
<PAGE>   1
 
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                    U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                                  FORM 10-KSB
(MARK ONE)
    [X]       ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF
              THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1995
 
                                       OR
    [  ]      TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF
              THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
 
                          COMMISSION FILE NO. 0-10521
 
                              QUEST MEDICAL, INC.
                 (Name of small business issuer in its charter)
 
<TABLE>
<S>                                           <C>
                    TEXAS                                       75-1646002
       (State or other jurisdiction of                       (I.R.S. Employer
        incorporation or organization)                     Identification No.)
            201 ALLENTOWN PARKWAY
                 ALLEN, TEXAS                                     75002
   (Address of principal executive offices)                     (Zip Code)
</TABLE>
 
                   Issuer's telephone number: (214) 390-9800
 
         SECURITIES REGISTERED UNDER SECTION 12(b) OF THE EXCHANGE ACT:
 
<TABLE>
<CAPTION>
                                                          NAME OF EACH EXCHANGE
             TITLE OF EACH CLASS                           ON WHICH REGISTERED
             -------------------                          ---------------------
<S>                                           <C>
                     NONE                                          NONE
</TABLE>
 
      SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE EXCHANGE ACT:
 
                                 TITLE OF CLASS
                          ----------------------------
                          Common Stock, $.05 Par Value
 
     Check whether the Issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act 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 / /
 
     Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained on this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB.  /X/
 
     Revenues for the Issuer for the Fiscal Year Ended December 31,
1995 -- $25,320,990.
 
     The approximate aggregate market value of voting stock held by
non-affiliates, computed by reference to the price at which the stock was sold,
or the average bid and asked prices of such stock, as of March 21, 1996, was
$103,246,407. The number of shares of common stock outstanding as of March 21,
1996, was 8,212,243 shares.
 
                      DOCUMENTS INCORPORATED BY REFERENCE:
 
     Portions of the registrant's definitive proxy statement relating to the
registrant's 1996 annual stockholders' meeting are incorporated by reference in
Part III of this Form 10-KSB.

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                               QUEST MEDICAL, INC.

                                  ANNUAL REPORT

                                   FORM 10-KSB

                          YEAR ENDED DECEMBER 31, 1995

                                     PART I


ITEM 1.   DESCRIPTION OF BUSINESS

GENERAL

Quest Medical, Inc., a Texas corporation ("Quest" or the "Company") designs,
develops, manufactures and markets a variety of healthcare products used
primarily in cardiovascular surgery, interventional pain management and
intravenous fluid delivery applications. The Company operates several stable and
profitable product lines, including cardiovascular products (such as pressure
control valves, filters and surgical retracting tapes), specialized intravenous
fluid delivery tubing sets and accessories and pressure monitoring kits used
primarily in labor and delivery. The Company has levered these product lines,
its existing corporate infrastructure and its core competencies in
manufacturing, engineering and regulatory affairs to expand into new markets as
evidenced by the internally funded development of the Quest MPS myocardial
protection system, an innovative and sophisticated system designed to manage the
delivery of solutions to the heart during open-heart surgery. In addition, the
Company recently entered the interventional pain management market by acquiring
Neuromed, Inc. ("Neuromed"), which designs, develops, manufactures and markets a
line of electronic spinal cord stimulation ("SCS") devices used to manage
chronic severe pain.

The Company was formed in 1979, and shortly thereafter became the successor to
the business of Med-Pro, Ltd., a four-year-old research and development medical
device company. Until September 1987, when it sold such business, Quest
developed, manufactured and marketed electronic volumetric intravenous infusion
devices and related disposables in addition to its other products.

In 1991, Quest acquired two companies that manufactured and marketed various
cardiovascular products, significantly enhancing the Company's presence in the
cardiovascular products marketplace. In 1992, Quest identified a real and
immediate need in this marketplace for an automated and integrated myocardial
protection system that would be versatile, easy to use, efficient to monitor and
cost-effective. Myocardial protection is the process of arresting and caring for
the heart during open-heart surgery. The Quest MPS system is designed to
integrate key functions relating to the delivery of solutions to the heart such
as varying the rate and ratio of oxygenated blood, crystalloid, potassium and
other additives, and controlling temperature, pressure and other variables to
allow simpler, more flexible and cost-effective management of this process. The
MPS system employs advanced pump, temperature control and microprocessor
technologies and includes a line of captive and non-captive disposable products.
The Company received 510(k) market


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clearance for its MPS system from the FDA in March 1996. Upon the completion of
clinical validation expected in the second quarter of 1996, management expects
to commence commercial shipment of MPS.

In its continuing effort to expand into potentially high growth niche markets in
the medical device industry, the Company acquired Neuromed in March 1995. SCS is
gaining increased acceptance as a viable, efficacious and cost-effective
treatment alternative to repeat back surgeries for relieving chronic severe back
pain. The Company believes that its recently introduced CompuStim products,
which are powered by radio frequency transmitters external to the body, are the
technological leaders in the field. The Company is currently test marketing
PainDoc, a pen-based computer system that works in tandem with the Company's
CompuStim devices to assist physicians and their patients in optimizing the
performance of the Company's SCS devices both pre- and post-operatively.

Since its founding in 1979, the Company has developed, manufactured and marketed
specialized intravenous fluid delivery tubing sets and accessories sold
primarily to major hospitals in the United States. Over the last several years,
the revenues generated by this product line, a substantial component of the
Company's historical base business, have significantly aided the funding of the
Company's research and development efforts. The Company manufactures and markets
over 70 distinct models of specialized intravenous fluid delivery tubing sets.

                                    PRODUCTS

The following table summarizes certain information with respect to the Company's
principal products in commercial distribution and under development.

<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------
         Products                                          Description/Use                        Status
      -------------                           --------------------------------------        --------------------
<S>                                          <C>                                           <C>   
Cardiovascular
  Pressure Control Valves                     Pressure control valves used during                Marketed
                                              open-heart surgery

  Arterial Line Filters and Bubble            Filters and traps used to remove                   Marketed
    Traps                                     potentially dangerous air and other
                                              matter from the blood during open-
                                              heart surgery

  Retract-O-Tape                              Surgical tubes used to retract and                 Marketed
                                              occlude blood vessels during open-
                                              heart surgery

  MPS System and Related                      Cardioplegia delivery system and               510(k) clearance
    Disposables                               related fluid delivery catheters and         3/96; certain related
                                              delivery sets                                     disposables
                                                                                           previously cleared for
                                                                                                 marketing

Interventional Pain Management
  SCS CompuStim Devices                       Neurostimulation devices used to                   Marketed
                                              relieve chronic pain
- ----------------------------------------------------------------------------------------------------------------
</TABLE>


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<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------
         Products                                          Description/Use                        Status
      -------------                           --------------------------------------        --------------------
<S>                                          <C>                                            <C>   
  PainDoc                                     Pen-based computer system used to              Test marketed as a
                                              optimize the performance of the                computer-based data
                                              Company's implanted SCS devices                  recording and
                                              both pre- and post-operatively                 programming device;
                                                                                              510(k) clearance
                                                                                             10/95 for use as an
                                                                                              interactive medical
                                                                                               treatment device

Intravenous Fluid Delivery
  Multiport(R) Sets                           Intravenous administration sets that               Marketed
                                              allow multiple drug infusions

  Anesthesia Sets                             Intravenous administration sets that               Marketed
                                              allow needleless "port" administration

Other
  Intrauterine Pressure                       Catheters and transducers used to                  Marketed
    Catheters/Transducers                     assess the frequency, duration and
                                              intensity of contractions during high
                                              risk labor
- ----------------------------------------------------------------------------------------------------------------
</TABLE>

CARDIOVASCULAR

Valves, Filters and Traps. The Company manufactures and markets a line of
proprietary specialized pressure control valves, pre-bypass and arterial line
filters and bubble traps, which are used by the perfusionist during
cardiopulmonary bypass surgery. Pressure control valves are placed in the
suction line to "vent," or decompress, the heart. These valves serve a number of
functions, including the maintenance of vacuum at a safe and consistent level to
minimize heart muscle tissue damage, as well as the prevention of inadvertent
and potentially catastrophic retrograde air flow into the heart. In 1993 and
1994, respectively, the Company introduced to the market two extensions of its
pressure control valve technology, the RetroGuard valve and the PlegiaGuard
valve. The RetroGuard valve is used with centrifugal pumps to prevent potential
retrograde blood flow and possible air embolism. The PlegiaGuard valve is used
to relieve overpressure in the cardioplegia line in the event that the line
becomes inadvertently clamped or occluded. The Company's arterial line filters
and bubble traps are used in the bypass circuit to remove air and other
potentially dangerous matter from the blood prior to the blood's return to the
patient. The Company's pre-bypass filters are used to flush the circuit external
to the patient's body prior to the initiation of the bypass procedure to
eliminate man-made debris within the lines. During the years ended December 31,
1995, 1994, and 1993, the Company's valves, filters and traps accounted for $5.2
million, $4.2 million, and $3.7 million, respectively, of total net revenue.

Surgical Tapes and Other Products. The Company also manufactures and markets
surgical retracting tapes under the trademark Retract-O-Tape, a product line of
silicone elastomer surgical tubing used to apply traction to and occlude blood
vessels during surgical procedures. The Company's surgical tapes are hollow
tubes, sealed at both ends to trap air, which resist collapsing when they come
into contact with a body structure. The Company's ACTester product line consists
of instrumentation and associated disposables used to


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measure the activated clotting time of blood. During the years ended December
31, 1995, 1994, and 1993, the Company's surgical tapes and other products
accounted for $1.8 million, $1.6 million, and $1.6 million, respectively, of
total net revenue.

MPS System. In 1992, based on discussions with perfusionists and cardiovascular
surgeons regarding the logistical limitations of existing cardioplegia delivery
systems, the Company identified a real and immediate need for an automated and
integrated myocardial protection system that would be versatile, easy to use,
efficient and cost-effective. Over the past several years, cardiovascular
surgeons have developed advanced myocardial protection protocols for open-heart
surgery that significantly complicate the safe and efficient administration of
cardioplegia delivery using existing systems. Protocols now call for warm or
cold cardioplegia, various levels of potassium, retrograde or antegrade
cardioplegia flow, and a number of other variables. Existing cardioplegia
delivery systems are limited in their ability to accommodate these evolving
protocols, and are also difficult to control and monitor due to the number of
different components and protocol variables. Based on its reengineering of the
conceptual approach to cardioplegia delivery, the Company designed the MPS
system to address the limitations of existing cardioplegia delivery systems. The
Company then commissioned an independent research firm to survey over 150
surgeons and perfusionists to confirm the market demand for an automated and
integrated approach to managing cardioplegia delivery.

The Company subsequently developed, and in August 1995 filed a 510(k) with the
FDA for, the MPS system. In March 1996, the Company received clearance from the
FDA to market MPS and is engaged in clinical testing of the system. Upon
completion of such testing, expected in the second quarter of 1996, management
expects to commence commercial shipment of MPS.

The MPS system, which employs advanced pump, temperature control and
microprocessor technologies, is designed to enable the perfusionist to vary the
blood/crystalloid ratio and potassium concentration, maintain a constant blood
temperature, and maintain a constant delivery pressure through an automated and
integrated device. The Quest MPS instrument is designed to provide this
flexibility through the simple setting of dials on its control panel. The
Company believes that the MPS system will simplify the cardioplegia delivery
process and thus improve the safety of this process by reducing the risk of
human error.

As a part of the MPS system, the Company has designed and developed a "captive"
disposable delivery set, which fits into the instrument and is necessary to the
operation of the instrument. The Company has also designed and developed
additional "non-captive" disposable tubing and other accessories for use with
the MPS system. These non-captive disposables are not integral to the operation
of the instrument and can be purchased from other manufacturers. The Company has
received FDA clearance to market certain of its non-captive disposables through
the submission and approval of 510(k)s, and expects to begin marketing such
products when the instrument is released to market.

INTERVENTIONAL PAIN MANAGEMENT

Background. SCS devices employ neurostimulation, the process of electrically
stimulating the spinal cord to reduce chronic severe neuropathic (as opposed to
acute) pain by "masking" the pain signals sent to the brain. Neuropathic pain
usually arises from nerve 



                                       -4-



<PAGE>   6




damage. SCS device implantation manages the pain associated with failed back
syndrome (resulting from certain spinal disorders or unsuccessful spinal cord
surgery), peripheral neuropathy, phantom limb or stump pain, ischemic pain and
reflex sympathetic dystrophy.

The market for SCS devices is currently divided between RF-coupled devices,
which use an external power source, and fully implantable systems known as
internal pulse generator ("IPG") devices. The Company believes that lPG devices
currently account for a substantial majority of the number of SCS procedures
performed, with RF-coupled devices accounting for the remainder. The Company
designs, develops, manufactures and markets RF-coupled SCS devices. The primary
advantages of the RF-coupled device include the simple replacement or recharge
of the external battery pack, and relatively lower overall cost. Although an IPG
device provides the convenience of a completely internalized system, IPG devices
involve added cost, complexity and risk because repeat surgeries are required to
replace the IPG power source. The Company believes that managed care and overall
cost sensitivity may lead to increased selection of RF-coupled devices.
Moreover, the latest generation SCS devices generally include more electrodes
and dual channel receivers, both of which consume more electrical energy than an
implanted power source can practically deliver over an extended period of time.

SCS Devices. The Company's SCS systems consist of three primary components:
leads, a receiver and a transmitter. The leads are most commonly placed through
the skin into the spinal column's epidural space. This procedure is similar to
that employed by physicians to administer drugs for anesthesia and other common
medical applications. Typically, one or two leads are inserted, each of which
has multiple electrodes that can be used to stimulate the targeted nerve roots
of the spinal cord. Each lead is then connected to the receiver, which is
implanted under the skin on the side of the abdomen. The receiver contains
electronics that receive RF energy and data from a source (the transmitter)
outside the body, and delivers the prescribed electrical pulses to the leads.
The transmitter is approximately the size of a pager, and is typically worn on a
belt. Since it is external to the body, the transmitter can be easily programmed
and serviced as needed, and its battery can be simply recharged or replaced.

Neuromed introduced its first product, the Multiprogrammable Spinal Cord
Stimulator, or Multistim, in 1979. Since that time, Neuromed has played a
significant role in the development of SCS products. Multistim incorporated a
quadrapolar electrode system within a single lead, and was considered a major
innovation in the field of neurostimulation because it significantly reduced
surgical time, cost and risk. Since the launch of Multistim, Neuromed has
developed and introduced a wide range of RF-coupled SCS systems with a variety
of options to accommodate different applications and degrees of pain.

The Company's recently introduced CompuStim systems include four, eight and
sixteen electrode leads; specialty leads for peripheral applications; single and
dual channel receivers; and rechargeable transmitters and antennae. The Company
believes that the CompuStim product line's multi-electrode leads and
multiprogrammable electronics technology have changed the manner in which
neurostimulation is performed worldwide. For example, Neuromed's "Dual Octrode"
device, a recently introduced system of dual leads with eight electrodes each,
creates a targeted current density that appears to be especially effective in
relieving chronic axial (or body trunk) pain. Previously, quadrapolar SCS
systems only relieved the leg pain associated with failed back syndrome.
Industry


                                       -5-



<PAGE>   7


sources support the view that the Dual Octrode device provides improved pain
relief to both the legs and the back. Consequently, although the Dual Octrode
device has only been on the United States market since February 1995, it now
accounts for approximately 60% of Neuromed's current product revenue and, in the
Company's judgment, is the technological leader in the SCS field. The Company
believes that the long term results of SCS in the treatment of pain have
improved as a result of the flexibility of Neuromed's designs, epitomized by the
Dual Octrode product. Moreover, the ease of use of the system has expanded the
potential market for these products.

Use of the Company's current SCS products in certain operating modes consumes
relatively greater amounts of electrical current, reducing the operating time of
the rechargeable, externally worn battery packs. In addition, certain of the
Company's current SCS products have experienced switch failures attributable in
significant part to a specific brand of switches. These switches are no longer
being purchased and are being replaced by a new switch that appears not to
exhibit the same problems. Patient misuse has also contributed to the switch
failures. Finally, the Company's SCS products have exhibited some intermittent
stimulation, which the Company believes is attributable to several factors
including improper antenna placement, physicians or patients adjusting
stimulation below perceptible levels, improper receiver implant placement
techniques and lead movement. The Company is developing and implementing
improved patient and physician communications and training programs and is
pursuing product design enhancements and improvements to address these matters.

PainDoc. In addition to its current array of SCS devices, the Company is
developing and testing PainDoc, a pen-based computer system that is designed to
assist physicians and their patients in optimizing the performance of the
Company's SCS devices both pre- and post-operatively. PainDoc interfaces with
the Company's CompuStim transmitters to optimize SCS therapy and document
treatment outcomes. PainDoc allows the physician to input information regarding
the patient's description of the location and intensity of the patient's pain.
The resulting "pain map" is then analyzed by the computer to assess and select
the most effective stimulation sets, or combination of multi-electrode
stimulation arrays, to treat the pain. The selected arrays are uploaded into the
patient's CompuStim transmitter. After a trial period, the patient reports to
the physician the location and level of pain relief. These trial results are
uploaded back into PainDoc for the physician's objective review and analysis.
The physician can visually compare the patient's pain map against a stimulation
map and assess whether desired levels of pain relief have been obtained and
whether excess stimulation has been delivered. This process can be effective in
targeting the location of desired pain relief, reducing the patchiness of pain
relief delivered by many SCS devices and reducing or eliminating
overstimulation.

PainDoc enables the physician to program up to 24 different stimulation sets
delivering electrical stimulation every 50 milliseconds to expand pain area
coverage and relief. The Company believes that PainDoc should also allow
physicians to create a broad based database tool that, by using a standardized
methodology, will enable physicians to share and compare outcomes data, which
can then be used to deliver more efficacious pain relief to individual patients.
The Company believes that PainDoc and CompuStim devices used in tandem should
significantly enhance the effectiveness, flexibility and precision of managing
chronic neuropathic pain. The Company expects PainDoc to promote the selection
of the Company's CompuStim devices for SCS procedures, especially as SCS devices
become





                                       -6-

<PAGE>   8


more complex and the pain management process becomes more refined. In October
1995, the Company received 510(k) approval from the FDA to market PainDoc as an
interactive medical treatment device. See Item 1: "Business -- Other Business
Matters -- Government Regulation."

During the year ended December 31, 1995, the Company's SCS products accounted
for $10.4 million of total net revenue.

INTRAVENOUS FLUID DELIVERY

Since its founding in 1979, the Company has developed, manufactured and marketed
specialized intravenous fluid delivery tubing sets and accessories sold
primarily to major hospitals in the United States. Over the last several years
the revenues generated by this product line, a substantial component of the
Company's historical base business, have significantly aided the funding of the
Company's research and development efforts. The Company's core competencies in
medical device manufacturing, engineering and regulatory affairs have largely
been developed as a consequence of its experience with intravenous fluid
delivery products, including the electronic intravenous pump and associated
disposables business that was sold in 1987.

The Company manufactures and markets over 70 distinct models of specialized
intravenous fluid delivery tubing sets, which can be broken down into two major
product categories --Multiport(R) sets and anesthesia sets. Hospitals frequently
require specialized disposable intravenous tubing sets for more complex therapy
procedures employed in anesthesia administration, intravenous feeding, intensive
care and cancer therapy. The Company's intravenous tubing sets generally consist
of specialized tubing and connector variations that distinguish them from
standard intravenous sets. The Company also manufactures and markets injection
sites used in heparin and other medication administrations.

The Company has one patented specialized tubing set, purchased primarily by the
University of Texas System Cancer Center (M.D. Anderson Hospital), which is used
to deliver multiple drugs for complex chemotherapy applications.  See Item 1: 
"Business -- Other Business Matters -- Marketing and Major Customer." During the
years ended December 31, 1995, 1994, and 1993 the Company's intravenous fluid
delivery products accounted for $6.0 million, $6.3 million, and $6.8 million,
respectively, of total net revenue.

OTHER PRODUCTS

The Company also designs, manufactures and markets other products for the
healthcare industry, including pressure monitoring kits used in labor and
delivery procedures and various critical care applications. The Company's
intrauterine pressure monitoring devices are used to determine pressure within
the mother's uterus primarily during high risk labor and delivery. Approximately
25% of the nearly four million births occurring annually in the United States
are categorized as "high risk" due to factors such as obesity, drug use,
disease, age or low fetus weight. During these procedures, a catheter is
inserted into the mother's uterus to measure uterine fluid pressure. This
information allows the clinician to monitor the progression of labor and to
determine whether intervention is necessary or advisable. The Company's
intrauterine pressure monitoring devices are marketed as kits containing all of
the components required to measure uterine fluid pressure. During the






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<PAGE>   9


years ended December 31, 1995, 1994, and 1993 the Company's other products
(primarily pressure monitoring kits) accounted for $1.8 million, $1.9 million,
and $1.6 million, respectively, of total net revenue.

                             OTHER BUSINESS MATTERS

MARKETING AND MAJOR CUSTOMER

The Company markets most of its cardiovascular products and intravenous fluid
delivery tubing sets through direct contact with hospitals, independent sales
representatives, marketing arrangements with certain distributors and, to a
lesser extent, through telemarketing and direct mail. The Company plans to
market its MPS system and family of related products domestically through a
direct sales force operating on a sales team approach. In anticipation of 510(k)
clearance, the Company at year-end 1995 employed five sales managers, four of
which were hired during the fourth quarter of 1995. The Company has received
510(k) clearance for the MPS system, as previously noted, and
plans to introduce MPS commercially during the second quarter of 1996. The
Company plans to add seven additional salespersons throughout 1996 to market the
MPS system and related products. The Company plans to market the MPS system and
related products internationally through specialty distributors. The Company
also employs one sales manager who oversees the distributors who sell the
Company's pressure monitoring kits. The Company derives approximately 80% of net
revenues attributable to its cardiovascular products from domestic sales and
approximately 20% from European, Australian and Japanese sales.

Neuromed has historically relied on specialty distributors to market its SCS
devices, and the Company expects to continue this sales and marketing strategy.
The Company employs two sales managers who oversee these specialty distributors.
The primary medical specialists the Company targets in its marketing efforts are
anesthesiologists, neurosurgeons and orthopedic surgeons. Although neurosurgeons
were the first practitioners to use SCS applications, anesthesiologists now
account for a greater percentage of sales as the relative number of these
practitioners has grown and as the understanding and acceptance of SCS treatment
has increased. The Company derives 84% of net revenues attributable to its SCS
devices from domestic sales and approximately 16% from European and Australian
sales.

The University of Texas Cancer Center (M.D. Anderson Hospital) accounted for
$2.6 million, $2.7 million, and $3.1 million, or 10%, 19% and 23%, of the
Company's net revenues for the years ended December 31, 1995, 1994 and 1993
respectively. The Company supplies a patented specialized tubing set used by
M.D. Anderson Hospital for oncology applications. While the Company believes its
relations with this customer are good, and while net revenues in percentage
terms have declined and are expected to decline further as a result of the
Neuromed acquisition and introduction of MPS, the loss of this customer could
have a material adverse effect on the Company's business, financial condition
and results of operations.

RESEARCH AND DEVELOPMENT





                                       -8-



<PAGE>   10


Since 1992, the Company has focused its research and development efforts on
designing and developing the MPS system and related products. The Company has
spent $10.3 million on the research and development of its MPS system and
related products, representing over 90% of the Company's research and
development expense since 1992. Although the Company plans to continue engaging
in ongoing research and development to introduce new products, enhance the
effectiveness, ease of use, safety and reliability of existing products and
expand the applications for which its products are appropriate, particularly in
the cardiovascular and interventional pain management fields, the Company
expects research and development expense to decline from peak levels during
1995, as a result of completing development of the MPS system and certain
related products during 1995. Research and development expense was $4.6 million,
$3.5 million and $1.9 million for the years ended December 31, 1995, 1994 and
1993, respectively. The Company has budgeted $3.3 million for research and
development during 1996. Management expects 60% of such expenditures to be
directed to refining and redesigning of Neuromed SCS products with the remainder
directed primarily to MPS. As of March 21, 1996, the Company had an in-house
research and development staff of 24 engineers, technicians and designers, down
from a peak number of 49 during April 1995.

MANUFACTURING

The Company manufactures and packages certain cardiovascular products (such as
pressure control valves, filters, traps, MPS and surgical retracting tapes) and
intravenous fluid delivery products at its primary manufacturing facility in
Allen, Texas. This facility received ISO 9001 certification (for design and
manufacturing processes) in July 1995. See Item 1. "Business -- Other Business
Matters -- Government Regulations." Until the first quarter of 1996, when such
operations were moved to the Allen, Texas facility, the Company manufactured its
line of SCS devices and related products at an ISO 9002 certified (manufacturing
only) facility in Fort Lauderdale, FL. Finally, the Company manufactures certain
cardiovascular products at a facility in Orange County, California, and will
continue to do so for the foreseeable future.

The Company's manufacturing processes consist of the assembly of standard and
custom component parts and the testing of completed products. The Company
subcontracts with various suppliers to provide it with the quantity of component
parts necessary to assemble its products. Almost all of these components are
available from a number of different suppliers, although certain components are
purchased from single sources, who manufacture these components from the
Company's toolings. For example, the Company relies on single suppliers for two
separate components of the specialized oncology intravenous tubing set that the
Company supplies to the University of Texas System Cancer Center (M.D. Anderson
Hospital), the Company's largest customer. The Company believes that there are
alternative and satisfactory sources for single-sourced components, although a
sudden disruption in supply from one of these suppliers could adversely affect
the Company's ability to deliver the finished product on time. The Company owns
its own molds for production of a majority of the components used in specialized
tubing sets and cardiovascular products. Consequently, in the event of supply
disruption, the Company would be able to fabricate its own components or
subcontract with another supplier, albeit after a delay in the production
process.






                                       -9-



<PAGE>   11



The Company devotes significant attention to quality control. Its quality
control measures begin at the manufacturing level where components are assembled
in a "clean room" environment designed and maintained to reduce product exposure
to particulate matter. Products are tested throughout the manufacturing process
for adherence to specifications. Finished components are shipped to outside
processors for sterilization through radiation or treatment with ethylene oxide
gas. After sterilization, the products are quarantined and tested before they
are shipped to customers.

Skills of assembly workers required for the manufacture of medical products are
similar to those required in typical assembly operations. The Company believes
that workers with these skills are readily available in the Dallas and Orange
County areas.

COMPETITION

In marketing its products, the Company competes with numerous companies that
have substantially greater financial resources and engage in substantially
greater research and development efforts than the Company. Numerous competitors
exist for the Company's cardiovascular products, specialized tubing sets, and
pressure monitoring kits. These markets are dominated by established
manufacturers that have broader product lines, greater distribution
capabilities, substantially greater capital resources and larger marketing,
research and development staffs and facilities than the Company. Many of these
competitors offer broader product lines within the specific product market
and/or in the general field of medical devices and supplies. Broad product lines
give many of the Company's competitors the ability to negotiate exclusive,
long-term medical device supply contracts and, consequently, the ability to
offer comprehensive pricing of their competing products. By offering a broader
product line in the general field of medical devices and supplies, competitors
may also have a significant advantage in marketing competing products to group
purchasing organizations, HMOs and other managed care organizations that are
increasingly seeking to reduce costs through centralization of purchasing
functions. In addition, the Company's competitors may use price reductions to
preserve market share in their product markets.

The Company is aware of at least two cardioplegia delivery systems currently in
development or in clinical testing that would compete with the MPS system. Both
products have received FDA 510(k) market clearance. While these products
represent improvements over cardioplegia delivery systems currently in use, the
Company believes that the MPS system will offer a greater range of
functionality, flexibility and ease-of-use. In addition, innovations in surgical
techniques or medical practices could have the effect of reducing or eliminating
market demand for one or more of the Company's products. For example, some
cardiovascular surgeons and medical device companies are developing techniques,
procedures and devices for performing coronary artery bypass surgery without
stopping the heart, both through open-heart surgery and minimally invasive
procedures, thereby eliminating the need for myocardial protection in these
cases and potentially reducing the market for Quest's MPS system. While these
techniques, procedures and devices have not to date attained widespread use,
there can be no assurance that they will not gain broader market acceptance.
While these and other surgical techniques, procedures and devices may reduce the
number of coronary artery bypass procedures that require myocardial protection,
the Company believes that most, if not all, surgical suites will need to be
equipped with a myocardial protection system.






                                       -10-



<PAGE>   12


Neuromed competes in the market for SCS devices with one other significant
supplier, Medtronic, Inc. Medtronic holds a substantial majority share of the
market and sells both RF-coupled systems and IPG devices.

The Company believes that the principal competitive factors in the
cardiovascular, interventional pain management and intravenous fluid delivery
markets are cost-effectiveness, impact on patient outcomes, product performance,
quality and ease of use, technical innovation and customer service. The Company
intends to continue to compete on the basis of its high performance products,
innovative technologies, manufacturing capability, close customer relations and
support and its strategy to increase its offerings of products within these
markets.

PATENTS, TRADEMARKS AND PROPRIETARY INFORMATION

The Company owns eighteen United States patents relating to products that the
Company currently sells or develops. Although one of the Company's patents
expired in February 1996 and another is scheduled to expire in January 1997, the
Company does not believe that either expiration will have a material adverse
effect on the Company or its ability to sell the applicable products. Eleven of
the eighteen patents cover the Company's cardiovascular products. From 1993
through 1995, the Company filed four applications for patents relating to the
MPS system and related products, one of which was issued in January 1995. The
issued patent contains 69 claims, many of which, in the Company's opinion,
contain broad coverage of key elements of the MPS system, including the MPS
system's innovative methods of pumping, mixing and heating fluids. Management
believes that the issued patent should provide significant protection for its
MPS system. The three other patent applications are pending.

Neuromed currently owns four of the United States patents referred to above, and
also owns five foreign patents. In management's view, these patents offer
reasonable coverage of its SCS devices' electrode, receiver and transmitter
technology. These patents cover both RF-coupled devices and IPG systems,
although the Company currently manufactures only RF-coupled devices. The Company
is assessing whether it will file for patent protection concerning its PainDoc
product. The Company also owns three patents relating to its intravenous fluid
delivery tubing sets and accessories and other products.

The validity of any patents issued to the Company may be challenged by others
and the Company could encounter legal and financial difficulties in enforcing
its patent rights against infringers. In addition, there can be no assurance
that other technologies cannot or will not be developed or that patents will not
be obtained by others which would render the Company's patents obsolete. With
the possible exception of the patent relating to the specialized tubing sets
manufactured for the University of Texas System Cancer Center (M.D. Anderson
Hospital), the loss of any one patent would not have a material adverse effect
on the Company's current revenue base. Although the Company does not believe
that patents are the sole determinant in the commercial success of its products,
the loss of a significant percentage of its patents or its patents relating to a
specific product line, particularly the MPS system or Neuromed's SCS product
line, could have a material adverse effect on the Company's business, financial
condition and results of operations.






                                      -11-


<PAGE>   13


The Company has developed significant technical knowledge which, although
non-patentable, is considered by the Company to be significant in enabling it to
compete. However, the proprietary nature of such knowledge may be difficult to
protect. The Company has entered into an agreement with each key employee
prohibiting such employee from disclosing any confidential information or trade
secrets of the Company and prohibiting that employee from engaging in any
competitive business while the employee is working for the Company and for a
period of one year thereafter. In addition, these agreements also provide that
any inventions or discoveries relating to the business of the Company by these
individuals will be assigned to the Company and become the Company's sole
property.

Claims by competitors and other third parties that the Company's products
allegedly infringe the patent rights of others could have a material adverse
effect on the Company. The medical device industry is characterized by frequent
and substantial intellectual property litigation. The cardiovascular device
market and the interventional pain management markets are maturing and, as such,
are characterized by extensive patent and other intellectual property claims,
which can create greater potential than in less developed markets for possible
allegations of infringement, particularly with respect to newly developed
technology. Intellectual property litigation is complex and expensive, and the
outcome of this litigation is difficult to predict. Any future litigation,
regardless of outcome, could result in substantial expense to the Company and
significant diversion of the efforts of the Company's technical and management
personnel. An adverse determination in any such proceeding could subject the
Company to significant liabilities to third parties, or require the Company to
seek licenses from third parties or pay royalties that may be substantial.
Furthermore, there can be no assurance that necessary licenses would be
available to the Company on satisfactory terms or at all. Accordingly, an
adverse determination in a judicial or administrative proceeding or failure to
obtain necessary licenses could prevent the Company from manufacturing or
selling certain of its products, which could have a material adverse effect on
the Company's business, financial condition and results of operations.

QUEST, MULTIPORT, RETROGUARD, RETRACT-O-TAPE, ACTest and DUO-TUBE are among the
Company's registered trademarks, and MPS, COMPUSTIM, PAINDOC and ACTester are
among its non-registered trademarks. Registration applications are pending with
respect to MPS, COMPUSTIM and PAINDOC.

GOVERNMENT REGULATION

The manufacture and sale of the Company's products are subject to regulation by
numerous governmental authorities, principally the FDA and corresponding foreign
agencies. The research and development, manufacturing, promotion, marketing and
distribution of the Company's products in the United States are governed by the
Federal Food, Drug, and Cosmetic Act and the regulations promulgated thereunder
(the "FDC Act and Regulations"). The Company is subject to inspection by the FDA
for compliance with such regulations and procedures.

The FDA has traditionally pursued a rigorous enforcement program to ensure that
regulated entities such as the Company comply with the FDC Act and Regulations.
A company not in compliance may face a variety of regulatory actions, including
warning letters, product detentions, device alerts, mandatory recalls or field
corrections, product seizures, injunctive 







                                      -12-

<PAGE>   14


actions or civil penalties and criminal prosecutions of the company or
responsible employees, officers and directors.

Under the FDA's requirements, if a manufacturer can establish that a newly
developed device is "substantially equivalent" to a legally marketed device, the
manufacturer may seek marketing clearance from the FDA to market the device by
filing a 510(k) premarket notification with the FDA. The 510(k) premarket
notification must be supported by data establishing the claim of substantial
equivalence to the satisfaction of the FDA. The process of obtaining a 510(k)
clearance typically can take several months to a year or longer. If substantial
equivalence cannot be established, or if the FDA determines that the device
requires a more rigorous review, the FDA will require that the manufacturer
submit a PMA that must be carefully reviewed and approved by the FDA prior to
sale and marketing of the device in the United States. The process of obtaining
a PMA can be expensive, uncertain and lengthy, frequently requiring anywhere
from one to several or more years from the date of FDA submission. Both a 510(k)
and a PMA, if granted, may include significant limitations on the indicated uses
for which a product may be marketed. FDA enforcement policy strictly prohibits
the promotion of approved medical devices for unapproved uses. In addition,
product approvals can be withdrawn for failure to comply with regulatory
requirements or the occurrence of unforeseen problems following initial
marketing. Although all of the Company's currently marketed products have been
the subject of successful 510(k) submissions, and the Company believes that its
products currently in development will also be eligible for the 510(k)
submission process, there can be no assurance that the FDA will agree with this
view.

The Company is also subject to regulation in each of the foreign countries in
which it sells its products with regard to product standards, packaging
requirements, labeling requirements, import restrictions, tariff regulations,
duties and tax requirements. Many of the regulations applicable to the Company's
products in such countries are similar to those of the FDA. The national health
or social security organizations of certain countries require the Company's
products to be qualified before they can be marketed in those countries. To
date, the Company has not experienced significant difficulty in complying with
these regulations.

To position itself for access to European and other international markets, Quest
sought and obtained certification under the ISO 9000 Series of Standards. ISO
9000 is a set of integrated requirements, which when implemented, form the
foundation and framework for an effective quality management system. These
standards were developed and published by the ISO, a worldwide federation of
national standard bodies, founded in Geneva, Switzerland in 1946. ISO has over
92 member countries. ISO certification is widely regarded as essential to enter
Western European markets.

The Company obtained certification and was registered as an ISO 9001 compliant
company on July 1, 1995. The ISO 9001 registration is the most stringent
standard in the ISO series and lasts for three years. The German notified body,
Landesgewerbeanstalt Bayern ("LGA") issued the certificate. The ISO 9001
standards cover design, production, installation and servicing of products. The
Company will be subject to an annual audit by LGA to maintain the registration.
This registration will simplify the process of obtaining the "CE" mark for its
products. This CE mark enables a company's products to be marketed, sold and
used throughout the European Union.






                                       -13-



<PAGE>   15

In 1991, prior to its acquisition by the Company, Neuromed commenced clinical
trials of a fully implantable SCS device in the United States and Europe. In
late 1993, the FDA canceled the IDE relating to this product and rescinded
Neuromed's export authority for this product due to alleged violations by
Neuromed, under its prior management, of applicable rules and regulations,
including good manufacturing practices. The clinical trials were discontinued
and the product was withdrawn from the market. During this period, Neuromed also
encountered regulatory difficulties in the United Kingdom due to alleged
noncompliance with applicable rules and regulations. Quest is engaged in a
process intended to restore good relations with regulatory authorities in the
United Kingdom. There can be no assurances that the Company will not encounter
similar difficulties in the future.

The financial arrangements through which the Company markets, sells and
distributes its products may be subject to certain federal and state laws and
regulations in the United States with respect to the provision of services or
products to patients who are Medicare or Medicaid beneficiaries. The "fraud and
abuse" laws and regulations prohibit the knowing and willful offer, payment or
receipt of anything of value to induce the referral of Medicare or Medicaid
patients for services or goods. In addition, the physician anti-referral laws
prohibit the referral of Medicare or Medicaid patients for certain "Designated
Health Services" to entities in which the referring physician has an ownership
or compensation interest. Violations of these laws and regulations may result in
civil and criminal penalties, including substantial fines and imprisonment. In a
number of states, the scope of fraud and abuse or physician anti-referral laws
and regulations, or both, have been extended to include the provision of
services or products to all patients, regardless of the source of payment,
although there is variation from state to state as to the exact provisions of
such laws or regulations. In other states, and, on a national level, several
health care reform initiatives have been proposed which would have a similar
impact. The Company believes that its operations and its marketing, sales and
distribution practices currently comply in all respects with all current fraud
and abuse and physician anti-referral laws and regulations, to the extent they
are applicable. Although the Company does not believe that it will need to
undertake any significant expense or modification to its operations or its
marketing, sales and distribution practices to comply with federal and state
fraud and abuse and physician anti-referral regulations currently in effect or
proposed, financial arrangements between manufacturers of medical devices and
other health care providers may be subject to increasing regulation in the
future. Compliance with such regulation could adversely affect the Company's
marketing, sales and distribution practices, and may affect the Company in other
respects not presently foreseeable, but which could have an adverse impact on
the Company's business, financial condition and results of operations.

THIRD PARTY REIMBURSEMENT AND COST CONTAINMENT

The Company's products are purchased primarily by hospitals and other users,
which then bill various third party payors for the services provided to the
patients. These payors, which include Medicare, Medicaid, private insurance
companies and managed care organizations, reimburse part or all of the costs and
fees associated with the procedures performed with these devices.

Medicare and Medicaid reimbursement for hospitals is based on a fixed amount for
admitting a patient with a specific diagnosis. Because of this fixed
reimbursement method,






                                      -14-


<PAGE>   16


hospitals have incentives to use less costly methods in treating Medicare and
Medicaid patients, and will frequently make capital expenditures to take
advantage of less costly treatment technologies. Frequently, reimbursement is
reduced to reflect the availability of a new procedure or technique, and as a
result hospitals are generally willing to implement new cost saving technologies
before these downward adjustments take effect. Likewise, because the rate of
reimbursement for certain physicians who perform certain procedures has been and
may in the future be reduced in the event of further changes in the
resource-based relative value scale method of payment calculation, physicians
may seek greater cost efficiency in treatment to minimize any negative impact of
reduced reimbursement. Any amendments to existing reimbursement rules and
regulations which restrict or terminate the reimbursement eligibility (or the
extent or amount of coverage) of medical procedures using the Company's products
or the eligibility (or the extent or amount of coverage) of the Company's
products could have an adverse impact on the Company's business, financial
condition and results of operations. Third party payors are increasingly
challenging the prices charged for medical products and services and may deny
reimbursement if they determine that a device was not used in accordance with
cost-effective treatment methods as determined by the payor, was experimental or
was used for an unapproved application.

The Company's SCS devices, for example, while cost-effective compared to repeat
back surgeries, have encountered some resistance to third party reimbursement.
Although Medicare, Medicaid and many private insurers reimburse for the SCS
device and procedure, especially after repeat back surgeries have failed to
relieve the chronic pain, certain payors refuse to reimburse for SCS devices and
others, including the Veterans Administration, restrict reimbursement. There can
be no assurance that in the future, third party payors will continue to
reimburse for the Company's products, or that their reimbursement levels will
not adversely affect the profitability of the Company's products. In addition,
the cost of health care has risen significantly over the past decade, and there
have been and may continue to be proposals by legislators and regulators to curb
these costs. Legislative action limiting reimbursement for certain procedures
could have a material adverse effect on the Company's business, financial
condition and results of operations.

In response to the focus of national attention on rising health care costs, a
number of changes to reduce costs have been proposed or have begun to emerge.
There have been, and may continue to be, proposals by legislators and regulators
and third party payors to curb these costs. There has also been a significant
increase in the number of Americans enrolling in some form of managed care plan.
It has become a typical practice for hospitals to affiliate themselves with as
many managed care plans as possible. Higher managed care penetration typically
drives down the prices of health care procedures, which in turn places pressure
on medical supply prices. This causes hospitals to implement tighter vendor
selection and certification processes, by reducing the number of vendors used,
purchasing more products from fewer vendors and trading discounts on price for
guaranteed higher volumes to vendors. Hospitals have also sought to control and
reduce costs over the last decade by joining group purchasing organizations or
purchasing alliances. The Company cannot predict what continuing or future
impact existing or proposed legislation, regulation or such third party payor
measures may have on its future business, financial condition or results of
operations.

Changes in reimbursement policies and practices of third party payors could have
a substantial and material impact on sales of certain of the Company's products.
The






                                      -15-



<PAGE>   17

development or increased use of more cost-effective treatments could cause such
payors to decrease or deny reimbursement to favor these other treatments.

EMPLOYEES

As of March 21, 1996, the Company employed 250 full-time employees, 24 in
research and development, 44 in sales and marketing, 156 in manufacturing and
related operations, and the remainder in executive and administrative positions.
This is an increase of 67 employees from the number at March 17, 1995. Of such
increase, 56 personnel were added to the employee base from the Neuromed
acquisition. The remainder of the increase is primarily due to additional sales
and marketing personnel in preparation for the commercial introduction of MPS.
None of the Company's employees is represented by a labor union and the Company
considers its employee relations to be good.

ADVISORY BOARD

The Company has established a Board of Clinical Advisors (the "Advisory Board")
comprised of individuals with substantial expertise in the field of myocardial
protection who have played instrumental roles in the identification of the
market need for the MPS system and its subsequent design and development.
Members of the Company's management and scientific and technical staff consult
closely with the Advisory Board to better understand the technical and clinical
requirements of the cardiovascular surgical team and product functionality
needed to meet those requirements. The Company anticipates that these Advisory
Board members will continue to play similar roles with respect to other
products, and may assist the Company in educating other physicians in the use of
the MPS system and related products.

Certain members of the Advisory Board are employed by academic institutions and
may have commitments to or consulting or advisory agreements with other entities
that may limit their availability to the Company. The members of the Advisory
Board may also serve as consultants to other medical device companies. No
members are expected to devote more than a small portion of their time to the
Company.

ITEM 2.       DESCRIPTION OF PROPERTY

In December 1993, the Company moved into its new manufacturing facility and
executive offices in Allen, Texas (located north of Dallas). The facility covers
approximately 107,000 square feet and was constructed during 1993 on a 19.2 acre
tract that the Company acquired in 1985. The Company borrowed $4.4 million from
MetLife Capital Corporation to construct and outfit this facility. This
financing is collateralized by the Allen land, the Allen facility and certain
equipment of the Company. See Note 5 of the Notes to Consolidated Financial
Statements. Management expects the current facility to serve its manufacturing,
storage and executive office needs in the Dallas area for the foreseeable
future.

The Company also currently leases approximately 4,600 square feet of office and
manufacturing space in Orange County, California on a month-to-month basis. The
Company plans to continue manufacturing certain cardiovascular surgery products
at this facility for the foreseeable future.






                                      -16-


<PAGE>   18


Neuromed leased, until February 1996 when such lease expired, approximately
18,000 square feet of office and manufacturing space in Fort Lauderdale,
Florida, where it manufactured and marketed its SCS devices. During late 1995
and early 1996, the Company relocated the Neuromed operations to the Company's
facility in Allen, Texas.

ITEM 3.    LEGAL PROCEEDINGS

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. While the Company
seeks to maintain appropriate levels of product liability insurance with
coverage that the Company believes is comparable to that maintained by companies
similar in size and serving similar markets, there can be no assurance that the
Company will avoid significant future product liability claims relating to its
SCS, cardiovascular, intravenous fluid delivery or other products.

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.

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

Inapplicable.





                                      -17-

<PAGE>   19

                                     PART II

ITEM 5.    MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
           MATTERS

The Company's common stock is quoted on the Nasdaq National Market under the
symbol "QMED." On March 21, 1996, there were approximately 827 holders of record
of the Company's common stock. The following table sets forth the quarterly high
and low closing sales prices for the Company's common stock. These prices do not
include adjustments for retail mark-ups, mark-downs or commissions.

1994:                          High              Low
- ----                           ----              ---     

First Quarter                  $ 4.72          $ 4.13
Second Quarter                 $ 7.38          $ 4.63
Third Quarter                  $ 6.38          $ 5.38
Fourth Quarter                 $ 5.75          $ 4.63

1995:                         High              Low
- ----                          ----              ---     

First Quarter                  $ 8.75          $ 4.88
Second Quarter                 $12.50          $ 7.13
Third Quarter                  $14.50          $11.75
Fourth Quarter                 $12.00          $ 9.75

1996:                         High              Low
- ----                          ----              ---     
First Quarter                  $14.50          $10.25
(through March 21, 1996)


To date, the Company has not declared or paid any cash dividends on its common
stock, and the present policy of the Board of Directors is to retain any
earnings to provide for the Company's growth. Any future determination to pay
dividends will be at the discretion of the Board of Directors, and dependent
upon the Company's financial condition, results of operations, capital
requirements and such other factors as the Board of Directors deems relevant. In
addition, the Company's current credit arrangement with NationsBank of Texas,
N.A. ("NationsBank") currently limits the payment of cash dividends to 75% of
annual net earnings (as defined in the credit agreement) if no draws exist under
the acquisition line of credit and 25% of annual net earnings if the acquisition
line of credit has been drawn upon.

The Company has paid one stock dividend on its common stock. During April 1994,
the Board of Directors approved a 3% stock dividend distributed on May 23, 1994
to shareholders of record as of May 6, 1994. In connection with the dividend,
the Company issued 152,829 shares of common stock from its treasury.

The Board of Directors on various occasions, beginning in October 1987 and as
recently as August 1993, approved stock repurchases of up to an aggregate of
3,150,000 shares, of which approximately 2,900,000 have been repurchased to
date. During the year ended December 31, 1995, the Company repurchased no shares
of common stock. During 1995, the Company issued 1,033,333 shares of common
stock from its treasury as partial consideration in the acquisition of Neuromed,
Inc. In addition, during the fourth quarter of 1995, the Company completed a
public offering in which it issued 1,676,667 shares, almost







                                      -18-

<PAGE>   20


all of which were issued from its treasury. The Company received net proceeds of
$15.2 million which were used to repay $13.9 million of senior bank
indebtedness. At December 31, 1995, the Company had no shares in its treasury
and does not anticipate further repurchases during the foreseeable future.

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

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

OVERVIEW

On March 31, 1995, the Company acquired all of the issued and outstanding
capital stock of Neuromed, Inc., which was held by Mr. William Borkan and his
brother, Mr. Burt Borkan. The Neuromed acquisition was accounted for as a
purchase. The Company paid the Borkans $15.4 million in cash ($200,000 of which
was paid in June 1995 as a purchase price adjustment) and issued them 833,333
shares of Common Stock valued then at $6.5 million. The Company also incurred
$1.1 million in acquisition and financing costs. Depending on Neuromed's
attainment of certain sales objectives, the Company also agreed to pay the
Borkans contingent "earn-out" consideration in January 1996 and January 1997,
payable in a combination of cash and Common Stock. In June 1995, Mr. William
Borkan was elected to the Company's Board of Directors.

In September 1995, the Company and Mr. William Borkan amended certain terms of
the Neuromed acquisition agreement. Under the amendment, (i) the Company agreed
to issue Mr. Borkan 200,000 additional shares of Common Stock concurrently with
the closing of the public offering completed in November 1995 and pay Mr. Borkan
$1.5 million in cash in January 1996 to satisfy the 1996 contingent payment
obligation, which had been earned in July 1995, (ii) the Company agreed to
include all of the Borkans' Common Stock (1,033,333 shares) in the public
offering, (iii) Mr. Borkan resigned from the Company's Board of Directors and
relinquished his board representation and attendance rights, (iv) Mr. Borkan
relinquished his registration rights, and (v) in the event the 1997 contingent
earn-out payment is fully earned, the Company agreed to pay Mr. Borkan an amount
in cash equal to $1.5 million plus the value of 200,000 shares of Common Stock
at the net public offering price ($9.35 per share after underwriting discounts
and commissions).

In connection with the Neuromed acquisition, the Company entered into the First
Amended and Restated Credit Agreement dated March 31, 1995, with NationsBank
(the "Loan Agreement"), which provided for $15.0 million in senior term
financing and a $5.0 million working capital line of credit. The senior term
debt was utilized to pay most of the Neuromed purchase price. The Company has
also drawn down $4.5 million on the working capital line of credit. This bank
debt was collateralized by certain of the Company's assets, including without
limitation, 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 $2.0 million.
NationsBank also excluded the Company's real property, building, and certain
equipment in Allen, Texas, which collateralize financing provided in 1993 by
MetLife Capital Corporation.





                                      -19-


<PAGE>   21


On November 15, 1995, the public offering of 2,400,000 shares of Common Stock
was completed. Of these shares, 1,316,667 were sold by the Company and 1,083,333
were sold by selling shareholders (1,033,333 shares by the Borkans). The Company
received $11.8 million, after deducting underwriters' discounts and commissions
and offering expenses payable by the Company. In addition, on December 6, 1995,
the Company sold an additional 360,000 shares (the "green shoe") and received
net proceeds of $3.4 million. The Company utilized $13.9 million of the proceeds
from the offering to repay in its entirety the senior term bank debt with
NationsBank. At year end 1995, the Company had a commitment from NationsBank to
provide, in addition to the $5.0 million working capital line, a $15 million
acquisition line of credit. The Company entered into a Second Amended and
Restated Credit Agreement on February 9, 1996, which provided for the $15.0
million acquisition line of credit and $5.0 million working capital line of
credit.

RESULTS OF OPERATIONS

Comparison of the Years Ended December 31, 1995 and 1994

Revenues. Net revenue of $25.3 million for the year ended December 31, 1995, was
$11.3 million, or 80.7% above the level for the comparable 1994 period of $14.0
million. This increase during 1995 compared to 1994 was primarily attributable
to revenue generated by Neuromed, which was acquired on March 31, 1995. See Item
1: "Business" and Note 3 of the Notes to Consolidated Financial Statements.
Neuromed develops, manufactures and markets a line of electronic spinal cord
stimulation ("SCS") devices used to manage chronic severe pain. Net revenue from
sales of the Company's other products increased 6.3% during 1995 compared to
1994 primarily due to higher unit sales volume from the Company's cardiovascular
products.

During August 1995, the Company filed for FDA market clearance under a
pre-market notification ("510(k)") on its MPS(TM) brand of myocardial protection
system. On March 8, 1996, the Company received clearance from the FDA to
commercially market the MPS system and related products and expects to introduce
the MPS system during the second quarter of 1996. Management expects that
Neuromed and MPS should enhance the long-range growth objectives of the Company.

Gross Profit. Gross profit during 1995 increased to $14.7 million compared to
$6.4 million in 1994, an increase of 130%. As a percentage of net revenue, gross
profit increased to 58.0% in 1995 compared to 45.6% during 1994. This increase
in gross profit and gross profit margin during 1995 compared to 1994 was
primarily attributable to the revenue generated by Neuromed, since Neuromed's
products contribute higher gross profit margins than the Company's other product
lines.

Operating Expenses. Research and development expense increased to approximately
$4.6 million during 1995 compared to the 1994 level of $3.5 million, although
such expense decreased as a percentage of net revenue from 25.3% during 1994 to
18.1% during 1995. These expenditures during 1995 were $2.1 million more than
originally budgeted at the beginning of fiscal 1995. Of such overage, $650,000
were expenditures directed toward newly acquired Neuromed while the remainder
represented additional expenditures directed at continued development of the
Company's MPS(TM) brand of myocardial protection system. See Item 1: "Business
- -- Other Business Matters -- Research and Development".







                                      -20-

<PAGE>   22


Myocardial protection is the process of arresting and caring for the heart
during open-heart surgery. The MPS system is designed to integrate key functions
relating to the delivery of solutions to the heart such as varying the rate and
ratio of oxygenated blood, crystalloid, potassium and other additives, and
controlling temperature, pressure and other variables to allow simpler, more
flexible and cost-effective management of this process. The Company's MPS system
features an electronic console and includes a line of captive and non-captive
disposable products. As previously noted, the Company filed for FDA market
clearance under a 510(k) during August 1995 and on March 8, 1996 received
clearance to commercially market the MPS system, which management believes will
occur during the second quarter of 1996. Increased expenditures during 1995
compared to 1994 were primarily the result of additional salary and contract
labor expense from staff additions and increased consulting expense.

The Company has budgeted $3.3 million for research and development activities
during 1996. Management expects that about 60% of such expenditures to be
directed to refining and redesigning of Neuromed products, with the remainder
directed primarily to continued development of MPS and related products.
Management expects that most of its research and development activities in
fiscal 1996 will be Company-sponsored and funded through its operations.

Marketing, general and administrative expenses as a percent of net revenue
decreased to 33.2% during 1995 compared to 35.6% during 1994, while the dollar
amount increased $3.4 million. Marketing expense as a percentage of net revenue
increased to 16.6% in 1995 from 13.7% during 1994, and the dollar amount
increased by $2.3 million. Of such increase, $1.7 million was Neuromed marketing
expense. The remainder of the increase in marketing expense was primarily the
result of additional salary and benefit expense from personnel additions, and
increased travel, commission, convention and recruiting expense. During the
fourth quarter of 1995, the Company hired four additional direct salespersons in
anticipation of the 510(k) clearance of its MPS system. Management expects to
introduce the MPS system during the second quarter of 1996 and anticipates
adding seven salespersons throughout 1996 to market the MPS system and related
products. General and administrative expense increased $1.1 million during 1995
compared to 1994, but as a percentage of net revenue, decreased from 21.9%
during 1994 to 16.6% during 1995. This increase in expense during 1995 compared
to 1994 was attributable to general and administrative expense of Neuromed,
including amortization expense of Neuromed intangibles.

Loss from Operations. On March 31, 1995, the Company acquired all of the capital
stock of Neuromed, Inc. See Note 3 of the Notes to Consolidated Financial
Statements. Of the aggregate purchase price for Neuromed, $10.5 million was
identified as purchased in-process research and development and in accordance
with generally accepted accounting principles was charged to expense, with no
related tax benefit, during 1995. As a result, the loss from operations
increased from $2.1 million in 1994 to $8.8 million during 1995. Excluding the
charge for purchased research and development, the Company generated earnings
from operations of $1.7 million compared to the $2.1 million loss for the 1994
period, reflecting the positive impact of the Neuromed acquisition.






                                      -21-


<PAGE>   23


Other Income (Expense). Other income (expense) decreased to an expense of $1.2
million during 1995 compared to income of $419,000 during 1994. This decrease
was primarily the result of higher interest expense which increased $1.1 million
during 1995 from 1994. The Company incurred $15.0 million of long-term bank debt
on March 31, 1995, which was used to fund most of the cash payment of the
Neuromed acquisition. See "-- Overview" and Notes 3 and 5 of the Notes to
Consolidated Financial Statements. Higher overall interest rates on borrowed
money also contributed to the increase in interest expense during 1995 compared
to 1994. In addition, gains recognized on the sale of the Company's investments
was $29,000 for 1995 compared to $464,000 for 1994, also contributing to the
decrease in other income.

Income Taxes. The Company recorded income tax expense of $155,000 during 1995 as
a consequence of the nondeductibility of the $10.5 million expense for purchased
research and development and amortization expense of costs in excess of net
assets acquired. No income tax benefit was recognized for the Company's 1994 net
operating loss.

Net Loss. The net loss increased from $1.7 million in 1994 to $10.4 million
during 1995 primarily as a result of the aforementioned $10.5 million expense
for purchased in-process research and development incurred in connection with
the Neuromed acquisition. In addition, the net loss for 1995 reflects an
extraordinary charge of $269,000 for the write-off of capitalized debt issuance
costs due to early repayment of the long-term bank debt.

Years Ended December 31, 1994 and 1993

Revenues. Net revenue of $14.0 million for the year ended December 31, 1994,
increased 2.6% from $13.6 million for the comparable 1993 period. Three of the
Company's product lines, however, contributed better results than the overall
2.6% year over year increase. Net revenue of the Company's cardiovascular
products increased $604,000, or 11.5%, due to higher unit sales volume from the
Company's family of pressure control valves. Net revenue generated by the
Company's pressure monitoring kits increased $160,000, or 11.7%, due to higher
unit sales volume. Net revenue generated by the Company's nasogastric feeding
tubes increased $108,000, or 48.2%. Of this increase, $74,000 was due to higher
unit sales volume with the remainder due to a price increase. Net revenue
generated by the Company's specialized tubing sets, however, decreased by
$518,500, or 7.7%, reflecting lower unit sales volume largely attributable to a
reduction in sales of specialized tubing sets used in oncology to the Companys'
largest customer, The University of Texas System Cancer Center (M.D. Anderson
Hospital), due to lower hospital census.

Gross Profit. Gross profit during 1994 decreased to $6.4 million compared to
$6.6 million in 1993, a reduction of $210,000. As a percentage of net revenue,
gross profit decreased to 45.6% in 1994 compared to 48.3% during 1993. The
decrease in gross profit during 1994 compared to 1993 resulted primarily from
the lower net revenue generated by the Company's specialized tubing sets. Lower
sales volume of this product line led not only to a reduction in actual gross
profit dollars from this product line, but also to a reduction in gross profit
margins for this product line, since manufacturing volumes were reduced, thus
resulting in higher overhead costs per unit.







                                      -22-

<PAGE>   24

Operating Expenses. Research and development expense increased to $3.5 million
during 1994 compared to the 1993 level of $1.9 million, and as a percentage of
net revenue increased from 14.0% to 25.3%. During 1994, the Company continued
development efforts on its MPS system and related products. See Item 1.
"Business -- Other Business Matters -- Research and Development". During June
1994, the Company completed assembly of five MPS prototypes. In September 1994,
the Company determined that more time was needed to redesign the MPS prototypes
into pre-production units and delayed the anticipated December 1994 510(k)
filing with the FDA. The redesign was completed during December 1994. Increases
in research and development expense during 1994 compared to 1993 were primarily
the result of additional salary and contract labor expense from personnel
additions, increased prototype tooling, test material, consulting, and
toxicology test expenses. The Company increased its development staff headcount
by fourteen personnel during 1994 bringing its total R&D staff to 39 at
year-end.

Marketing, general and administrative expense as a percent of net revenue
increased to 35.6% for 1994 compared to 32.2% for 1993, and the dollar amount
increased $577,000. Marketing expense remained relatively unchanged during 1994
as compared to 1993 and as a percentage of revenue, decreased from 14.1% during
1993 to 13.7% during 1994. General and administrative expense increased
$582,000, or 23.4%, during 1994 as compared to 1993, and as a percentage of net
revenue, increased from 18.2% during 1993 to 21.9% for 1994. This increase
during 1994 compared to 1993 was primarily the result of higher recruiting and
relocation expense, depreciation and amortization expense, health
insurance expense, employee relations expense and expenses related to a proposed
acquisition that was not consummated.

Earnings (Loss) from Operations. Earnings from operations decreased from
earnings of $281,000 during 1993 to a loss of $2.1 million in 1994 as a result
of the aforementioned increases in research and development and general and
administrative expenses and the decrease in gross profit.

Other Income (Expense). Other income decreased to $419,000 during 1994 compared
to other income of $667,000 for the prior year. This decrease resulted from an
increase in interest expense. Interest expense increased during 1994 as compared
to 1993 by $488,000 primarily due to two pieces of debt which were in place for
all of 1994 but only in place during the fourth quarter of 1993. During December
1993, the Company consummated a financing with MetLife Capital Corporation which
provided $4.4 million of long-term financing for the Company's new corporate
headquarters constructed during 1993. In addition, the Company increased
borrowings against its working capital line of credit with NationsBank during
1994.

No income tax benefit was recognized for the Company's 1994 net operating loss.
Income tax expense during 1993 was $301,000.

Net Earnings (Loss). Net earnings decreased from net earnings of $816,000 during
1993 to a net loss of $1.7 million in 1994 primarily as a result of the decrease
in earnings from operations (caused by lower gross profit and higher general and
administrative and research and development expenses) and the decrease in other
income discussed above. During May 1993, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards No. 115, "Accounting
for Certain Investments in Debt and Equity






                                      -23-



<PAGE>   25


Securities". The Company, as permitted under the Statement, elected to adopt the
provisions of the new standard at the end of fiscal 1993. The cumulative effect
as of December 31, 1993 of adopting Statement No. 115 was to increase net income
by $169,000, resulting from the reversal of unrealized losses recorded during
1993. The ending balance of stockholder's equity was decreased by $169,000 to
reflect the net unrealized holding loss on securities classified as
available-for-sale previously carried at the lower of cost or market.

LIQUIDITY AND CAPITAL RESOURCES

The Company's working capital of $12.2 million at the end of 1995 increased from
$7.4 million at the end of 1994. The ratio of current assets to current
liabilities was 3.7 to 1 at the end of 1995 and 2.8 to 1 at the end of 1994. The
Company's ratio of long-term debt to total capital was 28% at year-end 1995, up
slightly from 26% at year-end 1994.

As previously noted, the Company completed a public offering during the fourth
quarter of 1995. The total number of shares sold pursuant to the offering were
2,760,000, of which, 1,676,667 shares were sold on the Company's behalf. The
Company's net proceeds from the offering totaled $15.2 million. The Company used
$13.9 million of such proceeds to retire the senior term bank debt which was
incurred during March 1995 to consummate the Neuromed acquisition.

In February 1996, the Company amended its working capital line of credit and
added a $15 million acquisition line of credit with NationsBank. 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 on 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 such as, amongst others, 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.

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 1996.

CASH FLOWS

Net cash used by operating activities in 1995 increased slightly to $1.5 million
compared to $1.4 million in 1994. This increase was due to an increase in net
working capital, principally in the areas of accounts receivable, inventory and
prepaid expenses.

Investing activities in 1995 resulted in a net use of cash of $14.1 million
compared to cash being provided by investing activities during 1994 of $320,000.
This change during 1995





                                      -24-



<PAGE>   26


compared to 1994 was primarily the result of $16.0 million utilized to
consummate the Neuromed acquisition in March 1995. Additionally, capital
expenditures increased to $1.5 million in 1995, an increase of $400,000 from
1994. The sale of certain of the Company's investments in marketable securities
provided $3.3 million of cash, up from $1.3 million in 1994.

Financing activities in 1995 provided $16.9 million of cash compared to $620,000
in 1994. As discussed earlier, during 1995 the Company borrowed $15.0 million of
senior term bank debt to fund most of the cash portion of the Neuromed
acquisition purchase price and increased its borrowings under its working
capital line of credit by $1.9 million. Furthermore, as also discussed earlier,
the Company completed a public offering during 1995 which provided net proceeds
of $15.2 million. These proceeds were utilized to repay the senior term bank
indebtedness.

OUTLOOK AND UNCERTAINTIES

Quest does not provide forecasts of potential future financial performance.
While Quest management is optimistic about Quest's long-term prospects, the
following issues and uncertainties, among others, should be considered in
evaluating its growth outlook.

Product Development and Market Acceptance. The Company's growth depends in part
on the development and market acceptance of new products, including the MPS
system and related products. There is no assurance that the Company will
continue to develop successful products, that delays in product introduction
will not be experienced, or that once such products are introduced, the market
will accept them.

New Business Integration. To the extent the Company's business strategy involves
acquisitions, the integration of acquired businesses can be difficult and
costly. The Neuromed acquisition, for example, will require management time and
attention and will only be fully successful if operations are combined in an
orderly and timely manner.

Government Regulation.  The Company's business is subject to extensive
government regulation, principally by the FDA.  The regulatory process,
especially as it relates to product approvals, can be lengthy, expensive and
uncertain.

Competition and Technological Change. The medical device market is highly
competitive. The Company competes with many larger companies that have access to
greater capital, research and development, marketing, distribution and other
resources than the Company. In addition, this market is characterized by
extensive research efforts and rapid product development and technological
change, which could render the Company's products obsolete or noncompetitive.

Intellectual Property Rights. The Company relies in part on patents, trade
secrets and proprietary technology to remain competitive. It may be necessary to
defend these rights or to defend against claims that the Company is infringing
the rights of others. Intellectual property litigation and controversies are
disruptive and expensive.






                                      -25-

<PAGE>   27


Cost Pressures on Medical Technology. The overall escalating cost of medical
products and healthcare results in significant cost pressure. Third party payors
are under intense pressure to challenge the prices charged for medical products
and services.

Potential Product Liability.  The testing, manufacturing, marketing and sale of
medical devices entail substantial risks of liability claims or product recalls.

Other Uncertainties. Other operating, financial or legal risks or uncertainties
are discussed in the Form 10-K in specific contexts. The Company is, of course,
also subject to general economic risks, the risk of interruption in the source
of supply, the risk of loss of a major customer, dependence on key personnel and
other risks and uncertainties.

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 declined 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.

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.

ITEM 7.       FINANCIAL STATEMENTS

The information required by this item is set forth in Appendices A and B.

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

None






                                      -26-


<PAGE>   28

                                    PART II

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

The information required by this item is contained under the captions "Election
of Directors" and "Executive Officers" in the definitive proxy material of the
Company to be filed in connection with its 1996 annual meeting of stockholders,
which information is incorporated herein by reference.

ITEM 10.   EXECUTIVE COMPENSATION

The information required by this item is contained under the captions
"Compensation and Committees of the Board of Directors" and "Compensation of
Executive Officers" in the definitive proxy material of the Company to be filed
in connection with its 1996 annual meeting of stockholders, which information is
incorporated herein by reference.

ITEM 11.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
           MANAGEMENT

The information required by this item is contained under the caption "Security
Ownership of Management and Principal Shareholders" in the definitive proxy
material of the Company to be filed in connection with its 1996 annual meeting
of stockholders, which information is incorporated herein by reference.

ITEM 12.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is contained under the caption "Certain
Relationships and Related Transactions" in the definitive proxy material of the
Company to be filed in connection with its 1996 annual meeting of stockholders,
which information is incorporated herein by reference.

ITEM 13.   EXHIBITS, LISTS AND REPORTS ON FORM 8-K

(a)   Exhibits:

      2.1      Agreement for the Purchase and Sale of All of the Issued Capital 
               Stock of Neuromed, Inc. dated February 10, 1995, between Quest 
               Medical, Inc. and William N. Borkan(9)

      2.2      Amendment Agreement dated March 17, 1995, between Quest Medical,
               Inc. and William N. Borkan(9)

      2.3      Letter Agreement dated as of September 23, 1995, by and between
               Quest Medical, Inc. and William N. Borkan(10)

      3.1      Articles of Incorporation, as amended(10)

      3.2      Bylaws(1)

      4.1      Rights Agreement between Quest Medical, Inc. and MTrust Corp., 
               N.A. as Rights Agent dated as of October 12,1989 and Letter to 
               Shareholders of Quest Medical, Inc. dated October 13,1989, 
               including attached Summary of Rights to Purchase Shares(10)


                                      -27-

<PAGE>   29


     4.2       Amendment of Rights Agreement dated as of February 9, 1995, 
               between Quest Medical, Inc. and KeyCorp Shareholder Services, 
               Inc. as Rights Agent(9)

     10.1      Quest Medical, Inc. 1979 Amended and Restated Employees Stock 
               Option Plan(2)

     10.2      Form of 1979 Employees Stock Option Agreement(3)

     10.3      Quest Medical, Inc. Directors Stock Option Plan (as amended)(2)

     10.4      Form of Directors Stock Option Agreement(1)

     10.5      Quest Medical, Inc. 1987 Stock Option Plan(10)

     10.6      Form of 1987 Employee Stock Option Agreement(10)

     10.7      Quest Medical, Inc. 1995 Stock Option Plan(10)

     10.8      Form of 1995 Employee Stock Option Agreement(10)

     10.9      Form of Employment Agreement and Covenant Not to Compete, 
               between the Company and key employees(1)

     10.10     Sublease Agreement dated July 2,1992, effective September 1, 
               1992, between the Company and Unistor Corporation(5)

     10.11     Promissory Note dated December 28,1993, between Quest Medical, 
               Inc. and MetLife Capital Financial Corporation(8)

     10.12     Commercial Deed of Trust, Security Agreement and Assignment of 
               Leases and Rents and Fixture Filing dated December 28,1993, 
               between Quest Medical, Inc. and MetLife Capital Financial 
               Corporation(8)

     10.13     Term Promissory Note dated December 28,1993, between Quest 
               Medical, Inc. and MetLife Capital Corporation(8)

     10.14     Loan and Security Agreement dated December 28,1993, between Quest
               Medical, Inc. and MetLife Capital Corporation(8)

     10.15     Supplemental Security Agreement Number One dated December 28,
               1993, between Quest Medical, Inc. and MetLife Capital 
               Corporation(8)

     10.16     Security Agreement dated as of March 31, 1995 between Quest 
               Medical, Inc. and NationsBank of Texas, N.A.(11)

     10.17     Security Agreement dated as of March 31, 1995 between Neuromed,
               Inc. and NationsBank of Texas, N.A.(11)

     10.18     Intellectual Property Security Agreement and Assignment dated 
               as of March 31, 1995 between Quest Medical, Inc. and 
               NationsBank of Texas, N.A.(11)

     10.19     Intellectual Property Security Agreement and Assignment dated 
               as of March 31, 1995 between Neuromed, Inc. and NationsBank of 
               Texas, N.A.(11)

     10.20     License Agreement dated as of March 31, 1995 between Quest 
               Medical, Inc. and NationsBank of Texas, N.A.(11)

     10.21     License Agreement dated as of March 31, 1995 between Neuromed, 
               Inc. and NationsBank of Texas, N.A.(11)

     10.22     Guaranty of Neuromed, Inc. in favor of NationsBank of Texas, 
               N.A. under the First Amended and Restated Credit Agreement 
               dated as of March 31, 1995(11)

     10.23     Second Amended and Restated Credit Agreement dated as of 
               February 9, 1996, between Quest Medical, Inc. and NationsBank 
               of Texas, N.A.(12)

     10.24     Promissory Note (Facility A. Note) in the original principal 
               amount of $5 million dated February 9, 1996(12)

     10.25     Promissory Note (Facility B Note) in the original principal 
               amount of $15 million dated February 9, 1996(12)


                                      -28-

<PAGE>   30


     10.26     First Amendment to Security Agreement, Intellectual Property 
               Security Agreement and Assignment, License Agreement, and 
               Pledge Agreement dated February 9, 1996 between Quest Medical, 
               Inc. and NationsBank of Texas, N.A.(12)
 
     10.27     First Amendment to Security Agreement, Intellectual Property 
               Security Agreement and Assignment, License Agreement, and 
               Guaranty dated February 9, 1996, between Neuromed, Inc. and 
               NationsBank of Texas, N.A.(12)
 
     11.1      Computation of Earnings Per Share(12)

     21.1      Subsidiaries(12)

     23.1      Consent of Independent Auditors(12)
          
(b)      Reports on Form 8-K

      None


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

(1)   Filed as an Exhibit to the Company's Registration Statement on Form
      S-18, Registration No. 2-71198-FW, and incorporated herein by
      reference.

(2)   Filed as an Exhibit to the report of the Company on Form 10-K for the
      year ended December 31, 1987, and incorporated herein by reference.

(3)   Filed as an Exhibit to the Company's Registration Statement on Form
      S-1, Registration No. 2-78186, and incorporated herein by reference.

(4)   Filed as an Exhibit to the report of the Company on Form 8-K dated
      October 13, 1989, and incorporated herein by reference.

(5)   Filed as an Exhibit to the report of the Company on Form 10-KSB for
      the year ended December 31, 1992, and incorporated herein by
      reference.

(6)   Filed as an Exhibit to the report of the Company on Form 10-QSB for
      the period ended June 30, 1993, and incorporated herein by reference.

(7)   Filed as an Exhibit to the report of the Company on Form 10-QSB for
      the period ended September 30, 1993, and incorporated herein by
      reference.

(8)   Filed as an Exhibit to the report of the Company on Form 10-KSB for
      the year ended December 31, 1993, and incorporated herein by
      reference.

(9)   Filed as an Exhibit to the report of the Company on Form 10-KSB for
      the year ended December 31, 1994, and incorporated herein by
      reference.

(10)  Filed as an Exhibit to the Company's Registration Statement on Form
      SB-2, Registration No. 33-62991, and incorporated herein by
      reference.

(11)  Filed as an Exhibit to the report of the Company on Form 8-K dated
      April 13, 1995, and incorporated herein by reference.
 
(12)  Filed herewith.


                                      -29-

<PAGE>   31




                                   SIGNATURES


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

Date:  March 29, 1996
                                        QUEST MEDICAL, INC.



                                        By:    /s/THOMAS C. THOMPSON
                                             ------------------------------ 
                                               Thomas C. Thompson, President

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


<TABLE>
<CAPTION>

               Signature                               Title                                     Date
               ---------                               -----                                     ----

<S>                                       <C>                                               <C>   
/s/Thomas C. Thompson                      President and Director of Quest                   March 29, 1996
- ----------------------------------         Medical, Inc. (Principal Executive 
Thomas C. Thompson                         Officer)  
                                           


/s/F. Robert Merrill III                   Senior Vice President - Finance, Secretary        March 29, 1996
- ----------------------------------         and Treasurer of Quest Medical, Inc.
F. Robert Merrill III                      (Principal Financial and Accounting Officer)   
                                           


/s/Linton E. Barbee                        Director of Quest Medical, Inc.                   March 29, 1996
- ----------------------------------
Linton E. Barbee


/s/Robert C. Eberhart                      Director of Quest Medical, Inc.                   March 29, 1996
- ----------------------------------
Robert C. Eberhart


                                           Director of Quest Medical, Inc.                   March 29, 1996
- ----------------------------------
John A. Gula


                                           Director of Quest Medical, Inc.                   March 29, 1996
- ----------------------------------
Hugh M. Morrison

</TABLE>




                                      -30-

<PAGE>   32


<TABLE>
<CAPTION>
               Signature                               Title                                     Date
               ---------                               -----                                     ----
<S>                                       <C>                                               <C>   
/s/Michael J. Torma                        Director of Quest Medical, Inc.                   March 29, 1996
- ----------------------------------
Michael J. Torma


</TABLE>






                                                   
                                      -31-

<PAGE>   33

                                                                      APPENDIX A


                        CONSOLIDATED FINANCIAL STATEMENTS
                          INDEPENDENT AUDITORS' REPORT

                       THREE YEARS ENDED DECEMBER 31, 1995


                       FORMING A PART OF THE ANNUAL REPORT

                                   FORM 10-KSB

                                     ITEM 7


                                       OF


                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                                (NAME OF ISSUER)



                                 FILED WITH THE

                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549


                                      UNDER

                     THE SECURITIES AND EXCHANGE ACT OF 1934









<PAGE>   34




                      QUEST MEDICAL, INC. AND SUBSIDIARIES

                                TABLE OF CONTENTS
                                       TO
                        CONSOLIDATED FINANCIAL STATEMENTS

                              FORM 10-KSB - ITEM 7









INDEPENDENT AUDITORS' REPORT



CONSOLIDATED FINANCIAL STATEMENTS:

Consolidated Balance Sheets - December 31, 1995 and 1994 
Consolidated Statements of Operations - Three years ended December 31, 1995 
Consolidated Statements of Stockholders' Equity - Three years ended 
  December 31, 1995 
Consolidated Statements of Cash Flows - Three years ended December 31, 1995 
Notes to Consolidated Financial Statements







<PAGE>   35



                         Report of Independent Auditors

The Board of Directors
Quest Medical, Inc.

We have audited the accompanying consolidated balance sheets of Quest Medical,
Inc. and subsidiaries (the Company) as of December 31, 1995 and 1994, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 1995. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Quest Medical,
Inc. and subsidiaries at December 31, 1995 and 1994, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1995, in conformity with generally accepted
accounting principles.

As discussed in Note 4 to the financial statements, in 1993 the Company changed
its method of accounting for certain investments in debt and equity securities.


                                                ERNST & YOUNG LLP


Dallas, Texas
March 6, 1996

<PAGE>   36
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                           DECEMBER 31, 1995 AND 1994
<TABLE>
<CAPTION>


ASSETS                                                                         1995                    1994
- ------                                                                      -----------            -----------
<S>                                                                          <C>                  <C>              
Current assets:
    Cash and cash equivalents                                                $1,325,630            $    87,963
    Marketable securities                                                     2,588,547              5,174,470

    Receivables:
        Trade accounts, less allowance for doubtful
           accounts of $114,337 in 1995 and $14,337 in 1994                   4,955,235              1,671,684
        Interest and other                                                      128,492                172,969
                                                                            -----------            -----------
         Total receivables                                                    5,083,727              1,844,653
                                                                            -----------            -----------

    Inventories:
        Raw materials                                                         2,743,702              1,322,498
        Work-in-process                                                       1,077,529                580,432
        Finished goods                                                        2,285,961              2,084,522
                                                                            -----------            -----------
         Total inventories                                                    6,107,192              3,987,452
                                                                            -----------            -----------

    Deferred income taxes                                                       356,703                     --

    Prepaid expenses and other current assets                                 1,226,268                484,406
                                                                            -----------            -----------
         Total current assets                                                16,688,067             11,578,944
                                                                            -----------            -----------

Property, plant and equipment:
    Land                                                                      1,930,289              1,930,289
    Building and improvements                                                 5,271,718              5,258,976
    Furniture and fixtures                                                    2,964,471              2,587,738
    Machinery and equipment                                                   3,879,802              2,722,868
                                                                            -----------            -----------
                                                                             14,046,280             12,499,871

    Less accumulated depreciation and
        amortization                                                          3,784,510              2,867,453
                                                                            -----------            -----------
         Net property, plant and equipment                                   10,261,770              9,632,418
                                                                            -----------            -----------

Cost in excess of net assets acquired, net of
    accumulated amortization of $340,300 in 1995
    and $99,550 in 1994                                                       9,546,298                913,656
Patents, net of accumulated amortization of $1,086,433
    in 1995 and $857,965 in 1994                                              1,288,966              1,517,434
Purchased technology from acquisitions, net of
    accumulated amortization of $413,558 in 1995 and
    $163,007 in 1994                                                          4,284,442                534,993
Tradenames, net of accumulated amortization of
    $93,750 in 1995                                                           2,406,250                     --
Other assets, net of accumulated amortization of
    $178,667 in 1995 and $141,167 in 1994                                        19,964                 57,464
                                                                            -----------            -----------
                                                                            $44,495,757            $24,234,909
                                                                            ===========            ===========

                                                                                                   (Continued)

</TABLE>
See accompanying notes to consolidated financial statements.


<PAGE>   37



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                           DECEMBER 31, 1995 AND 1994
<TABLE>
<CAPTION>


LIABILITIES AND STOCKHOLDERS' EQUITY                                            1995                  1994
- ------------------------------------                                        -----------           -----------
<S>                                                                       <C>                    <C>   
Current liabilities:
    Accounts payable                                                        $ 1,210,265            $   951,208
    Short-term notes payable and current maturities of
        long-term notes payable                                               1,616,311              2,759,241
    Accrued salary and employee benefit costs                                   630,908                392,397
    Accrued relocation costs                                                    291,370                     --
    Other accrued expenses                                                      755,976                 65,393
                                                                            -----------            -----------
         Total current liabilities                                            4,504,830              4,168,239
                                                                            -----------            -----------


Notes payable                                                                 8,558,297              4,123,853


Deferred income taxes                                                           562,580                 11,837


Commitments and contingencies

Stockholders' equity:
    Common stock, $.05 par value.
        Authorized 10,000,000 shares;
           issued 8,147,349 shares in 1995
           and 7,982,498 shares in 1994                                         407,367                399,125
    Additional capital                                                       38,253,670             19,514,171
    Retained earnings (deficit)                                              (7,579,925)             2,794,118
    Unrealized loss on marketable securities net of
        tax benefit of $108,729 in 1995                                        (211,062)              (917,634)
    Cost of common shares in treasury; 2,705,816 shares
        in 1994.                                                                     --             (5,858,800)
                                                                            -----------            -----------
         Total stockholders' equity                                          30,870,050             15,930,980


                                                                            -----------            -----------
                                                                            $44,495,757            $24,234,909
                                                                            ===========            ===========

</TABLE>


See accompanying notes to consolidated financial statements.


<PAGE>   38



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                             YEARS ENDED DECEMBER 31

<TABLE>
<CAPTION>


                                                                           1995                   1994                  1993
                                                                     -------------           -------------          -------------
<S>                                                                 <C>                      <C>                    <C>    
Net revenue                                                          $  25,320,990             $13,999,165            $13,642,764
Cost of revenue                                                         10,624,215               7,617,932              7,052,157
                                                                     -------------           -------------          -------------
         Gross profit                                                   14,696,775               6,381,233              6,590,607
                                                                     -------------           -------------          -------------

Operating expenses:
    General and administrative                                           4,199,398               3,063,296              2,481,476
    Research and development                                             4,582,868               3,542,193              1,909,589
    Purchased research and development                                  10,500,000                      --                     --
    Marketing                                                            4,195,972               1,913,793              1,918,285
                                                                     -------------           -------------          -------------
                                                                        23,478,238               8,519,282              6,309,350
                                                                     -------------           -------------          -------------
         Earnings (loss) from operations                                (8,781,463)             (2,138,049)               281,257

Other income (expense):
    Gain on sale of marketable securities                                   29,115                 464,113                462,178
    Interest expense                                                    (1,657,818)               (569,428)               (81,800)
    Investment and other income, net                                       460,282                 524,171                286,171
                                                                     -------------           -------------          -------------
                                                                        (1,168,421)                418,856                666,549
                                                                     -------------           -------------          -------------
                                                                       
         Earnings (loss) before income taxes, cumulative
             effect of change in accounting principle 
             and extraordinary item                                     (9,949,884)             (1,719,193)               947,806

                                                                                                             
Income taxes                                                               155,114                     --                 300,769
                                                                     -------------           -------------          -------------
         Earnings (loss) before cumulative effect of change
             in accounting principle and extraordinary item            (10,104,998)             (1,719,193)               647,037

Extraordinary item - loss on early extinguishment of debt,
    net of income tax benefit of $138,599                                 (269,045)                     --                     --

Cumulative effect of change in accounting principle                             --                      --                169,308
                                                                     -------------           -------------          -------------
                                                                                

         Net earnings (loss)                                         $ (10,374,043)          $  (1,719,193)          $    816,345
                                                                     =============           =============          =============

Per common and common equivalent share:
    Earnings (loss) before cumulative effect of change in
        accounting principle and extraordinary item                  $       (1.52)          $        (.33)         $         .12
                                                                     =============           =============          =============
                                                                            
                                                                            
    Extraordinary item                                               $        (.04)          $         --           $          --
                                                                     =============           =============          =============
                                                                             
                                                                             
    Cumulative effect of change in accounting principle              $          --           $         --           $         .03
                                                                     =============           =============          =============
                                                                                
    Net earnings (loss)                                              $       (1.56)          $        (.33)         $         .15
                                                                     =============           =============          =============
                                                                                              
</TABLE>


See accompanying notes to consolidated financial statements.


<PAGE>   39



                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                             YEARS ENDED DECEMBER 31
<TABLE>
<CAPTION>


                                                                                   1995                1994              1993
                                                                                -----------         -----------       ----------
<S>                                                                           <C>                <C>                <C>    
Cash flows from operating activities:
    Net earnings (loss)                                                        $ (10,374,043)     $ (1,719,193)      $    816,345
    Adjustments to reconcile net earnings (loss)
        to net cash provided by (used in) operating activities:
        Depreciation                                                                 952,935           761,174            464,307
        Amortization                                                                 922,454           362,771            353,258
        Extraordinary item:  write off of debt issuance costs                        407,644                --                 --
        Deferred income taxes                                                        200,002                --             49,998
        Non-operating gains included in net earnings (loss)                         (137,898)         (464,113)          (634,516)
        Purchased research and development                                        10,500,000                --                 --
        Changes in assets and liabilities, net of effects of acquisition:
           Receivables                                                            (2,020,213)           387,347          (277,313)
           Inventories                                                              (557,095)            22,471           (12,032)
           Federal income tax recoverable                                                 --                --            616,823
           Prepaid expenses                                                         (750,284)         (128,770)           (71,400)
           Accounts payable                                                         (346,134)         (325,167)           444,610
           Accrued expenses                                                         (340,966)         (304,894)          (173,059)
           Other                                                                       9,720           (39,701)            (6,537)
                                                                                 -----------       -----------         ----------
                                                                                                                   
                                                                                       
              Net cash provided by (used in) operating activities                 (1,533,878)       (1,448,075)         1,570,484
                                                                                 -----------       -----------         ----------

Cash flows from investing activities:
    Net proceeds from marketable securities transactions                           3,317,881         1,346,903            182,085
    Additions to property, plant and equipment                                    (1,468,732)       (1,076,871)        (6,500,560)
    Acquisition, net of cash acquired                                            (15,996,910)               --                 --
    Other                                                                              6,550            19,510             47,338
                                                                                 -----------       -----------         ----------
              Net cash provided by (used in) investing activities                (14,141,211)          319,542         (6,271,137)
                                                                                -----------        -----------         ----------
Cash flows from financing activities:
    Net increase in short-term obligations                                                --           500,000          1,836,100
    Proceeds of long-term debt, net of debt issuance costs                        16,431,233           106,978          4,248,093
    Payment of long-term debt                                                    (15,108,486)         (121,977)          (726,999)
    Exercise of stock options                                                        369,449           137,047            119,756
    Net proceeds from public offering of common stock                             15,218,815                --                 --
    Issuance (purchase) of treasury stock, net                                         1,745                --           (349,004)
                                                                                 -----------       -----------         ----------
              Net cash provided by financing activities                           16,912,756           622,048          5,127,946
                                                                                 -----------       -----------         ----------
Net increase (decrease) in cash and cash equivalents                               1,237,667          (506,485)           427,293
Cash and cash equivalents at beginning of year                                        87,963           594,448            167,155
                                                                                 -----------       -----------         ----------
Cash and cash equivalents at end of year                                        $  1,325,630      $     87,963        $   594,448
                                                                                ============      ============        ===========

Supplemental cash flow information is presented below:

Income taxes paid                                                               $         --      $         --        $    46,000
                                                                                ============      ============        ===========
                                                                                         

Interest paid (net of amounts capitalized)                                      $  1,571,553      $    558,337        $    70,757
                                                                                ============      ============        ===========

</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>   40


                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                       THREE YEARS ENDED DECEMBER 31, 1995


<TABLE>
<CAPTION>

                                                                                              UNREALIZED               
                                                   COMMON STOCK                   RETAINED     LOSS ON                    TOTAL
                                               ------------------    ADDITIONAL   EARNINGS    MARKETABLE  TREASURY     STOCKHOLDERS'
                                               SHARES     AMOUNT      CAPITAL     (DEFICIT)   SECURITIES   STOCK         EQUITY
                                               ---------  --------   -----------  -----------  ---------  -----------  -----------
<S>                                            <C>        <C>      <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 of stock
        options                                   67,898     3,395       116,361           --         --           --      119,756
    Purchase of 100,000 common shares                 --        --            --           --         --     (349,004)    (349,004)
    Issuance of 1,490 common shares from              --        --            --           --         --        7,402        7,402
        treasury
    Tax effect of stock option
        exercise                                      --        --       187,236           --         --           --      187,236
    Adjustment to unrealized losses on
        marketable securities                         --        --            --           --   (169,308)          --     (169,308)
    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 of
        stock options                             43,057     2,153       134,894           --         --           --      137,047
    Issuance of 1,882 common shares from  
        treasury                                      --        --         5,595           --         --        4,075        9,670
    Stock dividend                                    --        --       586,054     (916,975)        --      330,921           --
    Adjustment to unrealized losses on
        marketable securities                         --        --            --           --   (748,326)          --     (748,326)
    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 of                                                 
        stock options                            160,422     8,021       361,429           --         --           --      369,450
    Issuance of 245 common shares from treasury       --        --         1,216           --         --          529        1,745
    Adjustment to unrealized losses on
        marketable securities                         --        --            --           --    706,572           --      706,572
    Issuance of 1,033,333 common shares from                                                     
        treasury for acquisition                      --        --     6,779,285           --         --    2,237,246    9,016,531
    Sale of treasury and new common shares in
        public offering, net of offering costs     4,429       221    11,597,569           --         --    3,621,025   15,218,815
    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
                                               =========  ========   ===========  ===========  =========  ===========  ===========
                                                                                                                      

</TABLE>

See accompanying notes to consolidated financial statements.


<PAGE>   41
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                               DECEMBER 31, 1995

(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 requirement or
      the occurrence of unforeseen problems following initial marketing. While
      the Company has received clearance for the MPS system, 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)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

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

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

      Effective December 31, 1993, 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. Prior to December 31, 1993,
      marketable securities were accounted for at the lower of cost or market.


<PAGE>   42



                                      - 2 -
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      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 December 31, 1995, 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 earnings per share for 1995, 1994, and 1993 are
      based upon 6,642,082, 5,256,683 and 5,559,422 common and common equivalent
      shares outstanding, respectively. Common stock equivalents are outstanding
      stock options and are included in average common and common equivalent
      shares outstanding using the treasury stock method except during periods
      where their effect would be antidilutive. During 1994, the Board of
      Directors approved a 3% stock dividend. The weighted average number of
      common and common equivalent shares outstanding used in computing 
      earnings per share were increased to retroactively reflect the stock
      dividend.

      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.

      Certain prior period amounts have been reclassified to conform to current
      year presentation.


                                                                     (Continued)


<PAGE>   43



                                      - 3 -
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(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 (payable in cash in January 1996). 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 year ended December 31, 1995.

      The purchase price allocation for the acquisition of Neuromed, as of
      December 31, 1995 is summarized below:

      Tradenames                                              $ 2,500,000
      Purchased technology                                      4,000,000
      Cost in excess of net assets acquired                     8,873,391
      Purchased research and development                       10,500,000
      Net tangible assets acquired                                640,050
      Deferred financing costs                                    468,767
                                                              -----------
                                                              $26,982,208
                                                              ===========

      In connection with the purchase, the Company determined that the
      operations of Neuromed will be relocated to the Company's facility in
      Allen, Texas by the end of the first


                                                                     (Continued)


<PAGE>   44



                                      - 4 -
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                      


      quarter of 1996. The estimated costs of the relocation of $850,000 were
      recorded during the year ended December 31, 1995 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, 1994. 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>
                                                               YEAR ENDED       YEAR ENDED
                                                              DECEMBER 31,      DECEMBER 31,
                                                                  1995             1994
                                                              ------------     ------------
<S>                                                            <C>              <C>
Pro forma revenue                                              $27,728,289      $22,043,518
Pro forma earnings (loss) from operations                        2,634,499          (86,467)
                                                               -----------      -----------
Pro forma net earnings (loss) before extraordinary
     item in 1995                                                  584,986       (1,220,055)
                                                               -----------      -----------
Pro forma net earnings (loss) per common and
     equivalent share before extraordinary item
     in 1995                                                   $       .08      $     (0.20)
                                                               ===========      ===========

</TABLE>


      The pro forma operations information excludes the non-recurring 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.

(4)   MARKETABLE SECURITIES

      The following is a summary of available-for-sale securities at December
      31, 1995:


<TABLE>
<CAPTION>                                                              GROSS               GROSS
                                                                     UNREALIZED          UNREALIZED          ESTIMATED
                                                    COST               GAINS               LOSSES            FAIR VALUE
                                                    ----            ----------           ----------          ----------
<S>                                            <C>                 <C>                  <C>                <C>
Investment grade preferred
  securities                                    $  993,241           $     252            $ 135,928          $  857,565
Publicly traded limited
  partnerships                                     506,447                  --               39,697             466,750
Real estate investment
  trusts                                         1,031,417              11,899               96,816             946,500
Other                                              377,233               3,884               63,385             317,732
                                                ----------           ---------            ---------          ----------
                                                $2,908,338           $  16,035            $ 335,826          $2,588,547
                                                ==========           =========            =========          ==========


</TABLE>


      At December 31, 1995, 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 December 31, 1995.


                                                                     (Continued)

<PAGE>   45


                                      - 5 -
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                      


      The following is a summary of available-for-sale securities at December
      31, 1994:


<TABLE>
<CAPTION> 
                                                                         GROSS               GROSS
                                                                       UNREALIZED          UNREALIZED           ESTIMATED
                                                      COST               GAINS               LOSSES             FAIR VALUE
                                                      ----             ----------          ----------           ----------
<S>                                               <C>                 <C>                  <C>                 <C>
Investment grade preferred
  securities                                      $2,788,587           $      --            $522,437           $2,266,150
Utility stocks                                       328,579                  --              48,704              279,875
Publicly traded limited
  partnerships                                       511,201                  --              80,263              430,938
Real estate investment trusts                      1,846,566              22,751             150,694            1,718,623
Other                                                617,171                 165             138,452              478,884
                                                  ----------           ---------            --------           ----------
                                                  $6,092,104           $  22,916            $940,550           $5,174,470
                                                  ==========           =========            ========           ==========

</TABLE>


      At December 31, 1994, no individual security represented more than 10% of
      the total portfolio or 2% of total assets. The Company did not have any
      investments in derivative financial instruments at December 31, 1994.

      In 1993 the Financial Accounting Standards Board issued Statement of
      Financial Accounting Standards No. 115, "Accounting for Certain
      Investments in Debt and Equity Securities." As permitted under the
      Statement, the Company elected to adopt the provisions of the new standard
      as of the end of 1993. The cumulative effect as of December 31, 1993, of
      adopting Statement 115, including the reversal of unrealized losses,
      increased net income by $169,308. The balance of stockholders' equity was
      decreased by $169,308 at December 31, 1993, to reflect the net unrealized
      holding loss on securities classified as available-for-sale.

(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 bear interest at prime plus 125
      basis points, or at the Company's option, LIBOR plus 300 basis points. The
      interest rate can be reduced based on the Company achieving certain ratios
      of senior bank debt to EBITDA (earnings before interest, taxes,
      depreciation and amortization). The facilities are 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 is 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 11). Borrowings under the working


                                                                     (Continued)

<PAGE>   46



                                    - 6 -
                     QUEST MEDICAL, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



      capital line are due and payable on May 31, 1997. At December 31, 1995,
      the Company had advances in the amount of $4,550,000 outstanding under the
      working capital line with a weighted average interest rate of 7.69%.

      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 acquisition line are
      immediately converted to a five-year term loan. The Company will be
      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 will also be 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 December 31, 1995, the Company had a note payable in the amount of
      $1,500,000 related to "earn-out" consideration for Neuromed, Inc. (See
      Note 3). The note is due in January 1996 and is non-interest bearing.

      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 $2,966,285 at December 31, 1995. 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 $1,158,323 at December 31, 1995.

      At December 31, 1995, the Company has 8% and 8.25% note facilities
      available that are collateralized by the Company's marketable securities
      held by investment companies. Borrowings under these notes are restricted
      to 50% of the market value of these securities and at December 31, 1995,
      the amounts available for total borrowings were $249,336 and $196,875,
      respectively. At December 31, 1995, the Company had no advances
      outstanding with respect to these notes.

      Total interest incurred during 1993 was $164,777. Capitalized interest, in
      conjunction with the construction of the principal office and
      manufacturing facility in 1993 was recorded as




                                                                     (Continued)



<PAGE>   47



                                    - 7 -
                     QUEST MEDICAL, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


      part of the building, and is amortized over the assets' useful life. In
      1993, $82,977 of interest costs were capitalized. No interest was
      capitalized in 1995 and 1994.

      The carrying value of the Company's debt approximates its fair value.

(6)   FEDERAL INCOME TAXES

      The significant components of the net deferred tax liability at December
      31, were as follows:

<TABLE>
<CAPTION>
                                                                                1995                   1994
                                                                           -------------           -------------
<S>                                                                         <C>                    <C>
  Deferred tax assets:
  Tax credit and net operating loss carry forwards                          $ 2,119,781             $ 1,664,528
  Accrued expenses and reserves                                                 377,302                 106,902
  Unrealized loss on marketable
    securities                                                                  108,729                 311,996
  Valuation allowance                                                          (271,767)             (1,745,090)
                                                                            -----------              ----------
  Total deferred tax asset                                                    2,334,045                 338,336

  Deferred tax liabilities:
  Purchased intangible assets                                                (2,110,125)                    --
  Excess of tax over book depreciation                                         (259,361)               (208,644)
  Other                                                                        (170,436)               (141,529)
                                                                            -----------              ----------
  Total deferred tax liability                                               (2,539,922)               (350,173)
                                                                            -----------              ----------

  Net deferred tax liability                                                $  (205,877)            $   (11,837)
                                                                            ===========             ===========

</TABLE>


      At December 31, 1995 and 1994, $271,767 and $137,927, respectively, of the
      total valuation allowance is attributable to stock option deductions
      which, when realized, will be credited to additional capital. During 1995,
      the valuation allowance decreased by $1,473,323 which was recorded as a
      reduction of costs in excess of net assets acquired because the decrease
      resulted from deferred tax liabilities recorded in connection with the
      acquisition of Neuromed. During 1994, the valuation allowance increased by
      $1,071,356.

      The provision for federal income taxes (benefit) for the years ended
      December 31 consists of the following amounts:


<TABLE>
<CAPTION>
                                              1995                     1994                    1993
                                              ----                     ----                    ----
<S>                                      <C>                       <C>                       <C>
Current                                   $ (44,888)                $     --                  $250,769
Deferred                                    200,002                       --                    50,000
                                           --------                 --------                  --------    
                                          $ 155,114                 $     --                  $300,769
                                           ========                 ========                  ========

</TABLE>


      A reconciliation of the provision (benefit) for taxes on earnings (loss)
      before cumulative effect of change in accounting principle and
      extraordinary item, to the taxes calculated at the U.S. statutory rate
      follows:


                                                                     (Continued)


<PAGE>   48



                                    - 8 -
                     QUEST MEDICAL, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


<TABLE>
<CAPTION>

                                                                       1995                  1994                1993
                                                                   -----------            ----------          ----------
<S>                                                               <C>                   <C>                  <C>
Federal income tax (benefit) at statutory
    rate                                                          $ (3,382,961)        $   (584,526)       $   322,254
Tax effect of:
    Tax exempt interest                                                (19,949)             (52,862)           (93,720)
    Nondeductible amortization of
        goodwill                                                        81,855               13,856             10,490
    Recognition of research and
        development tax benefit                                       (109,135)                   --                --
    Nondeductible writeoff of purchased
        in-process research and development                          3,570,000                   --                 --
    Benefit of net operating loss not
        recognized                                                          --              637,308                 --
    Other                                                               15,304              (13,776)            61,745
                                                                  ------------         ------------        -----------
           Income tax expense                                     $    155,114         $         --        $   300,769
                                                                  ============         ============        ===========

</TABLE>


      During 1993, the Company realized $187,236 of tax benefits from stock
      option deductions which were credited to additional capital.

      At December 31, 1995, general business credits of $861,047 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.

(7)   STOCKHOLDERS' EQUITY

      At December 31, 1995 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.

      Pursuant to the 1995 Stock Option Plan ("the 1995 Plan"), officers or
      other employees of the Company or any of its subsidiaries are eligible to
      receive stock option grants. The 1995 Plan provides for the grant of both
      incentive stock options intended to qualify for


                                                                     (Continued)

<PAGE>   49



                                    - 9 -
                     QUEST MEDICAL, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                     


      preferential tax treatment under Section 422 of the Internal Revenue Code
      of 1986, as amended, and nonqualified stock options that do not qualify
      for this treatment. The exercise price of all options granted under the
      1995 Plan must equal or exceed the fair market value of the Common Stock
      at the time of the grant. A total of 250,000 shares of Common Stock has
      been reserved for issuance under the 1995 Plan; provided, however, that on
      January 1 of each year (commencing in 1996), the aggregate number of
      shares of Common Stock reserved for issuance under the 1995 Plan shall be
      increased by the same percentage that the total number of issued and
      outstanding shares of Common Stock increased from the preceding January 1
      to the following December 31 (if such percentage is positive).

      At December 31, 1995, under all of the Company's stock option plans,
      options have been or may be granted to purchase 2,249,892 shares of its
      common stock of which 1,692,257 options have been or may be granted to key
      employees (Employees' Plan and the 1995 Plan) and 557,635 options have
      been or may be granted to directors and advisory directors (Directors'
      Plan). These options are exercisable one-fourth each year over a four-year
      period of continuous service. Certain options under both the Employees'
      Plan and Directors' Plan have a special two (2) year vesting schedule.
      These options are exercisable one-half each year over a two-year period.
      The stock options granted under the Employees' Plan and the 1995 Plan
      expire ten years from the date of grant. The stock options granted under
      the Directors' Plan expire six years from date of grant. The changes in
      the number of common shares issuable under outstanding options, the number
      of shares reserved for issuance and the price range of options for 1995
      and 1994 were as follows:

<TABLE>
<CAPTION>

                                                                       1995                          1994
                                                                    ---------                     ---------
<S>                                                                <C>                          <C>
Outstanding at beginning of year                                    1,088,003                       894,455
Granted                                                               239,520                       252,444
Effect of 3% stock dividend                                                --                        31,709
Rescinded                                                             (40,540)                      (47,548)
Exercised                                                            (160,422)                      (43,057)
                                                                    --------                      --------
Outstanding at end of year                                          1,126,561                     1,088,003
                                                                    =========                     =========

Exercisable at end of year                                            622,226                       488,590
                                                                   ==========                     =========

Shares reserved for issuance                                          127,214                       139,804
                                                                   ==========                     =========

Price range of options outstanding
at end of year                                                $1.45 to $12.13                $1.45 to $6.38

Price range of options exercised
during the year                                                $1.45 to $6.38                $1.45 to $4.25


</TABLE>


                                                                    (Continued)


<PAGE>   50



                                    - 10 -
                     QUEST MEDICAL, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                     

(8)   COMMITMENTS AND CONTINGENCIES

      The Company has no material commitments under noncancellable operating
      leases. Total rent expense under operating leases for the years ended
      December 31, 1995, 1994, and 1993 was $127,113, $24,930 and $293,221,
      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.

(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.

      Net sales to a major customer for each of the years ended December 31, as
      a percentage of total net revenues were as follows: 1995 - 10%, 1994 -
      19%, and 1993 - 23%. Foreign sales, primarily in Europe and Australia,
      were approximately 12% of total net revenues for the year ended December
      31, 1995.

(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
      $142,485 in 1995, $102,961 in 1994, and $86,903 in 1993.


 
                                                                     (Continued)


<PAGE>   51



                                    - 11 -
                     QUEST MEDICAL, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


(11)     SALE OF COMMON STOCK

      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. Net earnings (loss) per share 
      would have been ($1.28) if this transaction had occurred on March 31, 
      1995, the date at which the debt incurred in connection with the 
      Neuromed acquisition was first outstanding.


                                                                     (Continued)


<PAGE>   52





                                                                      APPENDIX B





                            QUARTERLY FINANCIAL DATA
                                  (UNAUDITED)




                      FORMING A PART OF THE ANNUAL REPORT

                                  FORM 10-KSB

                                     ITEM 7


                                       OF


                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                                (NAME OF ISSUER)



                                 FILED WITH THE

                       SECURITIES AND EXCHANGE COMMISSION

                             WASHINGTON, D.C. 20549


                                     UNDER

                    THE SECURITIES AND EXCHANGE ACT OF 1934
<PAGE>   53



<TABLE>
<CAPTION>
          1995                                               1ST              2ND(1),(2)              3RD              4TH(3)
- ------------------------------------------------------------------------------------------------------------------------------------
          <S>                                            <C>                 <C>                 <C>                <C>
          Net revenue                                     $4,071,640         $  7,231,494         $6,818,923        $7,198,933
          Gross profit                                     2,044,288            4,348,356          3,968,885         4,335,246
          Earnings (loss) from operations                   (336,944)          (9,775,378)           543,507           787,352
          Earnings (loss) before income taxes               (364,598)         (10,248,708)            90,541           572,881
          Earnings (loss) before extraordinary item         (364,598)         (10,248,708)            90,541           417,767
          Extraordinary item - loss on early
            extinguishment of debt                                --                   --                 --          (269,045)
          Net earnings (loss)                             $ (364,598)        $(10,248,708)        $   90,541        $  148,722
- ------------------------------------------------------------------------------------------------------------------------------------
          Per common and common
            equivalent share:
          Net earnings (loss) before extraordinary
            item                                          $     (.07)        $      (1.66)        $      .01        $      .05
          Extraordinary item                                      --                   --                 --              (.03)
- ------------------------------------------------------------------------------------------------------------------------------------
          Net earnings (loss)                             $     (.07)        $      (1.66)        $      .01        $      .02
====================================================================================================================================

          1994                                               1ST                   2ND                 3RD               4TH
- ------------------------------------------------------------------------------------------------------------------------------------
          Net revenue                                     $3,481,122         $  3,742,194         $3,457,971        $3,317,878
          Gross profit                                     1,469,803            1,725,701          1,628,565          ,557,164
          Loss from operations                              (303,885)            (414,921)          (511,352)         (907,891)
          Loss before income taxes                          (183,361)            (357,083)          (488,756)         (689,993)
          Net loss                                        $ (183,361)        $   (357,083)        $ (488,756)       $ (689,993)
- ------------------------------------------------------------------------------------------------------------------------------------
          Loss per common and common
            Equivalent share                              $     (.04)        $       (.07)        $     (.09)       $     (.13)
====================================================================================================================================
</TABLE>


__________________________________

(1)  Includes results of Neuromed, Inc. from April 1, 1995 (See Note 3)
(2)  Includes a non-recurring charge of $10,500,000 for purchased in-process
     research and development incurred in connection with the acquisition of 
     Neuromed, Inc. (See Note 3) 
(3)  Extraordinary item of $269,045 (net of income tax benefit of $138,599) from
     write-off of capitalized debt issuance costs due to repayment of bank debt.


<PAGE>   54
                              INDEX TO EXHIBITS

<TABLE>
<CAPTION>

Exhibit
Number                                        Description
- ---------                                     -----------

     <S>      <C>
      2.1     Agreement for the Purchase and Sale of All of the Issued Capital Stock of Neuromed, Inc. dated February
              10, 1995, between Quest Medical, Inc. and William N. Borkan(9)

      2.2     Amendment Agreement dated March 17, 1995, between Quest Medical, Inc. and William N. Borkan(9)

      2.3     Letter Agreement dated as of September 23, 1995, by and between Quest Medical, Inc. and William N.
              Borkan(10)

      3.1     Articles of Incorporation, as amended(10)

      3.2     Bylaws(1)

      4.1     Rights Agreement between Quest Medical, Inc. and MTrust Corp., N.A. as Rights Agent dated as of October
              12,1989 and Letter to Shareholders of Quest Medical, Inc. dated October 13,1989, including attached
              Summary of Rights to Purchase Shares(10)

      4.2     Amendment of Rights Agreement dated as of February 9, 1995, between Quest Medical, Inc. and KeyCorp
              Shareholder Services, Inc. as Rights Agent(9)

     10.1     Quest Medical, Inc. 1979 Amended and Restated Employees Stock Option Plan(2)

     10.2     Form of 1979 Employees Stock Option Agreement(3)

     10.3     Quest Medical, Inc. Directors Stock Option Plan (as amended)(2)

     10.4     Form of Directors Stock Option Agreement(1)

     10.5     Quest Medical, Inc. 1987 Stock Option Plan(10)

     10.6     Form of 1987 Employee Stock Option Agreement(10)

     10.7     Quest Medical, Inc. 1995 Stock Option Plan(10)

     10.8     Form of 1995 Employee Stock Option Agreement(10)

     10.9     Form of Employment Agreement and Covenant Not to Compete, between the Company and key employees(1)

     10.10    Sublease Agreement dated July 2,1992, effective September 1,1992, between the Company and Unistor
              Corporation(5)

     10.11    Promissory Note dated December 28,1993, between Quest Medical, Inc. and MetLife Capital Financial
              Corporation(8)

     10.12    Commercial Deed of Trust, Security Agreement and Assignment of Leases and Rents and Fixture Filing dated
              December 28,1993, between Quest Medical, Inc. and MetLife Capital Financial Corporation(8)

     10.13    Term Promissory Note dated December 28,1993, between Quest Medical, Inc. and MetLife Capital
              Corporation(8)

     10.14    Loan and Security Agreement dated December 28,1993, between Quest Medical, Inc. and MetLife Capital
              Corporation(8)

     10.15    Supplemental Security Agreement Number One dated December 28,1993, between Quest Medical, Inc. and MetLife
              Capital Corporation(8)

     10.16    Security Agreement dated as of March 31, 1995 between Quest Medical, Inc. and NationsBank of Texas,
              N.A.(11)

     10.17    Security Agreement dated as of March 31, 1995 between Neuromed, Inc. and NationsBank of Texas, N.A.(11)

     10.18    Intellectual Property Security Agreement and Assignment dated as of March 31, 1995 between Quest Medical,
              Inc. and NationsBank of Texas, N.A.(11)

     10.19    Intellectual Property Security Agreement and Assignment dated as of March 31, 1995 between Neuromed, Inc.
              and NationsBank of Texas, N.A. (11)
</TABLE>
<PAGE>   55
                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>

Exhibit
Number                                        Description
- -------                                       -----------
     <S>      <C>
     10.20    License Agreement dated as of March 31, 1995 between Quest Medical, Inc. and NationsBank of Texas, N.A.
              (11)

     10.21    License Agreement dated as of March 31, 1995 between Neuromed, Inc. and NationsBank of Texas, N.A.(11)

     10.22    Guaranty of Neuromed, Inc. in favor of NationsBank of Texas, N.A. under the First Amended and Restated
              Credit Agreement dated as of March 31, 1995(11)

     10.23    Second Amended and Restated Credit Agreement dated as of February 9, 1996, between Quest Medical, Inc. and
              NationsBank of Texas, N.A.(12)

     10.24    Promissory Note (Facility A. Note) in the original principal amount of $5 million dated February 9, 1996
              (12)

     10.25    Promissory Note (Facility B Note) in the original principal amount of $15 million dated February 9, 1996
              (12)

     10.26    First Amendment to Security Agreement, Intellectual Property Security Agreement and Assignment, License
              Agreement, and Pledge Agreement dated February 9, 1996 between Quest Medical, Inc. and NationsBank of
              Texas, N.A.(12)

     10.27    First Amendment to Security Agreement, Intellectual Property Security Agreement and Assignment, License
              Agreement, and Guaranty dated February 9, 1996, between Neuromed, Inc. and NationsBank of Texas, N.A.(12)

     11.1     Computation of Earnings Per Share(12)

     21.1     Subsidiaries(12)

     23.1     Consent of Independent Auditors(12)
</TABLE>




(1)      Filed as an Exhibit to the Company's Registration Statement on Form
         S-18, Registration No. 2-71198-FW, and incorporated herein by
         reference.

(2)      Filed as an Exhibit to the report of the Company on Form 10-K for the
         year ended December 31, 1987, and incorporated herein by reference.

(3)      Filed as an Exhibit to the Company's Registration Statement on Form
         S-1, Registration No. 2-78186, and incorporated herein by reference.

(4)      Filed as an Exhibit to the report of the Company on Form 8-K dated
         October 13, 1989, and incorporated herein by reference.

(5)      Filed as an Exhibit to the report of the Company on Form 10-KSB for
         the year ended December 31, 1992, and incorporated herein by
         reference.

(6)      Filed as an Exhibit to the report of the Company on Form 10-QSB for
         the period ended June 30, 1993, and incorporated herein by reference.

(7)      Filed as an Exhibit to the report of the Company on Form 10-QSB for
         the period ended September 30, 1993, and incorporated herein by
         reference.

(8)      Filed as an Exhibit to the report of the Company on Form 10-KSB for
         the year ended December 31, 1993, and incorporated herein by
         reference.

(9)      Filed as an Exhibit to the report of the Company on Form 10-KSB for
         the year ended December 31, 1994, and incorporated herein by
         reference.

(10)     Filed as an Exhibit to the Company's Registration Statement on Form
         SB-2, Registration No. 33-62991, and incorporated herein by reference.

(11)     Filed as an Exhibit to the report of the Company on Form 8-K dated
         April 13, 1995, and incorporated herein by reference.

(12)     Filed herewith.
