,250 in 1996 and $93,750 in 1995                                        2,343,750              2,406,250
 Other assets, at cost, less accumulated amortization                           
   of $190,000 in 1996 and $178,667 in 1995                                           9,931                 19,964
                                                                                -----------            -----------
                                                                                $44,684,752            $44,495,757
                                                                                ===========            ===========
</TABLE>

  See accompanying notes to condensed consolidated financial statements





                                       3
<PAGE>   5



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                      JUNE 30, 1996 AND DECEMBER 31, 1995

<TABLE>
<CAPTION>
                                                                                  JUNE 30,               DECEMBER 31,
                                                                                   1996                     1995
   LIABILITIES AND STOCKHOLDERS' EQUITY                                         (UNAUDITED)
   ------------------------------------                                      -----------------         -----------------
   <S>                                                                            <C>                      <C>
   Current liabilities:
    Accounts payable                                                                1,173,030                1,210,265
                                                                                                                      
    Short-term notes payable and current maturities
      of long-term notes payable                                                    1,889,553                1,616,311
    Accrued salary and employee benefit costs                                         631,954                  630,908
    Accrued relocation costs                                                           35,297                  291,370
    Other accrued expenses                                                            648,431                  755,976
                                                                                  -----------              -----------

      Total current liabilities                                                     4,378,265                4,504,830
                                                                                  -----------              -----------

   Notes payable                                                                    8,445,309                8,558,297
   Deferred income taxes                                                              495,998                  562,580

   Stockholders' equity:
    Common stock of $.05 par value.  Authorized
      25,000,000 shares in 1996 and 10,000,000 in 1995;
      issued 8,276,158 shares in 1996 and 8,147,349 in 1995                           413,808                  407,367
    Additional paid-in capital                                                     38,642,959               38,253,670
    Retained earnings (deficit)                                                    (7,560,174)              (7,579,925)
    Unrealized loss on marketable securities net of
      tax benefit of $67,697 in 1996 and $108,729 in 1995                            (131,413)                (211,062)
                                                                                  -----------              -----------

      Total stockholders' equity                                                   31,365,180               30,870,050


   Commitments and contingencies                                                                                      
                                                                                  -----------              -----------

                                                                                  $44,684,752              $44,495,757
                                                                                  ===========              ===========         
</TABLE>


   See accompanying notes to condensed consolidated financial statements





                                       4
<PAGE>   6



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
        FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 1996 AND 1995


<TABLE>
<CAPTION>
                                                              THREE MONTHS ENDED                      SIX MONTHS ENDED
                                                                   JUNE 30,                               JUNE 30,
                                                        ------------------------------        -------------------------------
                                                           1996                1995               1996                1995
                                                        ----------       -------------        ------------      -------------
<S>                                                     <C>              <C>                  <C>               <C>
Net revenue                                             $6,669,619       $   7,231,494        $12,818,745       $  11,303,134
Cost of revenue                                          2,737,704           2,883,138          5,389,854           4,910,490
                                                        ----------       -------------        ------------      -------------

         Gross profit                                    3,931,915           4,348,356          7,428,891           6,392,644
                                                        ----------       -------------        ------------      -------------

Operating expenses:
         Marketing                                       1,649,590           1,064,933          3,061,583           1,593,570
         General and administrative                      1,191,502           1,150,895          2,355,346           1,917,753
         Research and development                          872,845           1,407,906          1,769,188           2,493,643
         Purchased research and development                     --          10,500,000                 --          10,500,000
                                                        ----------       -------------        ------------      -------------
                                                         3,713,937          14,123,734          7,186,117          16,504,966
                                                        ----------       -------------        ------------      -------------

         Earnings (loss) from operations                   217,978          (9,775,378)           242,774         (10,112,322) 
                                                        ----------       -------------        ------------      -------------

Other income (expenses):
         Interest expense                                 (195,008)           (573,705)          (373,088)           (730,971)
         Interest and other income                          47,400              94,646            114,235             217,956
         Gain on sale of marketable securities
           and assets                                       52,305               5,729             62,529              12,031
                                                        ----------       -------------        ------------      -------------
                                                           (95,303)           (473,330)          (196,324)           (500,984)
                                                        ----------       -------------        ------------      ------------- 

         Earnings (loss) before income taxes               122,675         (10,248,708)            46,450         (10,613,306)

Income taxes                                                 8,352                  --             26,699                  --
                                                        ----------       -------------        ------------      -------------

         Net earnings (loss)                            $  114,323       $ (10,248,708)       $     19,751      $ (10,613,306)
                                                        ==========       =============        ============      =============

Net earnings (loss) per common and
         common equivalent share:                       $      .01       $       (1.66)       $        --       $      (1.85)
                                                        ==========       =============        ============      =============

Weighted average number of common and
         common equivalent shares used in
         computing earnings (loss) per share:            8,910,712           6,175,188          8,548,211           5,738,825
</TABLE>




See accompanying notes to condensed consolidated financial statements





                                       5
<PAGE>   7



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
                FOR THE SIX MONTHS ENDED JUNE 30, 1996 AND 1995


<TABLE>
<CAPTION>
                                                                                           SIX MONTHS ENDED
                                                                                               JUNE 30,
                                                                                -------------------------------------
                                                                                     1996                   1995
                                                                                -------------          --------------
    <S>                                                                          <C>                    <C>
    Cash flows from operating activities:
             Net earnings (loss)                                                 $     19,751           $ (10,613,306)
                                                                                 ------------           -------------
             Adjustments to reconcile net earnings (loss) to
                     net cash provided by operating activities:
             Depreciation and amortization                                          1,066,932                 806,163
              Purchased research and development                                           --              10,500,000
              Gain on sale of assets and marketable
                     securities                                                       (62,529)                (12,031)
             Deferred income taxes                                                    (66,582)                      --
             Changes in assets and liabilities, net of assets acquired
               and liabilities assumed:
                     Receivables                                                     (321,654)             (1,173,982)
                     Inventories                                                     (818,043)               (564,376)
                     Prepaid expenses and other assets                                 27,548                (297,415)
                     Accounts payable                                                 (37,235)              1,028,402
                     Other                                                                 --                  11,555
                     Accrued expenses                                                (746,907)                 89,835
                                                                                 ------------           -------------
                     Total adjustments                                               (958,470)             10,388,151
                                                                                 ------------           -------------
                     Net cash used in operating activities                           (938,719)               (225,155)
                                                                                 ------------           -------------

    Cash flows from investing activities:
             Purchases of marketable securities                                    (1,138,272)             (1,082,992)
             Proceeds from sales of marketable securities                           1,571,679               2,305,969
             Acquisition of Neuromed, Inc.                                                 --             (16,330,085)
             Additions to property, plant and equipment                            (1,040,179)               (994,707)
             Net proceeds from sale of assets                                           1,805                   2,600
                                                                                 ------------           -------------
                     Net cash used by investing activities                           (604,967)            (16,099,215)
                                                                                 ------------           -------------

    Cash flows from financing activities:
             Exercise of stock options                                                395,730                 279,829
             Proceeds from short-term obligations                                     328,881                 633,588
             Proceeds of long-term debt                                                    --              16,550,000
             Payment of long-term debt                                                (73,799)               (540,997)
             Payment of short-term obligations                                        (94,828)               (387,656)
             Issuance of tresury stock                                                     --                     529
                                                                                 ------------           -------------
                     Net cash provided by financing activities                        555,984              16,535,293
                                                                                 ------------           -------------
             Net increase (decrease) in cash and cash equivalents                    (987,702)                210,923

    Cash and cash equivalents at beginning of year                                  1,325,630                  87,963
                                                                                 ------------           -------------
    Cash and cash equivalents at June 30                                             $337,928                $298,886
                                                                                 ------------           -------------

    Supplemental cash flow information is presented below:

    Income taxes paid                                                            $         --           $          --
                                                                                 ============           =============

    Interest paid                                                                $    330,067           $     699,953
                                                                                 ============           =============
</TABLE>

    See accompanying notes to condensed consolidated financial statements





                                       6
<PAGE>   8


                                        
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
                                                                                                      
                                                                                            Unrealized                             
                                                                Additional     Retained       loss on                  Total stock-
                                        Common Stock             paid-in       earnings)    marketable     Treasury      holders'  
                                  Shares            Amount       capital       (deficit     securities      stock         equity   
                                  ------------------------      ----------    ----------    ----------  ------------  --------------
 <S>                                <C>            <C>          <C>           <C>            <C>
 Balance at December 31, 1992       7,871,543      $393,577     $18,484,031   $  4,613,941   $       --  $(5,852,194)  $ 17,639,355
         Shares issued upon
                  exercise             67,898         3,395         116,361             --           --            --       119,756
                  of stock
                  options
         Purchase of 100,000
                  common shares,           --            --              --             --           --     (349,004)      (349,004)
                  at cost
         Issuance of 1,490
                  common shares            --            --              --             --           --        7,402          7,402
         Tax effect of stock
                  option                   --            --         187,236             --           --           --        187,236
                  exercise
         Adjustment to
                  unrealized               --            --              --             --     (169,308)          --       (169,308)
                  losses
                  on marketable
                  securities
         Net earnings                                    --              --        816,345           --           --        816,345
                                    ---------      --------     -----------   ------------   ----------  -----------   ------------

 Balance at December 31, 1993       7,939,441       396,972      18,787,628      5,430,286     (169,308)  (6,193,796)    18,251,782
         Shares issued upon
                  exercise             43,057         2,153         134,894             --           --           --        137,047
                  of stock
                  options
         Issuance of 1,882
                  common shares            --            --           5,595             --           --        4,075          9,670
                  from treasury
         Adjustment to
                  unrealized               --            --              --             --     (748,236)          --       (748,236)
                  losses
                  on marketable
                  securities
         Stock dividend                    --            --         586,054       (916,975)          --      330,921             --
         Net loss                          --            --              --     (1,719,193)          --           --     (1,719,193)
                                    ---------      --------     -----------   ------------   ----------  -----------   ------------

      Balance at December 31, 1994  7,982,498       399,125      19,514,171      2,794,118     (917,634)  (5,858,800)    15,930,980
         Shares issued upon
                  exercise            160,422         8,021         361,429             --           --           --        369,450
                  of stock
                  options
         Issuance of 245 common
                  shares from              --            --           1,216             --           --          529          1,745
                  treasury
         Adjustment to
                  unrealized               --            --              --             --      706,572           --        706,572
                  losses
                  on marketable
                  securities
         Issuance of 1,033,333
                  common shares
                  from treasury            --            --       6,779,285             --           --    2,237,246      9,016,531
                  for
                  acquisition
         Sale of treasury and
                  new common
                  shares in             4,429           221      11,597,569             --           --    3,621,025     15,218,815
                  public
                  offering, net
                  of offering
                  costs
         Net loss                         --             --              --    (10,374,043)          --           --    (10,374,043)
                                    ---------      --------     -----------   ------------   ----------  -----------   ------------

Balance at December 31, 1995        8,147,349       407,367      38,253,670     (7,579,925)    (211,062)          --     30,870,050
         Shares issued upon
                  exercise            128,809         6,441         389,289             --           --           --        395,730
                  of stock
                  options
         Adjustment to
                  unrealized               --            --              --             --       79,649           --         79,649
                  losses
                  on marketable
                  securities
         Net earnings                      --            --              --         19,751           --           --         19,751
                                    ---------      --------     -----------   ------------   ----------  -----------   ------------

 Balance at June 30, 1996           8,276,158      $413,808     $38,642,959   $ (7,560,174)  $ (131,413) $        --   $ 31,365,180
                                    =========      ========     ===========   ============   ==========  ===========   ============
</TABLE>



 See accompanying notes to condensed consolidated financial statements





                                       7
<PAGE>   9
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1)      BUSINESS

         Quest Medical, Inc. and its subsidiaries (the "Company") design,
         develop, manufacture and market a variety of healthcare products used
         primarily in cardiovascular surgery, interventional pain management
         and intravenous fluid delivery applications.  The Company's revenues
         are derived primarily from sales throughout the United States, Europe
         and Australia.

         The research and development, manufacture, sale and distribution of
         medical devices is subject to extensive regulation by various public
         agencies, principally the Food and Drug Administration and
         corresponding state, local and foreign agencies.  Product approvals
         and clearances can be delayed or withdrawn for failure to comply with
         regulatory requirements or the occurrence of unforeseen problems
         following initial marketing.  While the Company received clearance for
         the MPS system during March 1996, for example, there can be no
         assurance that such clearance will not be withdrawn in the future.

         In addition, the Company's products are purchased primarily by
         hospitals and other users which then bill various third party payors
         including Medicare, Medicaid, private insurance companies and managed
         care organizations.  These third party payors reimburse fixed amounts
         for services based on a specific diagnosis.  The impact of changes in
         third party payor reimbursement policies and any amendments to
         existing reimbursement rules and regulations which restrict or
         terminate the eligibility of the Company's products could have an
         adverse impact on the Company's financial condition and results of
         operations.

(2)      CONDENSED FINANCIAL STATEMENTS

         The unaudited consolidated financial information contained in this
         report reflects all adjustments (consisting of normal recurring
         accruals) considered necessary, in the opinion of management, for a
         fair presentation of results for the interim periods presented. 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 these estimates.

         Certain information and footnote disclosures normally included in
         financial statements prepared in accordance with generally accepted
         accounting principles have been condensed or omitted. These financial
         statements should be read in conjunction with the financial statements
         and notes thereto included in the Company's December 31, 1995 Annual
         Report on Form 10-KSB.  The results of operations for periods ended
         June 30 are not necessarily indicative of operations for the full
         year.

         The consolidated financial statements include the accounts of Quest
         Medical, Inc. and subsidiaries (the "Company").  All significant
         intercompany balances and transactions have been eliminated in
         consolidation.

         Revenue from product sales is recognized at the time the product is
         shipped.





                                       8
<PAGE>   10
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         Cash equivalents include certificates of deposit and short-term,
         highly liquid debt instruments with original maturities of three
         months or less.

         The Company's marketable equity and debt securities are classified as
         available-for-sale and are carried at fair value, with the unrealized
         gains and losses reported in a separate component of stockholders'
         equity.  The amortized cost of debt securities in this category is
         adjusted for amortization of premiums and accretion of discounts to
         maturity.  Such amortization is included in investment income.
         Realized gains and losses and declines in value judged to be
         other-than-temporary are included in other income.  The cost of
         securities sold is based on the specific identification method.
         Interest and dividends are included in investment income.

         Inventories are recorded at the lower of standard cost or market.
         Standard cost approximates actual cost determined on the first-in,
         first-out (FIFO) basis.

         Property, plant and equipment are stated at cost.  Major renewals and
         betterments are capitalized; maintenance and repairs are charged to
         operations as incurred. Provisions for depreciation and amortization
         of property, plant and equipment are computed using the straight-line
         method using estimated useful lives of 3 to 30 years.

         The excess of costs over the net assets of businesses acquired is
         amortized on a straight line basis over the estimated useful lives of
         20 to 25 years.  The Company assesses the recoverability of this
         intangible asset, as well as other intangible assets, primarily based
         on its current and anticipated future undiscounted cash flows.  At
         June 30, 1996, the Company does not believe there has been any
         impairment of its intangible assets.

         Cost of purchased patents is amortized on a straight-line basis over
         the estimated useful lives (4 to 14 years) of such patents. Costs of
         patents which are the result of internal development are charged to
         current operations.

         The cost of purchased technology related to acquisitions is based on
         appraised values at the date of acquisition and is amortized on a
         straight-line basis over the estimated useful lives (10 to 15 years)
         of such technology.

         The cost of purchased tradenames is based on appraised values at the
         date of acquisition and is amortized on a straight-line basis over the
         estimated useful life (20 years) of such tradenames.

         Product development costs including start-up, research and
         development, advertising and promotional costs are charged to
         operations in the year in which such costs are incurred.

         Primary and fully diluted loss per share for the three months and six
         months ended June 30, 1996 are based upon 8,910,712 and 8,548,211
         common and common equivalent shares outstanding, respectively. Primary
         and fully diluted loss per share for the three months and six months
         ended June 30, 1995 are based upon 6,175,188 and 5,738,825 common and
         common equivalent shares outstanding, respectively. Common stock
         equivalents are outstanding stock options and are included in average
         common and





                                       9
<PAGE>   11
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         common equivalent shares outstanding using the treasury stock method
         except during periods where their effect would be antidilutive.

         Deferred income taxes are recorded based on the liability method and
         represent the tax effect of the differences between the financial and
         tax basis of assets and liabilities other than costs in excess of the
         net assets of businesses acquired.

(3)      ACQUISITION

         On March 31, 1995, the Company acquired for $15,403,263 cash
         (excluding $1,062,414 of related acquisition and financing costs) and
         833,333 shares of Quest common stock valued at $6,458,331, all of the
         capital stock of Neuromed, Inc. ("Neuromed"). The transaction also
         provided for contingent consideration over the following two years,
         payable in a combination of cash and additional shares of Quest common
         stock in January 1996 and January 1997, depending on sales of
         Neuromed's products reaching certain objectives.  Financing for the
         cash portion of the purchase price was provided by a bank. (See Note
         5.)

         In July 1995, the sales objectives for 1995 were reached which
         triggered a liability for the 1995 contingent consideration payments
         with regard to the Neuromed acquisition.  The Company recorded the
         additional "earn-out" consideration of 200,000 shares of Quest common
         stock valued at $2,558,200 and a $1,500,000 liability.  In addition,
         in September 1995, the Company amended certain terms of the
         acquisition agreement whereby the Company agreed to accelerate
         issuance of the 200,000 shares for the 1995 earn-out and the seller
         relinquished certain rights from the previous agreement.  The amended
         agreement sets the 1996 contingent consideration, payable in January
         1997, at a cash payment equal to $3,370,000, if earned.

         The acquisition was accounted for by the purchase method of
         accounting.  The allocation of the purchase price among identifiable
         tangible and intangible assets was based upon a risk adjusted income
         approach.  The cost in excess of net assets acquired is being
         amortized on a straight line basis over twenty years.

         Purchased in-process research and development was identified and
         valued through extensive interviews and analysis of data concerning
         Neuromed's products under development.  Expected future cash flows for
         products under development were discounted taking into account
         economic risks associated with the inherent difficulties and
         uncertainty in completing the products, and thereby achieving
         technological feasibility, and risks related to the viability of and
         potential changes in future target markets.  This resulted in
         $10,500,000 of purchased research and development which had not yet
         achieved technological feasibility and does not have alternative uses.
         Therefore, in accordance with generally accepted accounting
         principles, the $10,500,000, with no related tax benefit, was charged
         to expense during the three months ended June 30, 1995.





                                       10
<PAGE>   12
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         The purchase price allocation for the acquisition of Neuromed, as of
June 30, 1996, is summarized below:

<TABLE>
         <S>                                       <C>
         Tradenames                                $  2,500,000
         Purchased technology                         4,000,000
         Cost in excess of net assets acquired        9,127,052
         Purchased research and development          10,500,000
         Net tangible assets acquired                   386,389
         Deferred financing costs                       468,767
                                                   ------------
                                                   $ 26,982,208
                                                   ============
</TABLE>

         In connection with the purchase, the Company determined that the
         operations of Neuromed would be relocated to the Company's facility in
         Allen, Texas by the end of the first quarter of 1996.  The relocation
         was completed in March 1996 and the Company incurred $1,234,335 of
         relocation costs which were recorded as an adjustment to cost in
         excess of net assets acquired.

         The following unaudited pro forma summary presents the results of
         operations as if the acquisition had occurred on January 1, 1995.
         This summary does not purport to be indicative of what would have
         occurred had the acquisition been made as of this date or of results
         which may occur in the future.  This method of combining the companies
         is for the presentation of unaudited pro forma summary results of
         operations.  Actual statements of operations of Quest Medical and of
         Neuromed have been combined from the effective date of the acquisition
         forward.

<TABLE>
<CAPTION>
                                                               THREE MONTHS              SIX MONTHS
                                                                   ENDED                    ENDED
                                                               JUNE 30, 1995            JUNE 30, 1995
                                                               -------------            -------------
         <S>                                                     <C>                     <C>
         Pro forma revenue                                       $7,231,494              $13,961,433
         Pro forma earnings from operations                         724,622                1,398,081
                                                                 ----------              -----------
         Pro forma net earnings                                     262,451                  532,876
                                                                 ----------              -----------
         Pro forma net earnings per common
                 and equivalent share                                  $.04                     $.09
                                                                 ==========              ===========
</TABLE>

         The pro forma operations information excludes the charge of
         $10,500,000 ($1.72 per share) related to purchased in-process research
         and development which was expensed at the date of acquisition.





                                       11
<PAGE>   13
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(4)      MARKETABLE SECURITIES

         The following is a summary of available-for-sale securities at June
30, 1996:

<TABLE>
<CAPTION>
                                                                   GROSS            GROSS
                                                                 UNREALIZED      UNREALIZED        ESTIMATED
                                                  COST             GAINS           LOSSES          FAIR VALUE
                                                  ----             -----           ------          ----------
          <S>                                 <C>                 <C>            <C>              <C>
          Investment grade preferred
            securities                        $  885,600          $    --        $(122,588)       $  763,012
          Publicly traded limited
            partnerships                         211,250              500          (11,250)          200,500
          Real estate investment
            trusts                               772,058           10,182          (94,743)          687,497
          Other                                  666,747           88,652          (69,864)          685,535
                                              ----------          -------        ---------        ----------
                                              $2,535,655          $99,334        $ 298,445        $2,336,544
                                              ==========          =======        ==========       ==========
</TABLE>

         At June 30, 1996, no individual security represented more than 15% of
         the total portfolio or 2% of total assets.  The Company did not have
         any investments in derivative financial instruments at June 30, 1996.

(5)      CURRENT AND LONG-TERM DEBT

         On March 31, 1995, the Company entered into a loan agreement (the
         "Loan Agreement") with a bank providing for $15 million in senior term
         financing, which was utilized to pay substantially all of the cash
         portion of the Neuromed purchase price and a working capital line of
         up to $5 million. Borrowings under both facilities bore interest at
         prime plus 125 basis points, or at the Company's option, LIBOR plus
         300 basis points.  The interest rate could be reduced based on the
         Company achieving certain ratios of senior bank debt to EBITDA
         (earnings before interest, taxes, depreciation and amortization).  The
         facilities were collateralized by certain of the Company's assets,
         including accounts receivable, inventory, equipment, furniture and
         other fixed assets, patents, trademarks and other intangible property,
         and the Neuromed common stock, but excluding marketable securities in
         excess of $2 million, and excluding the real property, building, and
         equipment which collateralize their long-term financing described
         below.  The Company was subject to certain covenants related to the
         Loan Agreement including the maintenance of a minimum current ratio,
         ratio of debt to net worth (as defined) and restrictions on the
         payment of cash dividends. During December 1995, the Company repaid in
         its entirety the senior term loan utilizing net proceeds it received
         from a public offering (See Note 7).

         In February 1996, the Company amended the working capital line of
         credit and added a $15 million acquisition line of credit with the
         same bank.  Under the amended agreement, the working capital line of
         credit is collateralized by the Company's accounts receivable and
         inventory and the acquisition line, if drawn upon, will be
         collateralized by the Company's remaining unencumbered assets.  These
         facilities will expire on December 31, 1997 and will bear interest at
         the prime rate plus 25 basis points or LIBOR plus 200 basis points, at
         the Company's discretion.  The interest rate can be reduced based on
         the Company achieving certain ratios of senior bank debt to EBITDA.
         Advances under the





                                       12
<PAGE>   14
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         acquisition line are immediately converted to a five-year term loan.
         The Company is subject to certain covenants related to these
         facilities.  Significant covenants include the maintenance of minimum
         ratios of current maturities coverage ratio, fixed charge ratio and
         total liabilities to tangible net worth ratio (as defined).  The
         Company is also restricted on the payment of cash dividends to 75% of
         annual net earnings if no draws exist under the acquisition line and
         25% of annual net earnings if the acquisition line has been drawn
         upon.  At June 30, 1996, the Company had advances in the amount of
         $4,550,000 outstanding under the working capital line with a weighted
         average interest rate of 7.13%.  The Company has not drawn upon the
         acquisition line of credit.

         At June 30, 1996, the Company had a note payable in the amount of
         $1,500,000 related to "earn-out" consideration for Neuromed, Inc. (See
         Note 3).  Although the note was due and payable in January 1996 and
         was non-interest bearing, the Company has withheld payment of the note
         pending arbitration of certain purchase price adjustment disputes
         between the Company and Neuromed's former principal owner, Mr. William
         Borkan.

         On December 28, 1993, the Company entered into two agreements for
         long-term financing on their principal office and manufacturing
         facility in the amount of $4,355,071.  The first agreement, in the
         amount of $3,000,000, is related to the building.  This loan bore
         interest through 1995 at an adjustable rate based on the 30-day
         commercial paper rate plus 300 basis points.  Effective January 1996,
         the Company fixed the rate of interest for the remainder of the term
         of the loan at 8.59%.  This note has a 25-year amortization.  The
         Company has the option of prepaying this note during years 6-10,
         subject to certain provisions. The loan is collateralized by the Allen
         facility building and land and has an unpaid balance of $2,945,233 at
         June 30, 1996.  The second agreement, in the amount of $1,355,071, is
         related to certain equipment and furnishings. This loan bore interest
         through 1995 at an adjustable rate based on the 30-day commercial
         paper rate plus 250 basis points.  Effective January 1996, the Company
         fixed the rate of interest for the remainder of the term of the loan
         at 7.94%. This note has a 10-year amortization.  This loan is
         collateralized by the equipment and furnishings purchased with the
         proceeds and has an unpaid balance of $1,105,576 at June 30, 1996.

         At June 30, 1996, the Company had a 7.75% note payable for $234,053.
         This note was secured by certain of the Company's marketable
         securities investments, held by an investment company, which had a
         carrying value of $745,125.  Borrowings under this note are restricted
         to 50% of the market value of the Company's marketable securities held
         by the investment company.  At June 30, 1996, the amount available for
         additional borrowing under this note was $138,059.

(6)      FEDERAL INCOME TAXES

         At June 30, 1996, general business credits of $834,348 and alternative
         minimum tax credits of $134,284 are available to offset future tax
         liabilities.  If unused, the general business credits expire in
         various amounts beginning in 1997 through 2010.





                                       13
<PAGE>   15
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(7)      STOCKHOLDERS' EQUITY

         At June 30, 1996 the Company has outstanding stock purchase rights
         attached to each outstanding share of common stock.  The rights are
         not exercisable or transferable apart from the common stock until ten
         days after a public announcement that a person or group, with certain
         exceptions, either (1) has acquired or has obtained the right to
         acquire 15% or more of the Company's outstanding shares of common
         stock, or (2) has commenced or announced an intention to commence a
         tender offer or exchange offer for 20% or more of the outstanding
         shares of common stock.  Until a right is exercised, the holder of a
         right, as such, will have no rights as a stockholder of the Company,
         including, without limitation, the right to vote as a stockholder or
         receive dividends. Under the rights agreement, the number of shares
         issuable upon exercise of the rights are subject to adjustment by the
         Company in order to prevent dilution.  The purchase price (as defined
         in the rights agreement) for each one-half share of common stock
         purchased pursuant to the exercise of the right is $12.50.  Under
         certain circumstances described in the rights agreement, the holder
         will be entitled to receive, upon exercise of the right at the current
         exercise price, that number of shares of common stock of the Company
         or acquiring Company having a market value of two times the exercise
         price of the right.  The rights may be redeemed in whole by the
         Company at a price of $0.01 per right at any time prior to their
         expiration on October 12, 1999, or prior to the point at which they
         become exercisable.

         In the fourth quarter of 1995, the Company sold 1,676,667 shares in a
         public offering.  Net proceeds to the Company were $15.2 million of
         which $13.9 million was used to repay the senior term bank debt
         incurred in connection with the Neuromed acquisition.

(8)      COMMITMENTS AND CONTINGENCIES

         The Company has no material commitments under noncancellable operating
         leases. Total rent expense under operating leases for the three months
         ended June 30, 1996 and 1995 was $14,408 and $36,789, respectively,
         and $51,625 and $47,670 for the six months ended June 30, 1996 and
         1995, respectively.

         As a consequence of the Neuromed Acquisition in March 1995, the
         Company is currently a party to certain product liability claims
         related to SCS devices sold by Neuromed prior to the acquisition.
         Product liability insurers have assumed responsibility for defending
         the Company against these claims, subject to reservation of rights in
         certain cases.  Although the Company is entitled to contractual
         indemnification from Neuromed's former owner with respect to any
         losses exceeding its product liability insurance coverage, there can
         be no assurances that the Company will not incur significant monetary
         liability to the claimants if such insurance or indemnification is
         unavailable or inadequate for any reason, or that the Company's SCS
         business and new SCS product lines will not be adversely affected by
         these product liability claims.

         Except for such product liability claims and other ordinary routine
         litigation incidental or immaterial to its business, the Company is
         not currently a party to any other pending legal proceeding.  The
         Company maintains general liability insurance against risks arising
         out of the normal course of business.





                                       14
<PAGE>   16


(9)      FINANCIAL INSTRUMENTS, RISK CONCENTRATION, AND MAJOR CUSTOMERS

         In the United States, the Company's accounts receivable are due
         primarily from hospitals and distributors located throughout the
         country.  Internationally, the Company's accounts receivable are due
         primarily from distributors located in Europe and Australia.  The
         Company generally does not require collateral for trade receivables.
         The Company maintains an allowance for doubtful accounts based upon
         expected collectibility. Any losses from bad debts have historically
         been within management's expectations.

(10)     EMPLOYEE BENEFIT PLANS

         The Company has a defined contribution retirement savings plan (the
         "Plan") available to substantially all employees.  The Plan permits
         employees to elect salary deferral contributions of up to 15% of their
         compensation and requires the Company to make matching contributions
         equal to 50% of the participants' contributions, to a maximum of 6% of
         the participants' compensation.  The expense of the Company's
         contribution was $38,250 and $25,050 for the three months ended June
         30, 1996 and 1995, respectively, and $76,500 and $50,100 for the six
         months ended June 30, 1996 and 1995, respectively.





                                       15
<PAGE>   17



                      MANAGEMENT'S DISCUSSION AND ANALYSIS
                OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The following discussion of the financial condition and results of operations
of the Company should be read in conjunction with the Condensed Consolidated
Financial Statements of the Company and the related Notes thereto.

RESULTS OF OPERATIONS

COMPARISON OF THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 1996 AND 1995

Revenues.  Net revenue of $6.67 million for the three months ended June 30,
1996, was $562,000, or 7.8% below the level for the comparable 1995 period of
$7.23 million.  This decrease was primarily the result of lower unit sales
volume at the Company's Neuromed subsidiary which was acquired on March 31,
1995 and provides electronic spinal cord stimulation ("SCS") devices used to
manage chronic severe pain.  See Note 3 of the Notes to Condensed Consolidated
Financial Statements.  SCS revenue decreased 14% during the three months ended
June 30, 1996 compared to the prior year same period.  Net revenue from sales
of the Company's other products decreased 1.8%, or $67,000, during the three
months ended June 30, 1996 compared to the corresponding period a year ago,
primarily due to lower unit sales volume from the Company's specialized tubing
sets.  For the six months ended June 30, 1996, net revenue of $12.82 million
was $1.52 million, or 13.5%, above the comparable 1995 level of $11.30 million.
This increase during 1996 compared to 1995 was attributable to revenue
generated by Neuromed which provided six months of revenue during the 1996
period compared to only three months during the 1995 period. Net revenue from
sales of the Company's other products decreased 5.6%, or $434,000, primarily
due to lower unit sales volume from the Company's specialized tubing sets.

During the second quarter, management determined that to transform Neuromed
into an industry leader and compete effectively in the SCS market, Neuromed
must build an infrastructure to handle the future growth of the business.
Accordingly, the Company took the following steps toward that goal: (1)
relocated and integrated Neuromed's operations from Ft. Lauderdale, Florida to
the Company's corporate facility in Allen, Texas, (2) hired a new president of
Neuromed with significant experience in implantable devices, (3) reorganized
Neuromed's management team and distribution network, (4) improved Neuromed's
existing products to meet the Company's standard of quality, (5) began
designing training, customer support and sales and marketing materials and
videos, (6) completed customer requirements for next generation spinal cord
stimulation devices and (7) licensed implantable drug pump technology. For the
remainder of 1996 and into 1997, the Company expects to continue building
Neuromed's infrastructure to enable Neuromed to achieve its long-term
objectives of sustained and profitable growth.





                                       16
<PAGE>   18



During March 1996, the Company received clearance from the FDA to commercially
market the Company's MPS brand of myocardial protection system and related
products. During the second quarter of 1996, the Company began clinically
validating the system at selected medical institutions and to date, has
completed over 100 human open-heart cases using MPS. On July 24, 1996, the
Company announced the release of MPS to market, which should contribute to the
Company's second half financial results.

Gross Profit. Gross profit of $3.93 million for the three months ended June 30,
1996 was $416,000, or 9.6% below the level for the comparable 1995 period of
$4.35 million. As a percentage of net revenue, gross profit decreased during
the three months ended June 30, 1996 to 59.0% as compared to 60.1% for the
comparable 1995 period.  This decrease in gross profit and gross profit margin
during 1996 compared to 1995 was attributable to the decrease in revenue
generated by Neuromed, since Neuromed products contribute higher gross profit
margins than the Company's other product lines. For the six months ended June
30, 1996, gross profit increased to $7.43 million from $6.39 million for the
comparable 1995 period. As a percentage of net revenue, gross profit increased
during the six months ended June 30, 1996 to 58.0% as compared to 56.6% for the
comparable 1995 period. This increase in gross profit and gross profit margin
during the six month period of 1996 compared to 1995 was attributable to the
revenue generated by Neuromed, since the 1996 period includes six months of
revenue while the 1995 period includes only three months of revenue.

Operating Expenses. Research and development expense decreased to $873,000
during the three months ended June 30, 1996, compared to $1.41 million for the
same period a year ago, and decreased as a percentage of net revenue from 19.5%
in 1995 to 13.1% in 1996. Research and development expense decreased to $1.77
million during the six months ended June 30, 1996, compared to $2.49 million
for the same period during 1995, and decreased as a percentage of net revenue
from 22.1% in 1995 to 13.8% in 1996. This decrease during both periods of 1996
compared to 1995 was the result of a reduction in salary and contract labor
expense from staffing reductions due to the completion of the MPS system.
Management expects research and development expenditures to approximate $1.6
million for the remainder of 1996 and expects that about 60% of such
expenditures will be directed to the refining and redesigning of Neuromed
products, with the remainder directed primarily to continued development of MPS
and related products including modifications necessary to market the MPS
internationally.  The Company anticipates launching MPS to international
markets during fiscal 1997.  Management expects that most of its research and
development activities in 1996 will be financed through internally-generated
funds. During June 1996, the Company received a second patent on the MPS
system, and currently has two additional patent applications pending on MPS.

In connection with the March 31, 1995 acquisition of Neuromed, $10.5 million of
the aggregate purchase price was identified as purchased in-process research
and development. In accordance with generally accepted accounting principles,
an expense of  $10.5 million was recorded during the three months and six
months ended June 30, 1995, with no related tax benefit.

Marketing, general and administrative expenses as a percentage of net revenue
increased to 42.6% for the three months ended June 30, 1996, compared to 30.6%
for the comparable period during 1995, while the dollar amount increased by
$625,000. Marketing expense as a percentage of  net revenue increased to 24.7%
for the 1996 period compared to 14.7% during





                                       17
<PAGE>   19



the same period in 1995, and the dollar amount increased by $585,000.  Of such
increase, $451,000 was additional marketing expense of Neuromed primarily
related to higher salary, benefit and commission expense from personnel
additions, increased travel, samples and promotional expense.  During 1996, the
Company reorganized part of its distribution network for Neuromed products and
discontinued several distributors in certain areas of the United States,
replacing them with six direct salespersons who are principally compensated on
commission. The Company also began designing training, customer support and
sales and marketing materials and videos and will continue those efforts during
the second half of 1996. The remainder of the increase in marketing expense
during the 1996 period compared to 1995 was primarily the result of additional
salary, benefit and travel expense from four additional direct salespersons
hired during the fourth quarter of 1995 in preparation of the commercial
introduction of the MPS system. The Company currently employs five direct
salespersons to market MPS and its related products. Management anticipates
hiring additional salespersons to market the MPS system and related products as
circumstances warrant.  For the six months ended June 30, 1996, marketing
expense increased as a percentage of net revenue to 23.9% compared to 14.1% for
the same period during 1995, and the dollar amount increased by $1,468,000.  Of
such increase, $1,139,000 was additional marketing expense of Neuromed
primarily, as mentioned above, related to higher salary, benefit, commission,
travel, samples and promotional expense.  The 1995 six-month period included
only three months marketing expense of Neuromed from acquisition date of March
31, 1995, while the 1996 period included six months of expense.  The remainder
of the increase in marketing expense during the six-month 1996 period compared
to 1995 was primarily the result, as mentioned earlier, of additional salary,
benefit and travel expense from four additional direct salespersons hired
during the fourth quarter of 1995 in preparation for the commercial
introduction of the MPS system.  General and administrative expense as a
percentage of net revenue increased to 17.9% for the three months ended June
30, 1996, compared to 15.9% for the comparable period during 1995, and the
dollar amount increased by $41,000 primarily due to higher recruiting and
relocation expenses.  For the six months ended June 30, 1996, general and
administrative expense increased $438,000 compared to the same period in 1995,
and as a percentage of net revenue increased from 17.0% in 1995 to 18.4% during
1996.  The largest contributor to this increase was amortization expense of
Neuromed intangibles which were included in the 1995 period for only three
months from date of acquisition of March 31, 1995, while the 1996 period
included six months of amortization expense.  The remainder of the increase
during 1996 compared to 1995 was primarily the result of higher recruiting,
relocation, franchise tax and 401(K) Company match expenses.

Earnings (Loss) from Operations.  Earnings from operations increased to
$218,000 during the three months ended June 30, 1996, compared to a net loss
from operations of $9.78 million for the comparable 1995 period.  The 1995 loss
was due to the charge of $10.5 million for purchased research and development
discussed above.  Excluding such charge, however, earnings from operations
decreased from $725,000 in 1995 to $218,000 during 1996, due for the most part,
as discussed above, to the reduction in revenue and gross profit contributed by
Neuromed combined with higher Neuromed marketing costs.  Earnings from
operations increased to $243,000 during the six months ended June 30, 1996,
compared to a net loss from operations of $10.11 million for the comparable
1995 period again due to the 1995 charge of $10.5 million for purchased
research and development.  Excluding such charge, however, earnings from
operations decreased from $388,000 in 1995 to $243,000 during 1996 primarily
due to higher marketing expense and the other factors discussed above.





                                       18
<PAGE>   20



Other Income (Expense).  Other expense decreased to $95,000 during the three
months ended June 30, 1996, compared to an expense of $473,000 during the same
1995 period, a reduction of $378,000.  For the six months ended June 30, 1996,
other expense decreased to $196,000 compared to $501,000 for the same period in
1995, a reduction of $305,000.  This decrease in expense during both periods in
1996 compared to the 1995 periods was attributable to lower levels of interest
expense, since the 1995 periods included interest expense on $15 million of
bank debt incurred in connection with the Neuromed acquisition which debt was
repaid in the fourth quarter of 1995 from the proceeds of a public offering.
See Notes 3 and 5 of the Notes to Condensed Consolidated Financial Statements.
Interest income decreased $47,000 and $104,000, respectively, for the three
months and six months ended June 30, 1996 compared to the same periods in 1995
due to reduced funds available for investment.

Income Taxes.  The Company recorded income tax expense of $8,000 and $27,000
for the three months and six months ended June 30, 1996, respectively.  The
amortization expense of costs in excess of net assets acquired is not
deductible for tax purposes, thus explaining the relatively high rate of tax
(57.5%) for the six months compared to the U.S. statutory income tax rate
applicable to corporations of 34%. No income tax expense or benefit was
recorded during the 1995 periods.

Net Earnings (Loss).  Net earnings increased to $114,000 for the three months
ended June 30, 1996, compared to a net loss of  $10.25 million for the
comparable 1995 period due to the expense of $10.5 million for purchased
research and development incurred in connection with the Neuromed acquisition
during 1995. Excluding such charge, however, net earnings would have decreased
from $251,000 during 1995 to $114,000 in 1996, primarily due to the decrease in
revenue and gross profit contributed by Neuromed.  Net earnings increased to
$20,000 for the six months ended June 30, 1996, compared to a net loss of
$10.61 million for the comparable 1995 period due to the 1995 charge.
Excluding such charge, net earnings increased to $20,000 during 1996 compared
to a net loss of $113,000 during the six months ended June 30, 1995, due to
reduced interest expense since the 1995 period includes interest on $15.0
million of bank debt incurred in connection with the Neuromed acquisition which
was repaid during the fourth quarter of 1995 from the proceeds of a public
offering.

LIQUIDITY AND CAPITAL RESOURCES

The Company's working capital of $12.2 million at June 30, 1996 remained the
same as 1995 year end.  The ratio of current assets to current liabilities was
3.8 to 1 at June 30, 1996.  Cash, cash equivalents and marketable securities
totaled $2.7 million at June 30, 1996, a decrease of $1.2 million from 1995
year end.

In February 1996, the Company amended its working capital line of credit and
added a $15 million acquisition line of credit with NationsBank of Texas, N.A.
Under the amended agreement, the working capital line of credit is
collateralized by the Company's accounts receivable and inventory. The
acquisition line, if drawn upon, is collateralized by the Company's remaining
unencumbered assets.  Both facilities will expire on December 31, 1997, and
bear interest at the prime rate plus 25 basis points or LIBOR plus 200 basis
points, at the Company's discretion.  The interest rate can be reduced based
upon the Company achieving certain ratios of senior bank debt to EBITDA.
Advances under the acquisition line are immediately converted to a five-year
term loan.  The Company is subject to certain covenants related to the
facilities, including a current maturities coverage ratio, fixed charge ratio
and total liabilities to tangible net worth (as defined).  The





                                       19
<PAGE>   21



Company is also restricted on the payment of cash dividends to 75% of annual
net earnings if no draws exist under the acquisition line and 25% of annual net
earnings if the acquisition line has been drawn upon.  At June 30, 1996, the
Company had advances in the amount of $4.55 million outstanding under the
working capital line of credit with a weighted average interest rate of 7.13%.
The Company has not drawn upon the acquisition line of credit.

In connection with the acquisition of Neuromed, the Company agreed to pay
contingent consideration in January 1996 and January 1997 depending on
Neuromed's attainment of certain sales objectives.  At year end 1995, the
Company had a note payable in connection with the 1995 earn-out consideration
in the amount of $1.5 million, payable in January 1996.  The Company has
withheld payment of the $1.5 million pending arbitration of certain purchase
price adjustment disputes between the Company and Neuromed's former principal
owner, William Borkan.  The 1996 contingent consideration, if earned, could
total up to $3.37 million cash and would be payable during January 1997.  With
NationsBank assent, which, based on preliminary discussions with the bank,
management believes it could obtain, the Company may utilize a portion of its
acquisition line of credit to fund the payment of any necessary earn-out
considerations.

Management believes that its current cash, cash equivalents and marketable
securities, funds generated from operations, and if necessary, funds provided
by the working capital line of credit will be sufficient to satisfy normal cash
operating requirements and capital requirements during the remainder of 1996.

CASH FLOWS

Net cash used by operating activities for the first half of 1996 was $939,000.
Primary uses of cash included an increase of $818,000 in the Company's
investment in inventories primarily in preparation for the commercial
introduction of MPS, a reduction of $747,000 in accrued expenses primarily
related to expenditures incurred in the relocation of Neuromed from Ft.
Lauderdale, Florida to the corporate facility in Allen, Texas, and an increase
of $322,000 in trade and other receivables.

Investing activities for the first half of 1996 resulted in a net use of cash
of $605,000.  The Company used cash of $1.04 million for capital expenditures
for additional manufacturing tooling and equipment and an upgraded computer
system.  The Company anticipates capital expenditures of $672,000 for the
remainder of 1996.  The Company was a net seller of marketable securities
during the first half of 1996 which provided net cash of $433,000.

Financing activities during the first half of 1996 provided $556,000 of cash.
Primary sources of cash from financing activities was $396,000 from the
exercise of stock options and net short-term borrowings of $234,000.  The
Company utilized $74,000 for repayment against long-term debt during the first
half of 1996.

FORWARD LOOKING STATEMENTS

The following is a "safe harbor" statement under the Private Securities
Litigation Reform Act of 1995:  Other than historical information, the matters
discussed in this Management's Discussion and Analysis of Financial Condition
and Results of Operations are forward-looking statements that are based on
management assumptions and involve risks and uncertainties, including but not
limited to the Company's ability to develop, clinically validate and gain
market acceptance





                                       20
<PAGE>   22



for new products, including the MPS system, new generation Neuromed products
and other products; successfully developing the infrastructure at Neuromed that
will enable the Company to grow the business into a solid player in the SCS
market; government regulation; competition and technological changes that may
render the Company's products obsolete or noncompetitive; general domestic and
international economic conditions; and other risks detailed from time to time
in the Company's SEC public filings. Consequently, if such management
assumptions prove to be incorrect or such risks or uncertainties materialize,
the Company's actual results could differ materially from the results
forecasted in the forward-looking statements.

IMPACT OF INFLATION AND CHANGING PRICES

The Company attempts to minimize the impact of inflation on manufacturing and
operating costs through on-going quality and productivity programs. The Company
considers the impact of inflation on its operations to be insignificant as the
rate of inflation has remained low in recent years. When material price
increases have been experienced by the Company, it has generally attempted to
pass such cost increases on to customers through its prices, to the extent
permitted by competition and other factors.

CURRENCY FLUCTUATIONS

Substantially all of the Company's international sales are denominated in U.S.
dollars. Fluctuations in currency exchange rates in other countries could
reduce the demand for the Company's products by increasing the price of the
Company's products in the currency of the countries in which the products are
sold, although management does not believe currency fluctuations have had a
material effect on the Company's results of operations.





                                       21
<PAGE>   23



                                    PART II

                               OTHER INFORMATION




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


The Company held its 1996 Annual Meeting of Shareholders ("Annual Meeting") on
June 27, 1996 at the Company's corporate office in Allen, Texas.  At the Annual
Meeting, the following matters were voted on and approved:

<TABLE>
<CAPTION>
                                                                                              VOTES     
                                             VOTES FOR              VOTES AGAINST            ABSTAINED  
         PROPOSAL                        NOMINEE/PROPOSAL         NOMINEE/PROPOSAL          OR NOT VOTED
         --------                        ----------------         ----------------          ------------
<S>      <C>                               <C>                         <C>                       <C>
1)       Election of
         seven directors
         for a one-year term.

         Linton E. Barbee                   6,365,846                  346,643                   --   
         Robert C. Eberhart,Ph.D.           6,365,949                  345,540                   --   
         Richard A. Gilleland               6,364,813                  347,676                   --   
         Hugh M. Morrison                   6,365,846                  346,643                   --   
         Richard D. Nikolaev                6,365,028                  347,461                   --   
         Thomas C. Thompson                 6,365,846                  346,643                   --   
         Michael J. Torma, M.D.             6,365,543                  346,946                   --   

2)       Approval of an amendment
         to the Amended Articles of
         Incorporation of the Company
         to increase the number of
         shares of common stock
         authorized for issuance
         thereunder from 10,000,000
         to 25,000,000.                     5,694,348                  903,319              114,822
</TABLE>

There were present at the Annual Meeting in person or by proxy, shareholders
holding 6,712,489 shares, or approximately 81.5% of the eligible voting shares.





                                       22
<PAGE>   24



ITEM 6.          EXHIBITS AND REPORTS ON FORM 8-K

<TABLE>
         (a)     Exhibits

                 <S>      <C>
                 3.1   -- Articles of Amendment to the Articles of Incorporation

                 3.2   -- Amended and Restated Bylaws

                 27    -- Financial Data Schedule
</TABLE>

         (b)     No reports on Form 8-K have been filed during the quarter 
                 ended June 30, 1996.





                                       23
<PAGE>   25




                                   SIGNATURES



In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.





                                             QUEST MEDICAL, INC.



 DATE:  AUGUST 13, 1996                      BY:/S/ F. ROBERT MERRILL III
                                                --------------------------------
                                                F. ROBERT MERRILL III
                                                SENIOR VICE PRESIDENT FINANCE
                                                CHIEF FINANCIAL OFFICER AND 
                                                TREASURER





                                       24
<PAGE>   26
                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                      DESCRIPTION
- -------                     -----------
<S>           <C>
 3.1          Articles of Amendment to the Articles of Incorporation

 3.2          Amended and Restated Bylaws

 27           Financial Data Schedule
</TABLE>


