CERADYNE INC, 10-K405, 1997-03-31

CERADYNE INC
10-K405, 1997-03-31
ABRASIVE, ASBESTOS & MISC NONMETALLIC MINERAL PRODS

Previous: CENTRAL POWER & LIGHT CO /TX/, 35-CERT, 1997-03-31

Next: CHAMPION PARTS INC, 10-K, 1997-03-31

<PAGE>

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

X ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
- --- 1934 (Fee required)
For the Fiscal Year Ending December 31, 1996

___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 (No fee required)
For the transition period from _______ to _______

Commission File No. 0-13059

CERADYNE, INC.
----------------------------------------------------
(Exact name of Registrant as specified in its charter)

Delaware 33-0055414
- ------------------------------- ----------------------------
(State or other jurisdiction of (I.R.S. Employer Identifica-
incorporation or organization) tion Number)

3169 Red Hill Avenue, Costa Mesa, California 92626
---------------------------------------------------
(Address of principal executive offices)

Registrant's telephone number, including area code: (714) 549-0421
--------------

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
(Title of Class)

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

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

The aggregate market value (based on the closing price at which stock was sold)
of the voting shares held by non-affiliates of the registrant as of March 5,
1997 was $58,322,901.

As of March 5, 1997, the number of shares of the registrant's Common Stock
outstanding was 7,908,190.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement for its 1997 Annual Meeting of
Stockholders are incorporated by reference into Part III.
<PAGE>

PART I

This Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. The Company's actual results may differ
materially from the results projected in the forward-looking statements.
Factors that might cause such a difference include, but are not limited to,
those discussed in "Item 1 - Business," including the section therein entitled
"Certain Factors that May Affect the Company's Business and Future Results," and
in "Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations."

Item 1. Business
--------

INTRODUCTION

Ceradyne, Inc. ("Ceradyne" or the "Company") develops, manufactures and markets
advanced technical ceramic products and components for industrial, defense,
consumer and microwave applications. In many high performance applications,
products made of advanced technical ceramics meet specifications that similar
products made of metals or plastics cannot achieve. Advanced technical ceramics
can withstand extremely high temperatures, combine hardness with light weight,
are highly resistant to corrosion and wear, and have excellent electrical
insulation capability and other special electronic properties.

Ceradyne's technology was originally developed primarily for defense and
aerospace applications which have historically represented a substantial portion
of its business. As a result of the end of the "Cold War", one of the Company's
major defense contracts was canceled and the Company experienced reductions in
certain other defense-related business. As a result, the Company began to rely
more heavily on the development of new applications and markets, domestic and
international, for its advanced technical ceramic technology, while continuing
to serve its historical customer base which continued to account for a
substantial portion of the Company's business.

From revenues of $25.6 million in 1987, the Company's revenues declined to a
low of $15.9 million in 1993. Management believes that the Company's financial
recovery commenced in the fourth quarter of 1994 due to an increase in new
bookings and the divestiture of an historically unprofitable operation.
Revenues began to increase in the third quarter of 1994, and have continued to
increase during the years ended December 31, 1995, and December 31, 1996.

The Company continues to derive a substantial portion of its revenues from its
traditional products, such as lightweight ceramic armor for military helicopters
and microwave tube products. Management expects that newer products developed
or being developed by the Company for defense, industrial and consumer
applications will represent a growing share of its business. Examples of these
newer products include (i) large corrosion resistant ceramic components sold to
a wide range of semiconductor equipment manufacturers; (ii) lightweight ceramic
armor vests for military personnel; (iii) a modified translucent ceramic
orthodontic bracket, which is sold to Unitek Corporation, a subsidiary of 3M,
under an exclusive marketing agreement and marketed by Unitek under it's brand
name "Clarity" and (iv) wear resistant components for industrial machinery, such
as paper making equipment, made from the Company's Ceralloy(R) 147 silicon
nitride advanced technical ceramic.

1
<PAGE>

Additionally, the Company's ceramic-impregnated dispenser cathode is in early
limited production for next generation large screen and projection television.
The Company believes this product has applications in high-definition television
(HDTV) and enhanced resolution CRT monitors. There can be no assurance, however,
of wide market acceptance of this product.

The Company has a strategic relationship with the Ford Motor Company, pursuant
to which Ford has acquired a 15.3% equity interest in the Company, and
transferred ceramic-related technology to the Company with a long-term objective
of developing ceramic components for automobile engines. The Company's efforts
in automotive and diesel applications are still in the experimental stage and
the Company's ability to generate significant revenues from these applications
is uncertain and may not occur for several years, if at all.

INDUSTRY BACKGROUND

Developments in industrial processing, military systems, microwave electronics,
consumer electronics and orthodontics have generated a demand for high
performance materials with certain properties not readily available in metals or
plastics. In certain high performance applications, this demand has been met by
products made of advanced technical ceramics.

The following table compares certain favorable properties of selected advanced
technical ceramics commonly used by the Company with those of other selected
materials.

<TABLE>
<CAPTION>
===================================================================================================================
MELTING
POINT HARDNESS CHEMICAL DENSITY
(DEGREES (VICKERS RESISTANCE ELECTRICAL (GMS
MATERIALS FAHRENHEIT) SCALE) TO ACIDS PROPERTIES PER CC)
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Advanced technical ceramics 2,500 to 6,900 1,600 to 7,000 Excellent From conductors to 2.5 to 4.5
excellent insulators
- -------------------------------------------------------------------------------------------------------------------
High strength alloy steel 2,500 to 2,700 250 to 900 Fair Conductors 7.0 to 9.0
- -------------------------------------------------------------------------------------------------------------------
High performance plastics 275 to 750 5 to 10 Good to Good to excellent 1.0 to 2.0
Excellent insulators
===================================================================================================================
</TABLE>

Ceramics such as earthenware, glass, brick and tile have been made for centuries
and are still in common use today. The inertness and lasting qualities of
ceramics are illustrated by the artifacts uncovered intact in modern times.
Almost all traditional ceramics, including those of ancient times, were based on
clay. In recent years, significant advances have been made in ceramic
technology through the application of specialized processes to produce man-made
ceramic powders. In the 1950's and 1960's, developments in aluminum oxide and
other oxides provided ceramics that were excellent electrical insulators and
were capable of withstanding high temperatures. In the 1970's, these and other
developments resulted in the ability to manufacture advanced technical ceramics
with great strength at elevated temperatures and reduced brittleness,
historically a primary limitation of ceramics. The industry that has emerged
from these advances is known as advanced technical (or structural) ceramics.

2
<PAGE>

The properties of advanced technical ceramics present a compelling case for
their use in a wide array of applications. However, manufacturing costs
associated with the production of these materials need to be reduced in order to
accelerate the use of advanced technical ceramics as a direct replacement for
metals, plastics or other ceramics. A portion of these costs are related to the
need for diamond grinding finished components to exacting tolerances. Industry
cost reduction efforts have included the production of blanks or feed stock to
"near net shape" configurations, thus reducing the need for final finishing.
Manufacturers are also seeking to reduce costs through the use of high volume
automated processing and finishing equipment and techniques, and to achieve
economies of scale in areas such as powder processing, blank fabrication,
firing, finishing and inspection.

The automobile industry is particularly sensitive to initial as well as life
cycle costs. Although the current state of the art of advanced technical
ceramics suggests potential automotive acceptance, the cost factors currently
will not permit automobile related production. The industry goal is to bring
advanced technical ceramics' costs down as close as possible to the cost of
equivalent current metal parts.

CERADYNE STRATEGY

The Company's strategy is to capitalize on its existing technologies, developed
originally for defense and aerospace applications, to broaden its product and
customer base through increased marketing efforts both domestically and
internationally. The Company is focusing on additional customer opportunities
for existing products, and on emerging markets and products which require or can
benefit from the physical, chemical or electronic properties of advanced
technical ceramics. To support this strategy, the Company has recently hired
Andre Ezis to fill the newly created position of Vice President, Research and
Development. Mr. Ezis will hire additional staff to support the materials
research and development required to move rapidly into opportunities in the
semiconductor equipment and automotive business segments.

Ceradyne seeks to increase sales of its traditional products primarily through
expanded domestic and global marketing efforts. Examples of these products and
market applications include:

. Lightweight ceramic armor for military helicopters.

. Industrial ceramics utilizing fused silica ceramics for the glass tempering
and steel making markets.

. Microwave cathodes, microwave absorbing Ceralloy(R) ceramics and samarium
cobalt magnets for use in microwave power tubes in communications, radar and
electronic countermeasure applications.

In addition to the Company's strategy to leverage its existing technologies, the
Company expects much of its future growth to come from products which are
currently in early production or still in development. There can be no
assurance, however, that products still under development will be successfully
completed, or that any of these newer products, including those already in
production, will achieve wide market acceptance. See "Certain Factors That May
Affect the Company's Business and Future Results". The following table
illustrates these newer and planned products and the markets for which they are
intended.

3
<PAGE>

<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------------
MARKET OPPORTUNITY TECHNICAL DEMANDS OF MARKET CERADYNE'S STRATEGIC RESPONSE
- ---------------------------------------------------------------------------------------------------------------------------------
INDUSTRIAL
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Corrosion resistant non oxide ceramics for The industry has historically used silicon Ceradyne has created a new
use as semiconductor equipment chamber metal, quartz, and aluminum oxide ceramics business unit called "Semiconductor
components that handle wafers. to fabricate chamber components. Next Equipment Components" and has begun
generation equipment may have operating supplying high density and high purity
conditions that may deteriorate currently nitride and carbide ceramics to several
used materials in some sections. equipment suppliers. A newly created
R & D group is attempting to develop
compositions tailored to each
equipment manufacturer's environment.

Wear resistant components required on the Failure of industrial equipment is often Ceralloy 147 Sintered Reaction Bonded
rubbing or cutting surfaces of industrial caused by premature wearing out of Silicon Nitride (SRBSN) industrial
machinery, such as in paper making surfaces due to abrasive action. wear parts and cutting tool inserts
equipment, centrifuges, and cutting tool Examples include paper making where are designed to replace hard metal
inserts. the pulp slurry runs at 5000 feet or even oxide ceramic wear surfaces,
per minute, or in metal cutting where as resulting in great productivity,
much as .125 inch depth of cut are removed quality and longer "uptime."
in a single pass.
- ---------------------------------------------------------------------------------------------------------------------------------
DEFENSE
- ---------------------------------------------------------------------------------------------------------------------------------
Lightweight armor for military and law As tactical conflicts as well as terrorist Ceralloy 546 (boron carbide) or
enforcement personnel. and other activities result in the increased Ceralloy 146 (silicon carbide) backed
use of automatic weapons, it has become with KevlarO, SpectraO or other
necessary to stop bullets as great as a .50 laminates are designed to provide
caliber machine gun round. However, vests lightweight ballistic protection
or other armor must be light enough in weight greater than Kevlar alone at an
to allow freedom of movement without undue acceptable weight.
fatigue.

Missile nose cones (radomes). Next generation tactical missiles The Company's advanced technical
(Standard Missile Block IV and PAC-3) ceramic radomes are designed to
will be required to fly at extremely address demanding specifications
high velocities, tight turning radii, of next generation missile nose
and severe weather conditions. These cones.
operating conditions may preclude the
use of conventional polymer materials.
- ------------------------------------------------------------------------------------------------------------------------------------

CONSUMER
- ------------------------------------------------------------------------------------------------------------------------------------

Orthodontic brackets. Traditional stainless steel orthodontic Caradyne's Transtar translucent
ceramic brackets are often considered orthodontic brackets are inert,
unsightly. Substitute clear plastic pick up the color of the patient's
materials can be weak and may stain. teeth and allow the orthodontist to
Some orthodontic patients prefer correct the patient's bite. The
aesthetically pleasing brackets which Company and its marketing partner,
can be affixed to each tooth to support the 3M/Unitek, introduced an enhanced
archwire. version of this ceramic bracket in
1996, which is marketed by Unitek
under the brand name "Clarity".

Large screen televisions, projection To achieve sharper, brighter pictures Caradyne's CRT ceramic-impregnated
televisions, HDTV, and other cathode ray in next generation television picture dispenser cathodes are designed
tube (CRT) applications. tubes, it may be necessary to increase to offer the television manufacturer
current density (amperes/cm/2/) from increased power levels compared to
currently used oxide cathodes. conventional cathodes. The Company
Television manufacturers may require is now in early limited production
extra power as size of picture and for a large projection television and
number of pixels increase. wide screen consumer television.
- -----------------------------------------------------------------------------------------------------------------------------------
AUTOMOTIVE
- -----------------------------------------------------------------------------------------------------------------------------------
Automobile internal combustion engine In order to achieve diesel engine life of Ceradyne's Cerralloy 147 SRBSN is a
and diesel engine valve train and one million miles and automobile engine life candidate for a variety of engine
other engine components. of over 100,000 miles without major components including bucket tappet
maintenance, it may be necessary to replace inserts, engine valves, clevis pins
metal engine components with longer lasting and fuel injection pump parts. The
lighter weight, higher temperature resistant Company is in prototype development
parts at acceptable unit costs. of parts for Detroit Diesel Corp.,
Caterpillar Inc., and Ford Motor
Company. Volume production orders
may not occur for several years,
if at all, and will depend on
significant cost reduction and other
factors.
- ----------------------------------------------------------------------------------------------------------------------------------
</TABLE>

4
<PAGE>

As part of the Company's strategy, management intends to establish additional
sales representative and distributor relationships, particularly in
international markets. The Company will also seek to develop strategic product
development or marketing relationships with other manufacturing companies or key
customers whose expertise, marketing or financial resources will assist the
Company in accomplishing these objectives. See "Certain Factors That May Affect
the Company's Business and Future Results".

STRATEGIC RELATIONSHIPS

The Company has established two strategic relationships which have been, and the
Company expects will continue to be, important factors in the Company's efforts
to develop and expand its advanced technical ceramic technology into new
products and markets. These relationships are described below.

Ford Motor Company Joint Product Development Program. Ceradyne completed a
series of transactions with the Ford Motor Company ("Ford") in March 1986 with a
long-term objective of developing ceramic components for automobiles. Key to
this venture was the transfer of technology developed by Ford relating to
technical ceramics, including a portfolio of United States and corresponding
foreign patents and patent applications, and the investment of $10 million in
the Company in exchange for Common Stock which eventually resulted in an
ownership interest in Ceradyne of approximately 15%. Ford and the Company also
entered into a joint development program pursuant to which Ceradyne has been
applying its experience and expertise in technical ceramics to develop this
technology into commercial products with a view to eventually developing
components for automobile engines. Through fiscal 1996, Ford has contributed to
the Company, on a cost sharing basis, a total of $3.6 million in cash and
equipment under this joint development program. The technology acquired from
Ford and the efforts of this joint development program have led to the
development of Ceradyne's Ceralloy(R) 147 sintered reaction bonded silicon
nitride (SRBSN) advanced technical ceramic, from which the Company now produces
a line of industrial wear components and has made prototype parts for evaluation
and testing in internal combustion and diesel engines.

3M/Unitek Orthodontic Bracket Joint Program. In 1986, Ceradyne entered into a
joint development and supply agreement with 3M/Unitek, for the development of a
translucent ceramic bracket for orthodontic appliances commonly known as braces.
Under this agreement, 3M/Unitek, which is a major manufacturer of stainless
steel orthodontic brackets, provided Ceradyne with information regarding the
functional specifications and properties which ceramic brackets would be
required to satisfy. Based on this information and utilizing its experience
with translucent ceramics originally produced by Ceradyne for defense electronic
countermeasure applications, Ceradyne developed, and in 1987 began
manufacturing, translucent ceramic brackets. These brackets cosmetically blend
with the natural color of the patient's teeth while performing the structural
functions formerly performed by traditional stainless steel brackets.

5
<PAGE>

Ceradyne and 3M/Unitek have obtained and jointly own two United States patents
covering the basic use of translucent ceramics for an orthodontic bracket.
3M/Unitek has an exclusive right to market brackets based on this technology
until 2007.

MARKET APPLICATIONS

The Company's products can be categorized by the principal market applications
they address: (i) industrial, (ii) defense, (iii) consumer, (iv) microwave tube
products and (v) automotive. These markets accounted for approximately 29.2%,
24.6%, 3.7%, 41.1% and 1.4%, respectively, of the Company's net sales for fiscal
1994 and 37.5%, 18.4%, 9.3%, 33.7% and 1.1%, respectively, of net sales for the
year ended December 31, 1995, and 31.3%, 27.9%, 11.9%, 28.5%, and .4%,
respectively, of net sales for the year ended December 31, 1996.

Set forth below is a description of the Company's principal products itemized by
market:

INDUSTRIAL

Industrial Wear Components. Ceradyne's industrial wear components are made
primarily of its Ceralloy(R) 147 sintered reaction bonded silicon nitride
(SRBSN). These SRBSN ceramic components are generally incorporated in
industrial machinery where severe abrasive conditions exist which wear out vital
components. The Ceradyne wear resistant parts are used to replace conventional
wear materials such as tungsten carbide or ceramics such as alumina or zirconia.
Often these parts are incorporated in high wear areas at the original equipment
manufacturer's plant. Applications include metal cutting tool inserts, paper
and can making equipment, abrasive blasting nozzles as well as custom
applications.

Semiconductor Equipment Components. This is a new market that may offer
Ceradyne growth opportunities. The equipment used to make semiconductor devices
(wafers) is extremely advanced and the newest generation has operating
environments that are harsh enough to severely limit the life of the traditional
ceramic and metal components. Ceradyne is positioned to offer a new generation
of non oxide ceramics which have exceptional corrosion resistance.

Tempered Glass Furnace Components and Metallurgical and Industrial Tooling.
Fused silica ceramic is a ceramic which does not materially expand when heated,
nor materially contract when cooled. Therefore, it is used to produce
industrial tooling and molds where complicated shapes and dimensions must be
maintained over a wide range of temperatures. Such applications include the
forming and shaping of titanium metal, used in the manufacture of aircraft.
Other applications take advantage of fused silica's excellent thermal shock
resistance and inertness when in contact with glass. These applications include
components for equipment used in the fabrication of flat plate and tempered
glass or contoured shapes such as automobile windshields. Fused silica ceramic
shapes of up to 14 feet in length are produced in the Company's facility located
near Atlanta, Georgia.

6
<PAGE>

DEFENSE

Lightweight Ceramic Armor. Although armor has progressed through the centuries
from animal skin shields to metal armored suits, to Kevlar(TM) vests (for light
arms), to heavy steel plate, the requirements for light weight and maximum
projectile stopping capability vary little. Ceradyne has developed and is
producing lightweight ceramic armor capable of protecting against threats as
great as .50 caliber armor piercing machine gun bullets at 50% of the equivalent
steel plate weight. Utilizing hot pressed Ceralloy(R) ceramic, the Company's
armor plates are laminated with either Kevlar(TM), Spectra(TM) or fiberglass and
formed into a wide variety of shapes, structures and components. To date,
ceramic armor manufactured by the Company has been used principally for military
helicopter crew seats and airframe panels. The Company currently supplies
ceramic armor systems for the following helicopter programs: the Blackhawk
helicopter manufactured by Sikorsky Aircraft, the Apache helicopter manufactured
by McDonnell-Douglas Helicopters, Inc., the Cobra helicopter manufactured by the
Bell Helicopter division of Textron Inc., and the Sea King helicopter
manufactured by Westland Helicopters. The Company believes it is a leader in
producing lightweight ceramic armor for military helicopters. See "Certain
Factors That May Affect the Company's Business and Future Results".

The Company received its first production contract for ceramic armor vests for
military personnel in January 1995. This order, from the Defense Logistics
Agency of the United States Government, was for $3.5 million in vests which the
Company shipped during 1996. Ceradyne has been working closely with the various
government design agencies to test configurations for the new tri service vest.
Procurement efforts should begin in 1997 for this new vest.

Missile Nose Cones (Radomes). The Company produces conical shaped, precision
machined ceramic components, which are designed to be mounted by its customers
on the front end of tactical missiles. These nose cones, or radomes, are
designed for applications where the velocities and operating environments are
severe enough that the thermal shock and erosion resistance, high strength and
microwave transparency properties of advanced technical ceramics are required.
Revenues from sales of radomes have not been material to date. However, radomes
manufactured by the Company have been qualified for the Standard Missile Block
IV missile program and are currently undergoing early testing for the PAC-3
missile program.

CONSUMER

Ceramic Orthodontic Brackets. In the orthodontic process of correcting a
patient's tooth alignment, typically small (about 1/4'') stainless steel
brackets are adhered to each individual tooth in order to serve as a guide to
the archwire which is the wire that sets into each bracket. The cosmetic
appearance of all this metal is often considered quite unattractive. Ceradyne,
together with its marketing partner, 3M/Unitek, have developed and are marketing
ceramic orthodontic brackets made of Ceradyne's translucent ceramic,
Transtar(R). The translucency of this ceramic bracket, together with the
classic ceramic properties of hardness, chemical inertness and imperviousness,
have resulted in a cosmetic substitute for traditional stainless steel brackets.
These products are generally sold as aesthetic alternatives to conventional
metal brackets and have been in production since 1987. Ceradyne and 3M Unitek
introduced a new enhanced ceramic bracket called "Clarity" in October of 1996.
This product has strong patent protection and offers new features which improve
the bracket's strength and

7
<PAGE>

functionality, compared to earlier designs manufactured by the Company. Early
comments from the orthodontists who have purchased Clarity brackets have been
very positive. The Company believes Clarity brackets offer the orthodontist a
more robust product that will minimize treatment and chair time while providing
superior aesthetic appearance.

CRT (Television) Ceramic-Impregnated Dispenser Cathodes. Cathodes are the tiny
elements in an electron gun of a television tube that, when heated, emit a
stream of electrons. This electron stream strikes the phosphors (pixels) on the
inside glass of the tube, causing them to excite and glow creating a picture
when viewed from the outside. Dispenser cathodes, which are the most efficient
type of cathode, typically have been used for microwave tube applications, but
historically have not been cost effective for televisions. The Company has
developed a cathode design and manufacturing process which enables the Company
to produce a high current density ceramic-impregnated dispenser cathode for CRT
applications at a fraction of the cost of microwave tube ceramic-impregnated
dispenser cathodes. The Company's process and equipment are designed to produce
these cathodes at a very rapid rate with a current density (measured in
amperes/cm/2/) significantly greater than conventional oxide cathodes currently
used in televisions. These CRT dispenser cathodes are intended for large screen
televisions, projection televisions, HDTV and other high-end CRT applications,
and are currently being used by two manufacturers in limited production high-end
television sets. Any potential production volume use of the Company's CRT
cathode will require extensive customer evaluation and may be limited by cost
factors. There can be no assurance that the Company will obtain large volume
orders for this product. See "Certain Factors That May Affect the Company's
Business and Future Results".

MICROWAVE TUBE PRODUCTS

Microwave Ceramic-Impregnated Dispenser Cathodes. The Company manufactures
ceramic-impregnated dispenser cathodes which are used in microwave tubes for
applications in radar, satellite communications, electronic countermeasures and
other uses. Dispenser cathodes, when heated, provide the stream of electrons
which are magnetically focused into an electron beam. Microwave frequency
signals which interact with this beam of electrons are substantially increased
in power. Microwave dispenser cathodes are primarily composed of a porous
tungsten matrix impregnated with ceramic oxide compounds.

Samarium Cobalt Permanent Magnets. The Company's samarium cobalt magnets are
sold as components primarily for microwave tube applications. Electron beams in
microwave tubes generated by the dispenser cathodes described above can be
controlled by the magnetic force provided by these powerful permanent magnets.
The magnets are generally small sub-components of microwave traveling wave
tubes.

Precision Ceramics. Ceradyne produces a wide variety of hot pressed Ceralloy(R)
ceramic compositions, precision diamond ground to close tolerances, primarily
for microwave tube applications. The interior cavities of microwave tubes often
require ceramic components capable of operating at elevated temperatures and in
high vacuums.

AUTOMOTIVE MARKET

Internal Combustion and Diesel Engine Components. The demand for higher
performance, more efficient and more durable engines for heavy duty diesel
trucks and automobiles creates additional

8
<PAGE>

opportunities for advanced technical ceramics. For instance, the Company
believes that if engines could be produced using certain advanced technical
ceramic components, they could be lighter and longer lasting than those using
metal components and could operate at higher temperatures, with reduced cooling
and lubrication requirements. As a result, engines would use less fuel, achieve
more complete combustion, thereby reducing emissions, and be less costly to
maintain. Because of these potential benefits, industry-wide efforts are being
made to develop advanced technical ceramic technology to replace critical steel
components in diesel and automobile engines.

Ceradyne has provided a limited number of prototype parts made of Ceralloy(R)
147 SRBSN materials for evaluation and testing in internal combustion and diesel
engines. Ceradyne has no production contracts to produce any ceramic components
for automotive or diesel engine use. However, Ceradyne is engaged in a joint
development program with Ford to develop ceramic components for automobile
engines, and with a heavy-duty diesel engine manufacturer to develop silicon
nitride engine valves and clevis pins for diesel engines. Ford is not obligated
to purchase any minimum quantities of components developed under this program,
and Ceradyne's efforts in this area are still in the experimental stage with
future success greatly dependent on achieving cost reductions while maintaining
high quality levels. The Company believes that use of ceramic components in
high volume production automobile or diesel engines will not occur for several
years, if at all. See "Certain Factors That May Affect the Company's Business
and Future Results".

OTHER

Utilizing its advanced technical ceramics technologies and facilities, the
Company also manufactures a number of other products related to the foregoing
markets, such as dispenser cathodes for ion laser applications, samarium cobalt
permanent magnets for motors and instruments, and other precision advanced
technical ceramics. None of these products provides a material amount of
revenue to the Company.

MARKETING AND CUSTOMERS

Each of Ceradyne's three manufacturing locations maintains an autonomous sales
and marketing force promoting their individual products. The Company has more
than 10 employees directly involved in marketing and has agreements with more
than 25 manufacturers' representatives in the United States and other countries
who are compensated as a percent of sales in their territory. Ceradyne is
focusing much of its marketing effort outside the United States through direct
involvement of senior management personnel from the Company's U.S. facilities in
concert with local manufacturing representatives. Revenues from export sales
represented approximately 25%, 26% and 20% of total net sales in fiscal years
1994, 1995 and 1996, respectively.

Generally, the Company sells components to prime contractors or original
equipment manufacturers. To a lesser extent, Ceradyne sells its products
directly to the end user. The Company sells its translucent ceramic orthodontic
brackets only to 3M/Unitek pursuant to an exclusive marketing agreement with
that customer. See "Certain Factors That May Affect the Company's Business and
Future Results". Varian Associates, Inc., which purchases microwave tube
products from the Company, accounted for approximately 13% of the Company's
total net sales in fiscal 1994, no customer accounted for more than 10% of total
net sales in fiscal 1995, and. DLA Finance Center, which purchases Ceradyne
armor from the Company, accounted for approximately 17% of the Company's total
net sales for fiscal 1996.

9
<PAGE>

The Company continues to explore various domestic and international marketing,
and other relationships to increase its sales and market penetration.
Furthermore, Ceradyne is attempting to create long-term relationships with its
customers to promote a smoother, more predictable flow of orders and shipments
by entering into multi-year agreements or exclusive relationships where
possible.

MANUFACTURING PROCESSES

Ceradyne has a number of manufacturing processes which are dedicated to specific
products and markets. These processes and the product applications are
described below.

Hot Pressing. The Company's hot pressing process is generally used to fabricate
ceramic shapes for lightweight ceramic armor and semiconductor equipment
components. Ceradyne has developed and constructed induction heated furnaces
capable of operating at temperatures exceeding 4000 degrees in inert
atmospheres up to 5000 lbs. per square inch. This equipment enables Ceradyne
to fabricate parts more than 26 inches in diameter, which is considered
large for advanced technical ceramics. Through the use of multiple cavity
dies and special tooling, the Company can produce a number of parts in one
furnace during a single heating and pressing cycle.

Ceradyne procures its raw materials as fine powders from several outside
suppliers. After processing by the Company, the powders are either loaded
directly into the hot pressing molds or are shaped into preforms prior to
loading into the hot pressing molds. The powders are placed in specially
prepared graphite tooling, most of which is produced by Ceradyne. Heat and
pressure are gradually applied to the desired level, carefully maintained and
finally reduced. The furnace is removed from the press while cooling to permit
the press to be used with another furnace. For most products, about 20 hours
are required to perform this cycle. The resultant ceramic product generally has
mechanical, chemical and electrical properties of a quality approaching that
only theoretically obtainable. Almost all products are then finished by diamond
grinding to meet precise dimensional specifications.

Sintering of Fused Silica Ceramics. Sintering of fused silica ceramics is the
process Ceradyne uses to fabricate fused silica ceramic shapes for applications
in glass tempering furnaces, metallurgical tooling and other industrial uses.
To fabricate fused silica ceramic shapes, fused silica powders are made into
unfired shapes through slip casting or other ceramic compaction processes.
These unfired "green" shapes are fired as they move through a continuously
operated 150 foot long tunnel kiln at temperatures up to 2500 degrees F.
The final shapes are often marketed in the "as fired" condition or, in some
cases, precision diamond ground to achieve specific dimensional tolerances
or surface finishes required by certain customers. See "Business,
Manufacturing Processes-Diamond Grinding".

Ceramic-Impregnated Dispenser Cathode Fabrication. Ceramic-impregnated
dispenser cathode fabrication is used to produce cathodes for microwave power
tube applications and cathode ray tube ("CRT") cathodes for televisions. To
produce ceramic-impregnated dispenser cathodes, both tungsten metal powders and
ceramic powders are used. The tungsten metal powders are isostatically pressed
in polymer tooling, removed and fired in special atmospheres at temperatures in
excess of 4000 degrees F. The tungsten billets are machined into precision
shapes with exacting tolerances. The tungsten machined shapes are impregnated
with a ceramic composite and fired at high temperatures in special atmospheres.
The ceramic impregnated components are assembled and furnace brazed.

10
<PAGE>

Final processing includes the insertion of a metal heating element within a
ceramic insulating compound and the addition of an extremely thin layer of
precious metals to the surface. The Company's final quality inspection often
includes a test of the cathode's electron emitting capabilities at normal
operating temperatures. In order to produce high volume, inexpensive CRT
cathodes for television and other CRT applications, the Company has developed
and built high speed automated assembly equipment capable of producing a cathode
approximately every 6.5 seconds. To date, however, the Company has not produced
CRT cathodes in sustained high volumes. See "Certain Factors That May Affect
the Company's Business and Future Results".

Sintering and Reaction Bonding of Silicon Nitride. The Sintering of reaction
bonding silicon nitride results in the Company's Ceralloy(R) 147 SRBSN, which is
used in industrial and automotive applications. Ceradyne SRBSN is based on
technology acquired from Ford. See "Strategic Relationships". This SRBSN process
begins with relatively inexpensive high purity elemental silicon (Si) powders,
which contrasts sharply with most other competitors manufacturing techniques
which start with relatively more expensive silicon nitride (Si\\3\\N\\4\\)
powders.

After additives are incorporated by milling and spray drying, the silicon
powders are formed into shapes through conventional ceramic processing such as
dry pressing. These shapes are then fired in a nitrogen atmosphere which
converts the silicon part to a silicon nitride part. At this step (reaction
bonding), the silicon nitride is pressure sintered in an inert atmosphere
increasing the strength of the component three fold. As a result of SRBSN
processing, the ceramic crystals grow in an intertwining "needle-like" fashion
which the Company has named NeedleLok(TM). Ceradyne's NeedleLok(TM) structure
results in a tough, high fracture energy part. The process is economical due to
the low cost of the starting powders and can be used to produce extremely high
production volumes of parts due to the use of conventional pressing processes.

Fabrication of Translucent Ceramics (Transtar(R)). Ceradyne produces
translucent aluminum oxide (Transtar(R)) components primarily for use as
orthodontic ceramic brackets. The high purity powders are purchased from
outside vendors and processed by dedicated conventional ceramic mechanical dry
presses. The formed blanks are then fired in a segregated furnace in a hydrogen
atmosphere at 1800 degrees C until the ceramics enter to a strong translucent
condition. These fired aesthetic appearing brackets then have certain critical
features diamond ground into them. The final step is a proprietary treatment of
the bonding side in order to permit a sound mechanical seal when bound to the
patient's teeth.

Diamond Grinding. Many of Ceradyne's advanced technical ceramic products must be
finished by diamond grinding because of their extreme hardness. The Company's
finished components typically are machined to tolerances of +/- .001 inch and
occasionally are machined to tolerances up to +/- .0001 inch. To a limited
extent, the Company also performs diamond grinding services for customers
independently of its other manufacturing processes to specifications provided by
the customer. The Company's diamond grinding department can perform surface
grinding, diameter grinding, ultrasonic diamond grinding, diamond lapping,
diamond slicing and honing. The equipment includes manual, automatic and
computer numerically controlled (CNC) grinders. The CNC grinders have been
specially adapted by the Company for precision grinding of ceramic contours to
exacting tolerances.

Fabrication of Samarium Cobalt Permanent Magnets. The fabrication of samarium
cobalt permanent magnets results in various magnet shapes which are primarily
used in microwave tube applications. The Company procures premixed samarium
cobalt powder either as SmCo\\5\\ or Sm\\2\\Co\\17\\ compositions.

11
<PAGE>

The powders are then milled and formed into the final configuration by pressing
in a magnetic field using a specially designed magnet press. These "pre-fire" or
"green" magnets are then sintered at 2000 degrees F in helium or vacuum. The
magnets may then be subsequently diamond ground and characterized as to each
individual magnet's strength.

Raw Materials. The starting raw materials for Ceradyne's manufacturing
operations are generally fine, man-made powders available from several domestic
and foreign sources. The raw materials, such as Kevlar(TM), graphite, metal
components and ceramic powders are readily available from several commercial
sources.

Quality Control. Ceradyne products are made to a number of exacting
specifications. In order to meet both internal quality criteria and customer
requirements, the Company has implemented a number of quality assurance and in-
process statistical process control programs. These quality programs are
implemented separately at each of Ceradyne's three manufacturing locations.

ENGINEERING AND RESEARCH

Ceradyne's engineering and research efforts consist primarily of application
engineering in response to customer requirements. These efforts are directed to
the creation of new products, the modification of existing products to fit
specific customer needs, or the development of enhanced ceramic process
technology. The Company is also engaged in internally-funded research to
improve and reduce the cost of production and to develop new products. Costs
associated with application engineering and internally-funded research are
generally expensed as incurred and are included in cost of product sales. Costs
associated with Company-funded research were approximately $400,000, $400,000
and $360,000 in 1996, 1995 and 1994, respectively.

COMPETITION

Ceradyne competes on the basis of product performance, material specifications,
application engineering capabilities, customer support, reputation and price.
Competitive pressures vary in each specific product market, depending on the
product and program. In many instances, the competitors are well-known
companies with greater financial, marketing and technical resources than
Ceradyne. Ceradyne intends to continue to focus on selected business areas in
which it can exploit its technological, manufacturing and marketing strengths.
Some of Ceradyne's competitors often are divisions of larger companies with each
of Ceradyne's product lines subject to completely different competitors. Some
of the competitors of the Company include Kyocera Corporation's Industrial
Ceramics Group in industrial ceramic products, Vesuvius McDaniel Co. in fused
silica ceramics, and Simula Inc. and Brunswick Corp. in defense products. In
many applications the Company also competes with manufacturers of non-ceramic
materials. The principal competition for the Company's new CRT cathode are
oxide cathodes manufactured in-house by the television manufacturers who are the
Company's targeted customers for this product. For future automotive
applications, there is a wide range of both current and potential domestic and
international competitors. See "Certain Factors That May Affect the Company's
Business and Future Results".

12
<PAGE>

BACKLOG

Ceradyne records an item as backlog when it receives a contract or purchase
order indicating the number of units to be purchased, the purchase price,
specifications and other customary terms and conditions. Ceradyne customarily
includes unexercised options as a separate item in its backlog because the
purchase orders are given on the basis of the total order, including options.
Total backlog as of December 31, 1996 was approximately $21.7 million,
consisting of $11.2 million of firm scheduled orders and $10.5 million of
unexercised options. This compared to December 31, 1995 ending total backlog of
approximately $26.0 million consisting of $15.5 million of firm scheduled orders
and $10.5 million of unexercised options. Typically, firm orders are scheduled
to be shipped within 12 to 18 months from receipt of order. Included in
unexercised options as of December 31, 1995 and 1996 was a government option for
approximately $6.1 million which expired in March 1997 without being exercised.

PATENTS, LICENSES AND TRADEMARKS

The Company relies primarily on trade secrecy to protect compositions and
processes that it believes are proprietary. In certain cases, the disclosure of
information concerning such compositions or processes in issuing a patent could
be competitively disadvantageous. However, management believes that patents are
important for technologies where trade secrecy alone is not a reliable source of
protection. Accordingly, Ceradyne has applied for, or has been granted, several
United States patents relating to compositions, products or processes that
management believes are proprietary, including lightweight ceramic armor.

Two U.S. patents have been issued to the Company relating to translucent
ceramics for orthodontic brackets. The earliest of these patents expires in
2007. These patents are co-invented and co-owned by Ceradyne and 3M/Unitek.
Ceradyne and 3M/Unitek have granted licenses to eight companies whose ceramic
orthodontic brackets infringe the Ceradyne-3M/Unitek patents, wherein those
companies pay royalties to Ceradyne and 3M/Unitek based on sales of their
orthodontic ceramic brackets for the remaining life of the patents. See
"Certain Factors That May Affect the Company's Business and Future Results", and
"Strategic Relationships".

Ceradyne has been issued two U.S. patents and has one patent pending relating to
its CRT ceramic-impregnated dispenser cathode and has applied for corresponding
foreign patents in various foreign countries. The earliest of these patents
expires in 2006.

Through its association with Ford, Ceradyne acquired in excess of 80 U.S.
patents, of which 33 are still active, and corresponding foreign patents and
applications relating to technical ceramics for automotive technology. The last
of these patents will expire in August 2007. See "Strategic Relationships".

"Ceralloy(R)," the name of Ceradyne's technical ceramics, "Ceradyne(R)" and the
Ceradyne logo, comprising the stylized letters "CD(R)", are major trademarks of
the Company which have been registered in the United States and various foreign
countries. The Company also has other trademarks, including "Transtar(R)",
"Semicon(R)", "Thermo(R)", "Isomolded(R)" and "NeedleLok(TM) ".

13
<PAGE>

EMPLOYEES

At December 31, 1996, Ceradyne employed approximately 280 persons, including ten
employees with undergraduate or graduate degrees in ceramic engineering.
Management considers its employee relations to be excellent. The Company has
not experienced difficulty in attracting personnel. None of the Company's
employees are represented by a labor union.

CERTAIN FACTORS THAT MAY AFFECT THE COMPANY'S BUSINESS AND FUTURE RESULTS

HISTORY OF OPERATING LOSSES

For the fiscal years ended December 31, 1995 and 1996, the Company returned to
profitability after sustaining net losses from fiscal 1987 through fiscal 1994
totaling approximately $21.4 million. The Company's operating losses resulted
from a number of factors, including a decline in revenues due in part to reduced
government spending on defense related products, which historically have
represented the majority of the Company's business and are expected to represent
a substantial portion of the Company's business in the foreseeable future. Also
contributing to the Company's losses was a decline in sales of the Company's
translucent ceramic orthodontic bracket, from peak revenues of $6.2 million in
fiscal 1988 to $.4 million in fiscal 1994, due in part to excess inventory
levels accumulated by the Company's exclusive distributor of this product,
Unitek Corporation, a subsidiary of Minnesota Mining & Mfg. Co. ("3M/Unitek"),
and also in part to resistance by some orthodontists to use the product because
of technical problems experienced with earlier versions of the bracket. To
maintain profitability and achieve revenue growth, the Company must, among other
things, successfully address new opportunities for armor applications, including
the development of capacity to successfully manufacture ceramic body armor in
volume; achieve significant sales of the recently introduced new version of its
translucent orthodontic bracket product, which is marketed by 3M/Unitek under
the brand name "Clarity"; develop the capacity to successfully manufacture
semiconductor equipment components in volume at acceptable profit margins; and
continue to upgrade its technologies and commercialize products and services
incorporating such technologies. There can be no assurance, however, that the
Company will be able to sustain or improve its level of profitability in the
future.

14
<PAGE>

IMPORTANCE OF NEW PRODUCTS; LIMITED VOLUME MANUFACTURING EXPERIENCE FOR PRODUCTS
UNDER DEVELOPMENT

The Company believes that its future prospects will depend to a large extent on
the success of products which currently provide little revenue or which are
still under development. These products include, in particular, semiconductor
equipment components, lightweight ceramic armor vests for military personnel,
the Company's ceramic-impregnated dispenser cathode for television and other
cathode ray tube ("CRT") applications, improved versions of the Company's
translucent ceramic orthodontic bracket, and ceramic components for automobile
and diesel engines. Wide customer acceptance of the Company's CRT cathode and
the Company's ability to manufacture this cathode profitably will depend in part
on achieving significant manufacturing cost reductions, the Company's ability to
manufacture these components in high volumes at acceptable production yields,
and satisfying extensive customer testing and qualification procedures, which
often take many months or years to complete. Should the Company be unable to
achieve such cost reductions, manufacture with acceptable product yields or
satisfy customer testing and qualification procedures, the Company's prospects
and operating results may be materially and adversely affected. The Company has
recently introduced a new version of its translucent ceramic orthodontic bracket
called Clarity, which is designed to improve the performance and market
acceptance of this product. The Clarity bracket is more difficult and costly to
produce than earlier versions of this bracket and there can be no assurance that
the Company will be able to produce this version in high volume at acceptable
yields or that the new design will achieve market acceptance or result in
increased sales of this product. The Company's efforts in producing ceramic
components for automobile and diesel engines are still in the experimental
stage, with future success substantially dependent on achieving significant cost
reductions and developing high volume manufacturing capability while maintaining
high quality levels. Furthermore, lead times for the introduction of new
materials and components into production automobiles are typically several
years. The market for ceramic automotive and diesel components is new and
evolving, and advanced technical ceramics are not currently used in any
significant automotive applications. Accordingly, demand and market acceptance
for such products are subject to a high level of uncertainty. As a result of
these factors, the Company believes that the use of ceramic components in high
volume production automobile or diesel engines cannot be predicted and will not
occur for several years, if at all.

MANAGEMENT OF GROWTH

The Company is experiencing a period of new product introductions that have
placed, and will continue to place, a significant strain on its resources,
including personnel. The Company believes that future growth is significantly
dependent on introductions of other new products applying the Company's core
advanced technical ceramics technologies. The Company expects that management
of this transition will continue to place a strain on the Company's management,
operational and financial resources. The Company's ability to manage growth
effectively, particularly given the increasingly international scope of its
operations, will require it to add manufacturing capacity and personnel,
continue to implement and improve its operational, financial and management
information systems as well as to develop the management skills of its managers
and supervisors, and to train, motivate and manage its employees. These demands
are expected to require the addition of new management personnel and the
development of additional expertise by existing management personnel. The
Company's failure to effectively manage growth could have a material adverse
effect on the Company's results of operations.

15
<PAGE>

DEPENDENCE ON KEY PERSONNEL

The Company's future success depends in large part on the continued service of
Joel P. Moskowitz, its Chairman, Chief Executive Officer and President, and a
principal stockholder of the Company, as well as other principal members of its
management, the loss of whose services could have a material adverse effect upon
the business and financial condition of the Company. The company is also
dependent on other key personnel, and on its ability to continue to attract,
retain and motivate highly qualified personnel. The competition for such
employees is intense, and there can be no assurance that the Company will be
able to recruit and retain such personnel. Mr. Moskowitz has an employment
agreement with the Company which expires in July 1999, but no other employee has
an agreement for a specified term of employment with the Company.

COMPETITION

The markets for applications of advanced technical ceramics are competitive.
The Company believes the principal competitive factors in these markets are
product performance, material specifications, application engineering
capabilities, customer support, reputation and price. Many of the Company's
competitors, both domestic and international, have greater financial, marketing
and technical resources than Ceradyne. The Company's competitors often are
divisions of larger companies with each of Ceradyne's product lines subject to
completely different competitors. Some of the competitors of the Company
include Kyocera Corporation's Industrial Ceramics Group in industrial ceramic
products, Vesuvius McDaniel Co. in fused silica ceramics, and Simula Inc. and
Brunswick Corporation in defense products. In many applications the Company
also competes with manufacturers of non-ceramic materials. The principal
competition for the Company's new CRT cathode are oxide cathodes manufactured
in-house by the television manufacturers who are the Company's targeted
customers for this product. There can be no assurance that the Company will be
able to compete successfully against its current or future competitors or that
competition will not have a material adverse effect on the Company's results of
operations and financial condition.

ENVIRONMENTAL CONCERNS

The Company is subject to a variety of environmental regulations relating to the
use, storage, discharge and disposal of hazardous materials. Certain of the
Company's products are produced using beryllium oxide, which is highly toxic in
powder form. This powder, if inhaled, can cause chronic beryllium disease
("CBD") in a small percentage of the population. In recent years the Company
has been sued by several former employees and a family member of one such former
employee alleging that they had contracted CBD as a result of exposure to
beryllium oxide powders used in the Company's products. These claims have been
settled without material liability to the Company. There can be no assurance
that the Company will avoid liability to persons who contract CBD as a result of
exposure to beryllium oxide while employed with the Company. While the Company
believes that it is in material compliance with all existing applicable
environmental statutes and regulations, any failure by the Company to comply
with statutes and regulations presently existing or enacted in the future could
subject it to liabilities or the suspension of production. Furthermore, there
can be no assurance that claims against the Company related to exposure to
beryllium oxide powder will be covered by insurance or that, if covered, the
amount of insurance will be sufficient to cover any potential adverse judgment.

16
<PAGE>

DEPENDENCE ON UNITED STATES GOVERNMENT AND RISK OF CONTRACT TERMINATION

Of the Company's $21.7 million total backlog at December 31, 1996, approximately
$9.0 million, or 41% represents orders for lightweight ceramic armor for defense
applications. This amount includes options for lightweight ceramic armor vests
for military personnel of approximately $6.1 million, which expired in March
1997 without being exercised. The contract for armor vests and some of the
contracts for helicopter armor are directly or indirectly with agencies of the
United States government. The Company anticipates that it will continue to
depend heavily on direct or indirect sales to government agencies for a
significant percentage of the Company's revenues for the foreseeable future. In
recent years, budgets of many government agencies have been reduced, causing
certain customers and potential customers for the Company's products to re-
evaluate their needs. Such budget reductions are expected to continue over at
least the next several years. Future reductions in United States government
spending on defense-related products could have a material adverse effect on the
Company's prospects and operating results.

Under U.S. law, the Company's defense-related contracts may be canceled for
convenience at any time without cause by the government, with reimbursement to
the Company only for its actual expenses incurred. The Company has, in the
past, experienced the cancellation of a significant government order, which had
a material adverse effect on the Company's operating results. There can be no
assurance that the Company will not experience similar cancellations in the
future, and any such cancellations could adversely affect the Company's
operating results.

RELIANCE ON 3M/UNITEK RELATIONSHIP

The Company developed its translucent ceramic orthodontic bracket pursuant to a
joint development agreement with 3M/Unitek, and sells this product only to
3M/Unitek pursuant to an exclusive marketing agreement which expires in 2007.
Consequently, the Company depends entirely on the marketing and sales efforts of
3M/Unitek for the sales of this product. The Company also depends on customer
and technical feedback from 3M/Unitek for the design of improvements to the
bracket. Early versions of this product were not well accepted by some
orthodontists due in part to resistance to change from using traditional
stainless steel brackets and to certain technical problems experienced by some
users of the earlier versions of the Company's translucent ceramic orthodontic
bracket. These problems included difficulty in the removal, or debonding, of
the bracket from the tooth, breakage of brackets during the treatment process
more often than experienced with stainless steel brackets, and slower movement
of the metal arch wire through the ceramic brackets, resulting in longer
treatment times than with stainless steel brackets. Designs introduced in
October 1996 under the 3M/Unitek brand name "Clarity" are intended to improve
certain features of earlier versions of the bracket, but there can be no
assurance that these new products will completely eliminate the previous
problems or receive wide market acceptance. Furthermore, no assurance can be
given that 3M/Unitek will devote substantial marketing efforts to sales of the
Company's orthodontic products, or that it will not re-assess its commitment to
the Company's technologies or develop its own competitive technology. Any
failure by 3M/Unitek to actively market the Company's orthodontic product, or
any failure of such product to achieve market acceptance, would materially and
adversely impact the Company's prospects and results of operations.

17
<PAGE>

DEPENDENCE ON INTERNATIONAL SALES

Shipments to customers outside of the United States accounted for approximately
25%, 26% and 20% of the Company's sales in fiscal 1994, 1995, and 1996,
respectively. The Company anticipates that international shipments will continue
to account for a significant portion of its sales. Certain of these revenues
have been derived from sales to foreign government agencies and may be subject
to risks similar to those set forth in "Dependence on United States Government
and Risk of Contract Termination," set forth above.

There are a number of risks inherent in the Company's international business
activities, including unexpected changes in regulatory requirements, tariffs and
other trade barriers, longer account receivable payment cycles, potentially
adverse tax consequences, and the burdens of compliance with foreign laws.
Additionally, the Company does not engage in hedging activities to protect
against the risk of currency fluctuations. Fluctuations in currency exchange
rates could cause sales denominated in U.S. dollars to become relatively more
expensive to customers in a particular country, leading to a reduction in sales
or profitability in that country. Furthermore, future international activity
may result in foreign currency denominated sales which may result in gains and
losses on the conversion to U.S. dollars of accounts receivable and accounts
payable arising from international operations which may contribute significantly
to fluctuations in the Company's results of operations. The Company
historically has denominated export sales in United States dollars. There can
be no assurance, however, that the aforementioned factors will not have an
adverse effect on the revenues from the Company's future international sales
and, consequently, the Company's results of operations. Some of the Company's
products may not be exported to certain foreign countries without an export
license obtained from the United States government. The Company has, and may in
the future, experience difficulty in obtaining licenses to export its products
to certain countries. Failure to obtain such licenses could have a material
adverse effect on the Company's sales and prospects. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
"Business-Ceradyne Strategy" and "-Marketing and Customers".

PROTECTION OF INTELLECTUAL PROPERTY

The Company relies on a combination of patents, trade secrets, trademarks, and
other intellectual property law, nondisclosure agreements and other protective
measures to preserve its proprietary rights pertaining to its products and
production processes. Such protection, however, may not preclude competitors
from developing products or processes similar or superior to the Company's. In
addition, the laws of certain foreign countries do not protect intellectual
property rights to the same extent as the laws of the United States. Although
the Company continues to implement protective measures and intends to defend its
proprietary rights, there can be no assurance that these efforts will be
successful. Furthermore, there can be no assurance that the Company's products
or processes are not in violation of the patent rights of third parties, or that
any of the Company's patents will not be challenged, invalidated or
circumvented.

18
<PAGE>

Item 2. Facilities
----------

The Company serves its markets from three manufacturing facilities across the
United States. The Company's West Coast operations, located in Costa Mesa,
California, primarily produces armor and orthodontic products, and houses the
Company's SRBSN research and development activities. The Company's cathode
development and production are handled through its Semicon Associates division
located in Lexington, Kentucky. Fused silica products, including missile
radomes, are produced at the Company's Thermo Materials division located in
Scottdale, Georgia. These three facilities comprise approximately 63,000,
35,000 and 85,000 square feet, respectively. The Company's Costa Mesa and
Scottdale facilities are held under long-term leases which expire in October
2000 and December 2000, respectively. The Company owns its Lexington, Kentucky
facilities.

Ceradyne's manufacturing structure is summarized in the following table:
<TABLE>
<CAPTION>

====================================================================================================
FACILITY LOCATION PRODUCTS
- ----------------------------------------------------------------------------------------------------
<S> <C>
Costa Mesa, California . Semiconductor Equipment Components
Approximately 63,000 square feet. . Lightweight ceramic armor
. Orthodontic ceramic brackets
. Ceralloy(R) 147 SRBSN wear parts
. Precision ceramics
. Ceralloy(R) 147 SRBSN diesel/automotive engine parts (R&D)
- -----------------------------------------------------------------------------------------------------
Lexington, Kentucky . Microwave ceramic-impregnated dispenser cathodes
Approximately 35,000 square feet . CRT (television) ceramic-impregnated dispenser cathodes
. Ion laser ceramic-impregnated dispenser cathodes
. Samarium cobalt magnets
- -----------------------------------------------------------------------------------------------------
Scottdale, Georgia
Approximately 85,000 square feet . Glass tempering rolls (fused silica ceramics)
. Metallurgical tooling (fused silica ceramics)
. Missile radomes (fused silica ceramics)
. Castable and other fused silica product
=====================================================================================================
</TABLE>

19
<PAGE>

Item 3. Legal Proceedings
-----------------

The Company is, from time to time, involved in various legal and other
proceedings that relate to the ordinary course of operating its business,
including, but not limited to, employment-related actions and workers'
compensation claims.

In October 1995 the Company was served with a complaint that was filed by four
persons and the spouses of those persons, who are/were employed by one of the
Company's customers. The complaint, filed in the United States District Court,
Eastern District of Tennessee, alleges that the employees contracted chronic
beryllium disease as a result of their exposure, during the course of their
employment with the Company's customer, to beryllium-containing products sold by
Ceradyne. The complaint seeks compensatory damages in the amount of $3.0
million for each of the four plaintiffs who were employed by the Company's
customer, compensatory damages of $1.0 million each for the two spouses, and
punitive damages in the amount of $5.0 million. The case is in the early stages
of discovery. Based upon information currently available, the Company believes
that the plaintiffs' claims are without merit and that the resolution of this
matter will not have a material adverse effect on the financial condition or
operations of the Company. Defense of this case has been tendered to the
Company's insurance carriers, some of whom are providing a defense subject to a
reservation of rights. There can be no assurance, however, that this claim or
any of the claims related to exposure to beryllium oxide will be covered by
insurance, or that, if covered, the amount of insurance will be sufficient to
cover any potential judgment.

In February 1997 the Company was served with a complaint that was filed by a
former employee of one of the Company's customers and his wife. The complaint,
filed in the United States District Court, Eastern District of Tennessee,
alleges that the husband contracted chronic beryllium disease as a result of his
exposure to beryllium-containing products sold by Ceradyne. The complaint seeks
compensatory damages in the amount of $5.0 million for the husband, $1.0 million
for the wife, and punitive damages in the amount of $10.0 million. The Company
believes that the plaintiffs' claims are without merit and that the resolution
of this matter will not have a material adverse effect on the financial
condition or operations of the Company. Defense of this case has been tendered
to the Company's insurance carriers. There can be no assurance, however, that
this claim will be covered by insurance, or that, if covered, the amount of
insurance will be sufficient to cover any potential judgment.

During the third quarter of 1996, an action was concluded regarding a current
employee and his wife who filed suit in 1994 alleging that he had contracted
chronic beryllium disease as a result of his employment with the Company.
Ceradyne was dismissed as a direct defendant in March 1996, but a cross-
complaint filed by a previous landlord remains. An arbitration is pending to
resolve the dispute. The Company believes that the resolution of this matter
will not have a material adverse effect on the financial condition or operations
of the Company.

Item 4. Submission of matters to a vote of security holders
---------------------------------------------------

Not applicable

20
<PAGE>

MANAGEMENT

EXECUTIVE OFFICERS OF THE REGISTRANT.

The executive officers of the Company as of March 28, 1997 are as follows:
<TABLE>
<CAPTION>

NAME AGE POSITION
- ---------------------- --- -------------------------------------------------------------
<S> <C> <S>
Joel P. Moskowitz..... 57 Chairman of the Board, President and Chief Executive Officer
Howard F. George...... 52 Vice President, Finance; Chief Financial Officer and Secretay
Andre Ezis............ 53 Vice President, Research and Development
Louis R. Falce........ 68 Executive Vice President, Cathodes
Earl E. Conabee....... 59 Vice President
Donald A. Kenagy...... 55 Vice President
David P. Reed......... 42 Vice President
</TABLE>

Joel P. Moskowitz co-founded the Company's predecessor in 1967. He served as
President of the Company from 1974 until January 1987, and from September 1987
to the present. Mr. Moskowitz currently serves as Chairman of the Board,
President and Chief Executive Officer of the Company, which positions he has
held since 1983. Mr. Moskowitz currently serves on the Board of Trustees of
Alfred University. Mr. Moskowitz obtained a B.S. in Ceramic Engineering from
Alfred University in 1961 and an M.B.A. from the University of Southern
California in 1966.

Howard F. George was appointed to the positions of Vice President, Finance;
Chief Financial Officer, and Corporate Secretary in December 1995. Prior to
joining Ceradyne, Mr. George was Chief Financial Officer of Richmond Technology,
Inc. and Chief Operating Officer of its subsidiary, Static Control Services from
1992 to 1995. From 1990 to 1992, Mr. George was Vice President of Finance for
Sunset Richards, a subsidiary of Hanson, PLC. Mr. George earned his B.A. degree
in Business and Economics in 1970 at California State University Long Beach, and
an MBA from Pepperdine University, Malibu in 1980.

21
<PAGE>

Andre Ezis was appointed to the position of Vice President, Research and
Development in January, 1997. Prior to joining Ceradyne, Mr. Ezis was Vice
President of Research and Development at Cercom, Inc. for the period of 11
years. From 1970 Mr. Ezis was with Ford Motor Company at its Research Science
Center. Mr. Ezis earned a B.S. in Ceramic Engineering in 1966 at Ohio State
University, and a M.S. in Nuclear Engineering in 1969 also from Ohio State
University.

Louis R. Falce joined the Company in 1985 and has served as Vice President
since January 1987, and as Executive Vice President, Cathodes since July 1995.
Mr. Falce is responsible for the marketing of cathodes for the Company's Semicon
Associates division, and for the development and marketing of the Company's CRT
cathode for television and other CRT applications. Prior to joining the Company,
Mr. Falce served for ten years in various scientific and engineering positions
at Hughes Aircraft Company. Mr. Falce received B.S. degrees in Chemistry and
Industrial Management from Rutgers University in 1952.

Earl E. Conabee joined the Company in July 1985, and has served as Vice
President of the Company since June 1986. Mr. Conabee serves as Vice President
of Marketing for the Company's Thermo Materials division, where he is
responsible for the overall marketing and sales effort for fused silica
ceramics. Prior to joining the Company, Mr. Conabee served as General Manager
of Ceramatec, a manufacturer of technical ceramics, from 1983 to 1985, and as
Director of Refinery Operations for Englehard Minerals Corporation from 1973 to
1983. Mr. Conabee obtained a B.S. in Ceramic Engineering from Alfred University
in 1960.

Donald A. Kenagy joined the Company in December 1986 when the Company acquired
Thermo Materials, and has served as Vice President of the Company since July
1991. Mr. Kenagy is currently President of the Company's Thermo Materials
division, and as such is responsible for the operations, finances and marketing
of Thermo Materials. Mr. Kenagy joined Thermo Materials in 1972. Mr. Kenagy
received a B.S. in Ceramic Technology from Penn State in 1963, an M.S. in
Metallurgy from the Massachusetts Institute of Technology in 1965, and a Met.
Eng. degree from MIT in 1968.

David P. Reed joined the Company in November 1983, and has served as Vice
President since January 1988. Mr. Reed is responsible for the operations,
finances and marketing of the Company's Costa Mesa, California operations.
Prior to joining the Company, Mr. Reed served as Manager, Process Engineering
for the Industrial Ceramic Division of Norton Co. from 1980 to 1983. Mr. Reed
obtained a B.S. in Ceramic Engineering from Alfred University in 1976 and an
M.S. in Ceramic Engineering from the University of Illinois in 1978.

Officers serve at the discretion of the Board of Directors except for Mr.
Moskowitz, who serves pursuant to a five-year employment agreement which expires
in July 1999.

22
<PAGE>

PART II

Item 5. Market for the Registrant's Common Equity and Related
-----------------------------------------------------
Stockholder Matters
-------------------

The Company's Common Stock is traded on the Nasdaq National Market under the
symbol CRDN. The following table sets forth for the calendar quarters indicated
the high and low closing sale prices per share on the National Market as
reported by Nasdaq. As of January 2, 1997, the Company had approximately 547
record holders of its Common Stock.
<TABLE>
<CAPTION>
High Low
----- -----
<S> <C> <C>
Year ended December 31, 1995
First Quarter........................ 3 3/8 2 1/4
Second Quarter....................... 5 7/8 3
Third Quarter........................ 6 1/8 4 1/4
Fourth Quarter....................... 7 5/8 4 5/8

Year ended December 31, 1996
First Quarter........................ 9 1/4 5 3/4
Second Quarter....................... 11 3/4 8 3/8
Third Quarter........................ 11 3/8 7 5/8
Fourth Quarter....................... 10 1/4 6
</TABLE>

The present policy of Ceradyne is to retain earnings for the operation and
expansion of its business. Ceradyne has never paid cash dividends, and
management does not anticipate that it will do so in the foreseeable future.

The Company did not sell any equity securities during the year ended December
31, 1996 that were not registered under the Securities Act of 1933.

23
<PAGE>

Item 6. Selected Financial Data
-----------------------

Statements of Operations Data: (Amounts in thousands, except per share data)
- -----------------------------
<TABLE>
<CAPTION>

December 31,
------------
1996 1995 1994 1993 1992
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Net Sales $28,212 $23,404 $17,996 $ 15,987 $ 18,727
Cost of product sales 21,365 17,347 16,135 14,792 16,531
------- ------- ------- -------- --------
Gross profit 6,847 6,057 1,861 1,195 2,196
------- ------- ------- -------- --------

Operating expenses:
Selling 1,571 1,492 1,502 1,372 1,465
General & administrative 2,837 2,349 2,297 2,392 2,465
Royalty --- - -- --- --- 212
------- ------- ------- -------- --------
4,408 3,841 3,799 3,764 4,142
------- ------- ------- -------- --------
Income/(loss) from
operations 2,439 2,216 (1,938) (2,569) (1,946)

Other income (expense):
Other income 1,890 265 366 212 160
Interest expense (162) (342) (294) (240) (211)
------- ------- ------- -------- --------
Income (loss) before
provision for
income taxes 4,167 2,139 (1,866) (2,597) (1,997)
Taxes on income 127 50 --- --- ---
------- ------- ------- -------- --------
Net income/(loss) $ 4,040 $ 2,089 $(1,866) ($2,597) ($1,997)
======= ======= ======= ======== ========

Net income /(loss) per
share (1) $ .51 $ .32 $ (.30) $ (.42) $ (.33)
Weighted average shares
outstanding (1) 7,985 6,607 6,238 6,169 6,133

Balance Sheet Data:
- ------------------
</TABLE>

<TABLE>
<CAPTION>
December 31,
-----------
1996 1995 1994 1993 1992
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Working capital $15,892 $13,216 $ 5,053 $ 5,630 $ 6,808
Total assets 28,398 24,880 16,862 18,130 20,567
Long-term obligations 0 555 905 1,367 1,413
Shareholder's equity 24,440 19,852 11,602 13,443 15,813
</TABLE>
(1) Primary and fully diluted net income per share are the same for the periods
presented. See Notes 1 and 6 of Notes to Consolidated Financial
Statements.

24
<PAGE>

Item 7. Management's Discussion and Analysis of Financial
-------------------------------------------------
Condition and Results of Operations
-----------------------------------

OVERVIEW

Ceradyne develops, manufactures and markets advanced technical ceramic products
and components for industrial, defense, consumer and microwave applications.
The Company's technology was developed primarily for defense and aerospace
applications which have historically represented a substantial portion of its
business.

With the end of the "Cold War", one of the Company's major defense contracts was
canceled and the Company experienced reductions in certain other defense-related
business. As a result, the Company began to rely more heavily on the
development of new applications and markets for its technology, while continuing
to serve its historical customer base which continued to account for a
substantial portion of the Company's business.

From a high of $25.6 million in 1987, the Company's revenues declined to a low
of $15.9 million in 1993. Management believes that the Company's financial
recovery commenced in the fourth quarter of 1994 due to an increase in new
bookings and the divestiture of an historically unprofitable operation.
Revenues began to increase in the third quarter of 1994, and have continued to
increase during the years ended December 31, 1995 and 1996. The Company
achieved record sales of $28.2 million, and record net profit of $4.0 million
for year ended December 31, 1996. There can be no assurances, however, that the
Company's revenue or profit will continue to increase in the future.

In March 1997, an option held by the U.S. Government to purchase $6.1 million of
lightweight ceramic armor vests for military use expired without being
exercised. This option was planned to be over a 2 year period starting in 1997,
and may have an adverse effect on 1997 operating results.

The Company's cost of product sales includes the cost of materials, direct labor
expenses and manufacturing overhead expenses. The Company's business requires
that it maintain a relatively high fixed manufacturing overhead. As a result,
the Company's gross profit, in absolute dollars and as a percentage of net
sales, is greatly impacted by the Company's sales volume and the corresponding
absorption of fixed manufacturing overhead expenses. Furthermore, due to the
customized nature of many of its products, the Company is frequently required to
devote resources to sustaining engineering expenses, which are also included in
cost of product sales and are generally expensed as incurred.

25
<PAGE>

RESULTS OF OPERATIONS

The percentage relationships to net sales of certain income and expense items
for the three years ended December 31, 1996 are contained in the following
table.
<TABLE>
<CAPTION>

Year Ended December 31
---------------------------
1996 1995 1994
------ ------ -------
<S> <C> <C> <C>

Net Sales 100.00% 100.00% 100.00%
Cost of product sales 75.73 74.12 89.66
------ ------ -------

Gross Profit 24.27 25.88 10.34
------ ------ -------

Operating Expenses:
Selling 5.57 6.37 8.35
General & Administration 10.06 10.04 12.76
------ ------ -------
15.62 16.41 21.11
Income (loss) from ------ ------ -------
operations 8.65 9.47 (10.77)
Other income (expenses):
Other income 6.69 1.13 2.03
Interest expense (.57) (1.46) (1.63)
------ ------ -------
6.12 (.33) 0.40
------ ------ -------

Income (loss) before
provision for taxes on income. 14.77 9.14 (10.37)
Provision for taxes .45 .21 ---
------ ------ -------

Net income (loss) 14.32% 8.93% (10.37)%
====== ====== =======
</TABLE>

26
<PAGE>

YEARS ENDED DECEMBER 31, 1996 AND 1995.

Net Sales. Net sales for the year ended December 31, 1996 were $28.2 million,
which represents a 20.5% or a $4.8 million increase in net sales over the
corresponding period of the prior year. Highlighting the increase in sales of
$4.8 million for year ended December 31, 1996 was lightweight ceramic armor,
which accounted for 46% of the increase in sales. Industrial products accounted
for 34% of the sales increase, primarily components for paper making equipment
and centrifuges. Microwave cathodes and ceramic-impregnated dispenser cathodes
for large screen television and high definition television (HDTV) accounted for
16% of the sales increase. Orthodontic products contributed 4% of the sales
increase; this was mainly due to the late introduction of the new "Clarity"
ceramic orthodontic bracket by our marketing partner, 3M's Unitek division, in
the third quarter of 1996. However, the initial demand for the new "Clarity"
product did surpass the Company's production capability; therefore, Ceradyne
hired additional personnel, and invested in equipment to increase production of
this product line in the fourth quarter of 1996.

International sales have and are expected to continue to be an important part of
the Company's business, representing 20% of the Company's net sales for the
period ending December 31, 1996, down from 26% for the comparable period of the
prior year. The decrease in 1996 was due primarily to the completion in 1995 of
a contract for ceramic armor shipped to a United Kingdom customer; partially
offset by increased international shipments of ceramic-impregnated dispenser
cathodes for large screen television and high definition television (HDTV), and
other ceramic products for the glass making industry.

Gross Profit. The Company's gross profit increased to $6.9 million, or 24.3% of
net sales, for the year ended December 31, 1996, compared to $6.1 million, or
25.9% of net sales, for the year ended December 31, 1995. The increase in gross
profit for the year ended December 31, 1996 as compared to the prior year was
$.8 million or 13.0%. The Company's sales volume for the year ended December
31, 1996, versus the prior year, had a favorable impact on absorbing fixed
manufacturing overhead, and as a result, the Company's gross profit, in absolute
dollars was impacted positively. Highlighting the products that contributed to
gross profit increases were armor products and other advanced technical
products. The armor products contributed to the gross profit because of
betterment in yields due to a continuing favorable volume during the year.
Other advanced technical products had record shipments, combined with a
favorable product mix, such as semiconductor equipment chamber components that
handle wafers, paper industry ceramic products and centrifuge ceramic
components.

However, as a percentage of net sales, there was a decrease of 1.6% in gross
profit over the prior year, and the reason for the decrease was that early in
the first quarter of 1997, management determined that manufacturing processes
and resulting complexities in the cost accounting methodology created an over
valuation of inventory among certain of the product lines at the Semicon
Associates Division. Therefore, an adjustment was made to write down work-in-
process inventory by $595,000, and to reserve an additional $300,000 for excess
inventory for year ended December 31, 1996.

Selling expenses were $1.6 million for the year ended December 31, 1996, an
increase of .5% from the comparable period of the prior year. This increase was
mainly due to commission expense related to increased sales volume.

27
<PAGE>

General and administrative expenses were $2.8 million for the year ended
December 31, 1996, a 20.8% increase from the comparable period of the prior
year. This increase was primarily due to the payment of employee incentive
bonuses indexed to the Company's profitability during the year ended December
31, 1996.

Other Income and Expense. Other income increased to $1,890,000 for the year
ended December 31, 1996 compared to $265,000 for the year ended December 31,
1995. The increase of $1,625,000 was mainly attributable to: Royalty income
from orthodontic sales of approximately $118,000; interest income of $140,000
from cash deposits on hand; a reimbursement of $164,000 from an insurance
carrier for legal expenses; and an insurance settlement the Company favorably
negotiated in litigation brought against an insurance carrier netted $1.3
million to the Company.

Interest Expense. For the year ended December 31, 1996 interest expense was
$162,000, a 52.3% decrease over the comparable period of the prior year,
primarily attributable to a decrease in debt of approximately $1.2 million from
the prior year.

Income Taxes. The Company made a $127,000 provision for income taxes for the
year ended December 31, 1996, due to the alternative minimum tax (AMT). For
both Federal and State tax purposes, only 90% of the Company's income before
income taxes may be offset by the available net operating losses carryforward of
approximately $11.7 million due to the assessment of alternative minimum income
taxes.

Net Income. Reflecting all of the matters discussed above, record net income
was $4,040,000 (or $.51 per share) for the year ended December 31, 1996 compared
to a net income of $2,089,000 (or $.32 per share) for the prior year.

28
<PAGE>

YEARS ENDED DECEMBER 31, 1995 AND 1994.

Net Sales. Net sales for the year ended December 31, 1995 were $23.4 million,
which represents a 30% or a $5.4 million increase in net sales for the
corresponding period of the prior year. This increase was primarily due to a
76.7% (or $3.3 million) increase in sales of the Company's industrial products
(consisting of a $1.6 million increase in fused silica ceramic products and a
$1.7 million increase in sales of ceramic orthodontic products), as well as an
increase in sales in substantially all of the Company's other product lines.

International sales have and will continue to be an important part of the
Company's business, representing 26.4% of the Company's net sales for the period
ending December 31, 1995, up from 25.5% for the comparable period of the prior
year, due primarily to shipments of microwave tube products and CRT cathode
products. The Company intends to increase its efforts to expand sales in the
international market.

Gross Profit. The Company's gross profit increased to $6 million, or 25.9% of
net sales, for the year ended December 31, 1995, compared to $1.9 million, or
10.3% of net sales, for the year ended December 31, 1994. Of the $4.1 million
increase in gross profit, approximately $1.5 million resulted from increased
gross profit at the Company's Semicon division in Lexington, Kentucky and
approximately $1.1 million resulted from increased gross profit at the Company's
Thermo Materials division in Scottdale, Georgia. These increases were
attributable primarily to increased sales and improvements in manufacturing
productivity at those facilities. Also contributing to the improvement in gross
profit for 1995 was the absence of the Company's ceramic-to-metal operations,
which were divested in the fourth quarter of 1994 and which had a negative gross
margin of approximately $.7 million during the year ended December 31, 1994.
Other factors contributing to the improvement in gross profit during 1995
included increased sales of products with greater profit margins, increased
manufacturing productivity, a 30% increase in total net sales during the period,
and absorption of fixed manufacturing overhead over the increased sales volume.

During the fiscal quarter ended June 30, 1995 the Company renegotiated the lease
for its West Coast facility, reducing both leased space and rent. This
reduction of approximately $350,000 per year, the majority of which will reduce
manufacturing overhead expense, commenced in November 1995.

Operating Expense. Operating expenses were $3.8 million for the year ended
December 31, 1995, an increase of 1.1% from the comparable period of the prior
year, and represented 16.4% of net sales compared to 21.1% of net sales for the
year ended December 31, 1994. The improvement as a percentage of net sales was
due to increased sales for the period ended December 31, 1995.

Selling expenses were $1.5 million for the year ended December 31, 1995, a
decrease of .7% from the comparable period of the prior year. This decrease in
aggregate selling expenses was due primarily to the sale by the Company in the
fourth quarter of 1994 of its ceramic-to-metal product line, which historically
had required a relatively higher commitment of selling expenses. Selling
expenses attributable to this product line were approximately $184,000 during
the year ended December 31, 1994. While actual amounts expended will depend
upon a variety of factors, the Company anticipates that selling expenses will
increase in future years as the Company increases its marketing efforts both
domestically and internationally.

29
<PAGE>

General and administrative expenses were $2.3 million for the year ended
December 31, 1995, a 2.3% increase from the comparable period of the prior year.
This increase was primarily due to the payment of employee incentive bonuses
indexed to the Company's profitability during the year ended December 31, 1995.

Given the nature of the Company's business, management believes that the present
aggregate dollar level of operating expense, which has not changed materially
over the last several years, is necessary to support the Company at its current
sales level, as well as that experienced in the recent past. On the other hand,
management believes that the Company should be able to significantly increase
its sales without corresponding increases in selling, general and administrative
expenses.

Other Income. Other income decreased to $265,000 for the year ended December
31, 1995 compared to $366,000 for the year ended December 31, 1994. The
decrease of $101,000 was mainly attributable to non-recurring deferred revenue
for Ceradyne Specialty Products, a division which is no longer active.

Interest Expense. For the year ended December 31, 1995 interest expense was
$342,000, a 16.3% increase over the comparable period of the prior year,
primarily attributable to higher interest rates.

Income Taxes. The Company made a $50,000 provision for income taxes for the
year ended December 31, 1995, due to the alternative minimum tax (AMT). For
both Federal and State tax purposes, only 90% of the Company's income before
income taxes may be offset by the available net operating losses carryforward of
approximately $17.3 million due to the assessment of alternative minimum income
taxes.

Net Income. Reflecting all of the matters discussed above, net income was
$2,089,000 (or $.32 per share) for the year ended December 31, 1995 compared to
a loss of $1,866,000 (or $.30 per share) for the prior year.

30
<PAGE>

LIQUIDITY AND CAPITAL RESOURCES

The Company generally meets its operating and capital requirements for cash flow
from operating activities and borrowings under its credit facilities. On
December 4, 1995, the Company completed a public offering of 1,380,000 shares of
its common stock at $5.00 per share. After commissions and other related
expenses, Ceradyne netted approximately $6 million cash from the offering. As
of December 31, 1996, the Company had cash and cash equivalents of $4.6 million.

On January 30, 1996, the Company amended its revolving credit agreement with a
financial lending institution. The debt with this lender was reduced from $2.1
million to $1.0 million. The Company has delivered to the lender cash
collateral, in the form of a bank certificate of deposit, in the sum of $1.0
million as security for the credit facility. The interest rate on the new debt
of $1.0 million has decreased from 3.6% over prime rate to 2.0% over prime rate.
The maximum overall credit facility with this lender is $4.0 million and the
Company is only utilizing $1.0 million in borrowing at present. This credit
facility will expire on November 29, 1997. See Notes to Consolidated Financial
Statements.

Management believes that its current cash and cash equivalents on hand, as well
as cash generated from operations and the ability to borrow under the existing
credit facility, will be sufficient to finance anticipated capital and operating
requirements for at least the next 12 months.

Item 8. Consolidated Financial Statements and Supplementary Data
--------------------------------------------------------

The Consolidated Financial Statements and Supplementary Data commence at page 39
of this report and an index thereto in included in Part IV, Item 14 of this
report.

Item 9. Changes in and Disagreements with Accountants on
------------------------------------------------
Accounting and Financial Disclosure
-----------------------------------

Not applicable

31
<PAGE>

PART III

Item 10. Directors and Executive Officers of the Registrant
--------------------------------------------------

Information in response to this item (except for certain information concerning
officers included in Part I herein) is incorporated by reference from the
registrant's definitive proxy statement to be filed with the Commission within
120 days after the close of registrant's fiscal year.

Item 11. Executive Compensation
----------------------

Information in response to this item is incorporated by reference from the
registrant's definitive proxy statement to be filed with the Commission within
120 days after the close of registrant's fiscal year.

Item 12. Security Ownership of Certain Beneficial Owners and Management
--------------------------------------------------------------

Item 13. Certain Relationships and Related Transactions
----------------------------------------------

32
<PAGE>

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
---------------------------------------------------------------
(a) List of documents filed as part of this report:

(1) Financial Statements: Page
-------------------- ----
<S> <C>
Report of Independent Public Accountants 38
Consolidated Balance Sheets at December 31, 1996 and 1995 39-40
Consolidated Statements of Operations for 41
the Years Ended December 31, 1996, 1995 and 1994
Consolidated Statements of Cash Flows for the Years ended 43-44
December 31, 1996, 1995 and 1994
Notes to Consolidated Financial Statements 45-56

(2) Financial Statement Schedules:
-----------------------------

Schedule VIII -- Valuation and Qualifying Accounts 57
</TABLE>

All other schedules are omitted since the required information is not
present or is not present in amounts sufficient to require submission of
the schedule, or because the information required is included in the
Consolidated Financial Statements and Notes thereto.

(b) The following reports on Form 8-K were filed during the last quarter of
the fiscal year ended December 31, 1996:

None

<C> <S>
3.1 Certificate of Incorporation of the Registrant. Incorporated herein by
reference to Exhibit 3.1 to the Registrant's Registrant Statement on
Form 8-B.

3.2 Bylaws of Registrant. Incorporated herein by reference to Exhibit 3.2
to the Registrant's Form 10-Q Report for the period ended June 30,
1996.

3.3 Amendment to Bylaws of Registrant, adopted April 29, 1996. Incorporated
herein by reference to Exhibit 3.3 to the Registrants Form 10-Q Report
for the period ended June 30, 1996.

4.1 Form of Representatives' Common Stock Purchase Warrant. Incorporated
herein by reference to Exhibit 4.1 to the Registrant's Registration
Statement on Form S-1 (File No. 33-62345).

10.1 Agreement for Purchase and Incorporated herein by Sale of Stock of the
reference to Exhibit Registrant dated January 10.1 to the 12, 1983.
Registrant's Statement on Form S-1 (File No. 2-90821).
</TABLE>

33
<PAGE>

10.2 Payment Schedule dated January 12, 1983. Incorporated herein by
reference to Exhibit 10.2 to the Registrant's Statement on Form S-1
(File No. 2-90821).

10.3 Ceradyne, Inc. Patent and Know-How License Agreement dated January 12,
1983. Incorporated herein by reference to Exhibit 10.4 to the
Registrant's Registration Statement on Form S-1 (File No. 2-90821).

10.4* Ceradyne, Inc. 1983 Stock Option Plan as amended and restated.
(Incorporated by reference from Exhibit 10.13 to the Company's
Registration Statement on Form S-1 (File No. 2-99930) filed on
September 25, 1985 (the "1985 S-1").

10.5 Lease between Trico Rents and the Registrant dated March 23, 1984,
covering premises located at 235 Paularino Avenue, Costa Mesa,
California. Incorporated herein by reference to Exhibit 10.14 to
the Registrant's Registration Statement on Form S-1 (File No.2-90821).

10.6 Lease covering premises located at 3169-A Red Hill Avenue, Costa Mesa,
California dated October 28, 1985. Incorporated herein by
reference to Exhibit 10.30 to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31, 1985.

10.7 Stock Sale Agreement between the Registrant and Ford Motor Company
dated March 11, 1986. Incorporated herein by reference to Exhibit 10.31
to the Registrant's Annual Report on Form 10-K for the fiscal year
ended December 31, 1985.

10.8 Agreement between certain shareholders of the Registrant and Ford Motor
Company dated March 11, 1986. Incorporated herein by reference to
Exhibit 10.32 to the Registrant's Annual Report on Form 10-K
for the year ended December 31, 1985.

10.9 Stock Purchase Agreement between Ceradyne Advanced Products, Inc., the
Registrant and Ford Motor Company dated March 11, 1986. Incorporated
herein by reference to Exhibit 10.33 to the Registrant's Annual Report
on Form 10-K for the fiscal year ended December 31, 1985.

10.10 Patent and Technology Transfer Agreement between Ford Motor Company and
Ceradyne Advanced Products, Inc. dated March 11, 1986. Incorporated
herein by reference to Exhibit 10.34 to the Registrant's Annual Report
on Form 10-K for the fiscal year ended December 31, 1985.

10.11 License Agreement between the Registrant and Ceradyne Advanced
Products, Inc. dated March 11, 1986. Incorporated herein by reference
to Exhibit 10.35 to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31, 1985.

10.12 License Agreement between Ford Motor Company and the Registrant dated
March 11, 1986. Incorporated herein by reference to Exhibit 10.36 to
the Registrant's Annual Report on Form 10-K for the fiscal year ended
December 31, 1985.
</TABLE>

34
<PAGE>

<C> <S>
10.13 Joint Development Agreement between the Registrant and Ford Motor
Company dated March 11, 1986. Incorporated herein by reference to
Exhibit 10.37 to the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1985.

10.14 Cathode Purchase Agreement, dated as of October 4, 1986, between the
Registrant and Varian Associates. Incorporated herein by reference to
Exhibit 28.2 to the Company's Current Report on Form 8-K dated November
17, 1986.

10.15 Lease dated March 31, 1986 covering premises located at 3163 Red Hill
Avenue, Costa Mesa, California. Incorporated herein by reference to
Exhibit 10.45 to the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1986.

10.16 Lease dated August 5, 1986 covering premises located at 225 Paularino
Avenue, Costa Mesa, California. Incorporated herein by reference to
Exhibit 10.46 to the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1986.

10.17 Short-form Memorandum of Lease Assignment dated December 15, 1986, and
Lease dated June 23, 1980, covering premises located at 3449 Church
Street, Scottdale, Georgia. Incorporated herein by reference to Exhibit
10.47 to the Registrant's Annual Report on Form 10-K for the fiscal
year ended December 31, 1986.

10.18* Amendment dated June 3, 1986 to the Ceradyne, Inc. 1983 Stock Option
Plan. Incorporated herein by reference to Exhibit 10.50 to the
Registrant's Annual Report on Form 10-K for the fiscal year ended
December 31, 1986.

10.19* Amendment dated March 16, 1987 to the Ceradyne, Inc. 1983 Stock Option
Plan. Incorporated herein by reference to Exhibit 10.51 to the
Registrant's Annual Report on Form 10-K for the fiscal year ended
December 31, 1986.

10.20 Joint Development Agreement dated March 28, 1986 between Unitek
Corporation and the Registrant, and First and Second Amendments
thereto. Incorporated herein by reference to Exhibit 10.52 to the
Registrant's Annual Report on Form 10-K for the fiscal year ended
December 31, 1986.

10.21* Amendment dated April 30, 1987 to the Ceradyne, Inc. 1983 Stock Option
Plan. Incorporated herein by reference to Exhibit 10.56 to the
Registrant's Registration Statement on Form 8-B.

10.22 Loan and Security Agreement dated November 27, 1989 between the
Registrant and Fidelcor Business Credit Corp. Incorporated
herein by reference to Exhibit 28.1 to the Registrant's
Current Report on Form 8-K dated December 8, 1989.

10.23 Promissory Note Agreement dated November 27, 1989 between the
Registrant and Fidelcor Business Credit Corp. Incorporated herein by
reference to Exhibit 28.2 to the Company's Current Report on Form 8-K
dated December 8, 1989.
</TABLE>

35
<PAGE>

<C> <S>
10.24 Collateral Assignment of Patents Agreement dated November 27, 1989
between the Registrant and Fidelcor Business Credit Corp. Incorporated
herein by reference to Exhibit 28.3 to the Registrant's Current Report
on Form 8-K dated December 8, 1989.

10.25 Collateral Assignment of Trademarks Agreement dated November 27, 1989
between the Registrant and Fidelcor Business Credit Corp. Incorporated
herein by reference to Exhibit 28.4 to the Registrant's Current Report
on Form 8-K dated December 8, 1989.

10.26 Amendment dated September 22, 1994 to Loan and Security Agreement
dated November 27, 1989, and all addenda and supplements thereto
between the Registrant and the CIT Group/Credit Finance, inc. assignee
of Fidelcor Business Credit Corporation. Incorporated herein by
reference to Exhibit 10.27 to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31, 1993.

10.27 Amendment dated September 22, 1994 to Loan and Security Agreement
dated November 27, 1989, and all amendments and supplements thereto
between the CIT Group/Credit Finance, Inc. and the Registrant.
Incorporated herein by reference to Exhibit 10.29 to the Registrant's
Annual Report on Form 10-K for fiscal year ended December 31, 1994.

10.28* Employment Agreement entered into as of July 5, 1994 entered into as
by and between Joel P. Moskowitz and the Registrant. Incorporated
herein by reference to Exhibit 10.30 to the Registrant's Annual Report
on Form 10-K for the fiscal year ended December 31, 1994.

10.29* Ceradyne, Inc. 1994 Stock Incentive Plan. Incorporated herein by
reference to Exhibit 10.31 to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31, 1994.

10.30* Amendment No. 1 to the Ceradyne, Inc. 1994 Stock Incentive Plan.
Incorporated herein by reference Exhibit 4.2 Registrant's Registration
Statement on Form S-8 (File No. 33-61675).

10.31* Ceradyne, Inc. 1995 Employee Stock Purchase Plan. Incorporated herein
by reference to Exhibit 4.1 to Registrant's Registration Statement on
Form S-8 (File No. 33-61677).

10.32 Amendment No. 2, dated June 5, 1995, to Lease between Trico Rents and
the Registrant covering premises located at 235 Paularino Avenue,
Costa Mesa, California. Incorporated herein by reference to Exhibit
10.32 to the Registrant's Registration Statement on Form S-1 (File No.
33-62345).

10.33 Amendment No. 2, dated June 5, 1995, to Lease covering premises
located at 3169-A Red Hill Avenue, Costa Mesa, California.
Incorporated herein by reference to Exhibit 10.33 to the Registrant's
Registration Statement on Form S-1 (File No. 33-62345).
</TABLE>

36
<PAGE>

<S> <C>
10.34 Amendment No. 2, dated June 5, 1995, to Lease dated March 31, 1986
covering premises located at 3163 Red Hill Avenue, Costa Mesa,
California. Incorporated herein by reference to Exhibit 10.34 to the
Registrant's Registration Statement on Form S-1 (File No. 33-62345).

10.35 Amendment No. 2, dated June 5, 1995, to Lease dated August 5, 1986
covering premises located at 225 Paularino Avenue, Costa Mesa,
California. Incorporated herein by reference to Exhibit 10.35 to the
Registrant's Registration Statement on Form S-1 (File No. 33-62345).

10.36* Amendment No. 2 to the Ceradyne, Inc. 1994 Stock Incentive Plan.

21.1 Subsidiaries of the Registrant. Incorporated herein by reference to
Exhibit 23.2 to the Registrant's Registration Statement on Form S-1
(File No. 33-62345).

23.1 Consent of Arthur Andersen LLP.

27 Financial Data Schedule

* Each of these exhibits constitutes a management contract,
compensatory plan, or arrangement required to be filed as an exhibit
to this Report pursuant to Item 14(c) of this Report.
</TABLE>

37
<PAGE>

REPORT OF INDEPENDENT PUBLIC ACCOUNTS
-------------------------------------

To Ceradyne, Inc.:

We have audited the accompanying consolidated balance sheets of CERADYNE, INC.
(a Delaware corporation) and subisidiaries as of December 31, 1996 and 1995, and
the related consolidated statements of operations, shareholders' equity and cash
flows for each of the three years in the period ended December 31, 1996. These
financial statements are the responsibility of the Company's management, Our
responsibility is to express an opinion on these financial statments 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 statments. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Ceradyne, Inc. and subsidiaries
as of December 31, 1996 and 1995, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 1996, in
conformity with generally accepted accounting principles.

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

ARTHUR ANDERSEN LLP

Orange County, California
March 20, 1997

38
<PAGE>

CERADYNE, INC.
--------------

CONSOLIDATED BALANCE SHEETS
---------------------------

DECEMBER 31, 1996 AND 1995
--------------------------

ASSETS
------
(Amounts in thousands)

<TABLE>
<CAPTION>
1996 1995
------- -------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 4,643 $ 6,219
Accounts receivable, net of allowances of
approximately $125 and $150 for doubtful
accounts in 1996 and 1995, respectively 4,854 3,759
Other receivables 1,397 12
Inventories 7,756 6,749
Production tooling 538 366
Prepaid expenses and other 401 323
------- -------
Total current assets 19,589 17,428
------- -------

PROPERTY, PLANT AND EQUIPMENT, at cost
Land 422 422
Buildings and improvements 1,825 1,825
Lease rights 2,659 2,659
Machinery and equipment 15,718 14,907
Leasehold improvements 1,278 1,141
Office equipment 1,829 1,383
Construction in progress 600 134
------- -------
24,331 22,471
Less--Accumulated depreciation and amortization 18,073 17,750
------- -------
6,258 4,721
------- -------

COSTS IN EXCESS OF NET ASSETS ACQUIRED,
net of accumulated amortization of $1,595 and $1,441 in
1996 and 1995, respectively 2,079 2,233
------- -------
OTHER ASSETS, net of accumulated amortization of
$565 and $539 in 1996 and 1995, respectively 472 498
------- -------
Total assets $28,398 $24,880
======= =======
</TABLE>

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

39
<PAGE>

CERADYNE, INC.
--------------

CONSOLIDATED BALANCE SHEETS
---------------------------

DECEMBER 31, 1996 AND 1995
--------------------------

LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
(Amounts in thousands, except share data)

<TABLE>
<CAPTION>
1996 1995
-------- --------
<S> <C> <C>
CURRENT LIABILITIES:
Current portion of long-term debt $ 1,000 $ 1,601
Accounts payable 1,662 1,642
Accrued expenses:
Payroll and payroll related 662 588
Other 373 381
-------- --------
Total current liabilities 3,697 4,212
-------- --------
LONG-TERM DEBT --- 555
-------- --------
DEFERRED REVENUE 261 261
-------- --------
COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY
Common stock, $.01 par value:
Authorized--12,000,000 shares
Outstanding--7,901,790 and 7,715,624 shares
in 1996 and 1995, respectively 37,138 36,590
Accumulated deficit (12,698) (16,738)
-------- --------
Total shareholders' equity 24,440 19,852
-------- --------
Total liabilities and stockholders' equity $ 28,398 $ 24,880
======== ========
</TABLE>

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

40
<PAGE>

CERADYNE, INC.
--------------

CONSOLIDATED STATEMENTS OF OPERATIONS
-------------------------------------

FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
-----------------------------------------------------
(Amounts in thousands, except per-share data)
<TABLE>
<CAPTION>

1996 1995 1994
------- ------- -------
<S> <C> <C> <C>

NET SALES $28,212 $23,404 $17,996

COST OF PRODUCT SALES 21,365 17,347 16,135
------- ------- -------
Gross profit 6,847 6,057 1,861
------- ------- -------
OPERATING EXPENSES:
Selling 1,571 1,492 1,502
General and administrative 2,837 2,349 2,297
------- ------- -------
4,408 3,841 3,799
------- ------- -------
Income/(loss) from operations 2,439 2,216 (1,938)
------- ------- -------
OTHER INCOME (EXPENSE):
Other income, net 1,890 265 366
Interest expense (162) (342) (294)
------- ------- -------
1,728 (77) 72
------- ------- -------
Income/(loss) before provision
for income taxes 4,167 2,139 (1,866)

PROVISION FOR INCOME TAXES 127 50 --
------- ------- -------
Net income/(loss) $ 4,040 $ 2,089 $(1,866)
======= ======= =======
NET INCOME/(LOSS) PER COMMON
AND EQUIVALENT SHARE $.51 $.32 $(.30)
======= ======= =======
</TABLE>

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

41
<PAGE>

CERADYNE, INC.
--------------

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
-----------------------------------------------

FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, and 1994
-----------------------------------------------------
(Amounts in thousands, except share data)

<TABLE>
<CAPTION>
Common Stock
-------------------
Number Accumulated
of Shares Amount Deficit
--------- ------- --------
<S> <C> <C> <C>
BALANCE, December 31, 1993 6,231,079 30,404 (16,961)

Issuance of common stock 9,655 8 ---
Exercise of stock options 3,000 17 ---
Net loss --- --- (1,866)
--------- ------- --------
BALANCE, December 31, 1994 6,243,734 30,429 (18,827)

Issuance of common stock 13,090 22 ---
Exercise of stock options 78,800 205 ---
Public offering 1,380,000 5,934 ---
Net income --- --- 2,089
--------- ------- --------
BALANCE, December 31, 1995 7,715,624 $36,590 $(16,738)
--------- ------- --------

Issuance of common stock 25,521 147 ---
Exercise of stock options 160,645 401 ---

Net Income --- --- 4,040
--------- ------- --------
BALANCE, December 31, 1996 7,901,790 $37,138 ($12,698)
========= ======= ========
</TABLE>

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

42
<PAGE>

CERADYNE, INC.
--------------

CONSOLIDATED STATEMENTS OF CASH FLOW
------------------------------------

FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
----------------------------------------------------
(Amounts in thousands)

<TABLE>
<CAPTION>
1996 1995 1994
------- ------- --------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 4,040 $ 2,089 $(1,866)

Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 1,284 1,532 1,577
Gain on sale of property, plant & equipment --- --- 103
Increase in accounts receivable, net (1,095) (868) (266)
(Increase) decrease in other receivables (1,385) (6) 15
Increase in inventories (1,007) (1,013) (344)
(Increase) decrease in production tooling (172) (123) 135
(Increase) decrease in prepaid expenses and other assets (78) (302) 70
Increase (decrease) in accounts payable 20 (288) 917
Increase (decrease) in accrued expenses 66 84 (9)
Increase(decrease) in deferred revenue --- (250) 404
------- ------- --------
Net cash provided by operating activities 1,673 855 736
------- ------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:

Proceeds from sale of property, plant & equipment --- --- 140
Purchases of property, plant and equipment (2,641) (1,019) (256)
------- ------- --------
Net cash used in investing activities (2,641) (1,019) (116)
------- ------- --------
</TABLE>

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

43
<PAGE>

CERADYNE, INC.
--------------

- 2 -
<TABLE>
<CAPTION>

1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>

CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock, net $ 548 $6,161 $ 25
Net borrowing (payments) on long-term borrowing (1,156) 222 (739)
------- ------ -----
Net cash provided by (used in) financing activities (608) 6,383 (714)
------- ------ -----
Increase (decrease) in cash and cash equivalents (1,576) 6,219 (94)

Cash and cash equivalents, beginning of period 6,219 0 94
------- ------ -----
Cash and cash equivalents, end of period 4,643 $6,219 $ ---
======= ====== =====
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:

Interest paid $ 150 $ 342 $ 294
======= ====== =====
Income taxes paid $ 177 $ 21 $ 22
======= ====== =====
</TABLE>

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

44
<PAGE>

CERADYNE, INC.
--------------

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
DECEMBER 31, 1996, 1995 AND 1994
--------------------------------

1. Summary of Significant Accounting Policies
------------------------------------------

a. Principles of Consolidation and Nature of Operations
----------------------------------------------------

The consolidated financial statements include the financial statements of
Ceradyne, Inc. and its subsidiaries (a Delaware Corporation). Ceradyne, Inc. and
its subsidiaries are collectively referred to herein as the Company. All
significant intercompany accounts and transactions have been eliminated.

The Company develops, manufactures and markets advanced technical ceramic
products and components for industrial, defense, consumer and microwave
applications. The products are sold primarily to industrial, consumer, and
defense concerns globally.

b. Cash and Cash Equivalents
-------------------------

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.

c. Accounts Receivable
-------------------

The allowance for doubtful accounts includes management's estimate of the amount
expected to be lost on specific accounts and for losses on other as yet
unidentified accounts included in accounts receivable. In estimating the
potential losses on specific accounts, management relies on in-house prepared
analysis and review of other available information. The amounts the Company will
ultimately realize could differ from the amounts assumed in arriving at the
allowance for doubtful accounts in the accompanying financial statements.

d. Inventories
-----------

Inventories are valued at the lower of cost (first-in, first-out) or market.
Allowances for obsolete inventory are based on management's estimate of the
amount considered obsolete based on specific reviews of inventory items. In
estimating the allowance, management relies on its knowledge of the industry as
well as its current inventory levels. The amounts the Company will ultimately
realize could differ from amounts estimated by management. Inventory costs
include the cost of material, labor and manufacturing overhead. The following is
a summary of inventory by component:

45
<PAGE>

December 31,
------------------------
1996 1995
----------- ----------
<S> <C> <C>
Raw materials $2,742,000 $2,833,000
Work-in-process 4,531,000 3,378,000
Finished goods 483,000 538,000
---------- ----------
$7,756,000 $6,749,000
========== ==========
</TABLE>

e. Property, Plant and Equipment
-----------------------------

Depreciation and amortization of property, plant and equipment are provided
using the straight-line method over the following estimated useful lives:

<TABLE>
<CAPTION>
<S> <C>
Buildings and improvements 20 years
Lease rights Term of lease and renewal option
Machinery and equipment 3 to 12 years
Leasehold improvements Term of lease
Office equipment 5 years
</TABLE>

Maintenance, repairs and minor renewals are charged to expense as incurred.
Repairs and maintenance expense was $598,000, $414,000, and $370,000 in 1996,
1995 and 1994, respectively. Additions and improvements are capitalized. When
assets are disposed of, the applicable costs and accumulated depreciation and
amortization are removed from the accounts and any resulting gain or loss is
included in the results of operations.

f. Sales Recognition
-----------------

Sales are recorded as of the date shipments are made to, or goods are accepted
by, customers for production contracts. Revenue is recognized using the
percentage-of-completion method for cost plus fixed fee, government sponsored,
and research and development contracts. For the years ending December 31, 1996,
1995 and 1994, revenues from cost plus fixed fee contracts were less than 10
percent of net sales.

g. Deferred Revenue
----------------

As part of the sale in October 1989 of its wholly-owned subsidiary, Ceradyne
Specialty Products, Inc., the Company received proceeds of $785,000 for an
option to issue a license attributable to certain technology and an agreement
not to compete for a period of five years. The revenue was fully amortized at
December 31, 1994.

In September 1994, the Company entered into an agreement which waived a minimum
production per quarter requirement as well as a minimum rework lot quantity for
the translucent ceramic bracket. In consideration for entering into this
modification, the Company received a cash fee of $250,000 which was amortized to
other income in 1995.

46
<PAGE>

In September 1994, the Company finalized an agreement to manufacture and supply
a specific cathode to a third party at reduced prices. In consideration for
entering into this contract, the Company received a cash fee of $261,000. The
fee has been deferred in the accompanying financial statements and will be
recognized over the life of the agreement once shipments commence. At December
31, 1996, none of the fee has been recognized.

h. Net Income (Loss) Per Share
---------------------------

The number of shares used in computing primary net income (loss) per share
equals the total of the weighted average number of shares outstanding during the
periods plus, in 1995 and 1996, common stock equivalents relating to options.
Common stock equivalents relating to options issued under the 1983 Stock Option
Plan (as amended), the 1994 Stock Incentive Plan, the 1985 Employee Stock
Purchase Plan and the 1995 Employee Stock Purchase Plan (see Note 6) represent
additional shares which may be issued in connection with their exercise, reduced
by the number of shares which could be repurchased with the proceeds at the
average market price per share. Common stock equivalents relating to options
are not included when their effect is antidilutive. The following is a summary
of the number of shares entering into the computation of net loss per common and
common equivalent share:
<TABLE>
<CAPTION>

December 31,
---------------------------------
1996 1995 1994
--------- --------- ---------
<S> <C> <C> <C>
Weighted average number of
shares outstanding 7,807,768 6,497,000 6,238,000
Common stock equivalents 177,232 110,000 ---
--------- --------- ---------
Number of shares 7,985,000 6,607,000 6,238,000
========= ========= =========
</TABLE>

i. Costs in Excess of Net Assets Acquired
--------------------------------------

Costs in excess of net assets acquired arising from the Company's acquisitions
are being amortized over a 20 to 30 year period. Management evaluates, on an
ongoing basis, the carrying value of excess acquisition cost and makes a
specific provision against the asset when impairment is identified. When a loss
is expected from the proposed sale of a business or product line, a diminution
in the value of the excess of cost over the net asset value of the business
acquired is identified. In the instance of an ongoing business, such a
diminution is recognized when there has been a history of the business'
inability to generate operating income after the amortization of goodwill and in
management's judgment, the business will not recover from this position in the
future. There were no impairment charges in any of the three years ended
December 31, 1996.

j. Deferred Start-up Costs
-----------------------

Start-up costs incurred to establish the technological feasibility of a new
product to be sold or otherwise marketed are charged to expense in the period
incurred. Costs incurred subsequent to establishing technological feasibility
but prior to commercial sales to customers are capitalized and amortized over
the estimated economic life of the product. Amortization will be computed, once
shipments commence, using the greater of the ratio of current revenues to
anticipated current and future revenues or the straight-line method. During the
years ended December 31, 1996, 1995 and 1994, there were no additional

47
<PAGE>

deferred costs capitalized. Deferred costs, totaling $338,000, are included in
Other Assets. No amortization expense was charged to operations for the years
ending December 31, 1996, 1995 and 1994, respectively. Revenues and associated
amortization are expected to commence in 1997.

k. Use of Estimates
----------------

The preparation of financial statements in accordance 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.
Actual results could differ from those estimates.

l. Engineering and Research
------------------------

Costs associated with application engineering and internally-funded research are
expensed as incurred and are included in cost of product sales. Costs
associated with Company-funded research were approximately $400,000, $400,000
and $360,000 in 1996, 1995 and 1994.

m. Stock Based Compensation Plans
------------------------------

Effective January 1, 1996, the Company adopted the disclosure provisions of SFAS
No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 requires the
Company to disclose proforma net income and earnings per share as if the fair
value based accounting method of SFAS No. 123 had been used to account for
stock-based compensation. These disclosures are included in Note 6.

n. Fair Value of Financial Instruments
-----------------------------------

The carrying value of accounts receivable and trade payables approximates the
fair value due to their short-term maturities. The carrying value of the
Company's line of credit is considered to approximate fair market value as the
interest rates of these instruments are based predominately on variable
reference rates.

o. Environmental Liabilities and Expenditures
------------------------------------------

Accruals for environmental matters are recorded in operating expenses when it is
probable that a liability has been incurred and the amount of the liability can
be reasonably estimated.

48
<PAGE>

2. Debt and Bank Borrowing Arrangements
------------------------------------
Long-term debt consisted of the following at December 31, 1996 and 1995:

<TABLE>
<CAPTION>
1996 1995
--------- ----------
<S> <C> <C>
Credit facility with asset-based lender, bearing
interest at the institution's prime rate
(8.25 percent at December 31, 1996)
plus 2.0 percent:
Five year term loan, payable in monthly
installments of $26,428 -0- $ 817,000
Revolving line of credit 1,000,000 1,294,000
--------- ----------
1,000,000 2,111,000
Four contract capital leases, bearing
interest between 5.38 percent and 11.64
percent, payable in monthly installments
of $18,948 expiring from May 1995
through September 1996, secured by
equipment with a net book value of
$68,000 as of December 31, 1995 -0- 45,000
--------- ----------
1,000,000 2,156,000
Less-current portion 1,000,000 1,601,000
--------- ----------
Long-term debt -0- $ 555,000
========= ==========
</TABLE>

On January 30, 1996, the Company amended its revolving credit agreement set
forth above. The total credit facility with the Company's lender remains at
$4,000,000; however, the debt on the total facility has been reduced to
$1,000,000, which is the minimum borrowing requirement. The previous minimum
borrowing requirement was $2,000,000. The pay down of $1,000,000 was part of
the stated use of the proceeds from the public offering in December 1995.
Additionally, the interest rate was decreased from 3.6% over prime rate to 2.0%
over prime rate and all financial loan covenants were eliminated. Also, in
computing interest charges, the locbox account of the Company maintained by
lender will be credited with remittances and other payments 2.5 business days
after funds have been credited to lender's account at lender's bank. The
Company has delivered to the lender cash collateral in the sum of $1,000,000 as
security for the credit facility. The collateral has been invested as a
certificate of deposit at Sumitomo Bank. All interest for this certificate of
deposit is to be forwarded to the Company. The credit facility shall be
effective until November 29, 1997 and automatically renewed for successive terms
of two years thereafter unless terminated at the end of the initial term by
either party giving the other written notice at least sixty (60) days prior to
the end of the then-current term.

49
<PAGE>

3. Income Taxes
------------

Effective the first quarter of 1993, the Company adopted Statement of Financial
Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The new
standard provides revised criteria for the recognition of net deferred tax
assets. The Company's net deferred tax asset, which is $5,654,800 at December
31, 1996 relates to its tax net operating loss carryforward, which totals
approximately $11.7 million and expires as follows:
<TABLE>
<CAPTION>
<S> <C>
2003 $ 3,335,100
2004 3,015,100
2005 161,000
2006 217,700
2007 1,092,800
2008 2,050,100
2009 1,828,200
-----------
$11,700,000
===========
</TABLE>

The Company's net deferred tax asset has been offset with a valuation allowance
since there is uncertainty regarding the Company's ability to recognize this tax
benefit because the benefit is dependent upon the Company's ability to continue
to generate future taxable income.

The components of the Company's net deferred income tax asset as of December 31,
1996 and 1995 are as follows:
<TABLE>
<CAPTION>
December 31,
-------------------------------
1996 1995
----------- -----------
<S> <C> <C>
Inventory adjustments $ 437,900 $ 272,800
Contingency reserves 112,500 98,500
Deferred revenue 104,500 104,500
Vacation accrual 151,700 145,400
Bad debt allowance 50,100 59,800
Net operating loss and tax credit carryforwards 4,694,000 6,911,300
Other 104,100 59,000
----------- -----------
5,654,800 7,651,300
Valuation allowance (5,654,800) (7,651,300)
----------- -----------
Net deferred tax asset $ --- $ ---
=========== ===========
</TABLE>
The effective income tax rate for the years ended December 31, 1995 and 1994
differs from the Federal statutory federal income tax rate due to the limitation
of net operating loss benefits. For the years ended December 31, 1996 and 1995,
the effective tax rate differs from the Federal statutory rate of 34 percent due
to the following items:

<TABLE>
<CAPTION>
1996 1995
----------- ----------
<S> <C> <C>
Income before taxes $ 4,167,000 $2,139,000
----------- ----------
Provision for income taxes at statutory rate 1,416,780 727,260
Increases (decreases) in tax resulting from:
Utilization of net operating loss carryforward (1,388,444) (711,342)
Other 98,664 34,082
----------- ----------
Provision for income taxes 127,000 50,000
----------- ----------
Effective tax rate 3.05% 2.34%
=========== ==========
</TABLE>

50
<PAGE>

4. Commitments and Contingencies
-----------------------------

a. Operating Lease Obligations
---------------------------

The Company leases certain of its manufacturing facilities under
noncancelable operating leases expiring at various dates through November
2000. One of the facility leases is subject to a 4 percent annual escalation
clause. The Company incurred rental expense under these leases of $596,000,
$837,000 and $915,000 in 1996, 1995 and 1994, respectively. The approximate
minimum rental commitments required under existing noncancelable leases as
of December 31, 1996 are as follows:

b. Employment Agreement
--------------------

The Company has an employment agreement with the Chief Executive Officer
which expires on July 5, 1999. In addition to a base salary, the agreement
provides for a bonus to be determined by the Compensation Committee of the
Board of Directors. No maximum compensation limit exists. The compensation
expense in 1996, 1995 and 1994 was $196,000, $167,000 and $151,000,
respectively.

c. Legal Proceedings
-----------------

In October 1995 the Company was served with a complaint that was filed by
four persons and the spouses of those persons, who are/were employed by one
of the Company's customers. The complaint, filed in the United States
District Court, Eastern District of Tennessee, alleges that the employees
contracted chronic beryllium disease as a result of their exposure, during
the course of their employment with the Company's customer, to beryllium-
containing products sold by Ceradyne. The complaint seeks compensatory
damages in the amount of $3.0 million for each of the four plaintiffs who
were employed by the Company's customer, compensatory damages of $1.0
million each for the two spouses, and punitive damages in the amount of $5.0
million. The case is in the early stages of discovery. Based upon
information currently available, the Company believes that the plaintiffs'
claims are without merit and that the resolution of this matter will not
have a material adverse effect on the financial condition or operations of
the Company. Defense of this case has been tendered to the Company's
insurance carriers, some of whom are providing a defense subject to a
reservation of rights. There can be no assurance, however, that this claim
or any of the claims related to exposure to beryllium oxide will be covered
by insurance, or that, if covered, the amount of insurance will be
sufficient to cover any potential judgment.

51
<PAGE>

In February 1997 the Company was served with a complaint that was filed by a
former employee of one of the Company's customers and his wife. The
complaint, filed in the United States District Court, Eastern District of
Tennessee, alleges that the husband contracted chronic beryllium disease as
a result of his exposure to beryllium-containing products sold by Ceradyne.
The complaint seeks compensatory damages in the amount of $5.0 million for
the husband, $1.0 million for the wife, and punitive damages in the amount
of $10.0 million. The Company believes that the plaintiffs' claims are
without merit and that the resolution of this matter will not have a
material adverse effect on the financial condition or operations of the
Company. Defense of this case has been tendered to the Company's insurance
carriers. There can be no assurances, however, that this claim will be
covered by insurance, or that, if covered, the amount of insurance will be
sufficient to cover any potential judgment.

During the third quarter of 1996, an action was concluded regarding a
current employee and his wife who filed suit in 1994 alleging that he had
contracted chronic beryllium disease as a result of his employment with the
Company. Ceradyne was dismissed as a direct defendant in March 1996, but a
cross-complaint filed by a previous landlord remains. An arbitration is
pending to resolve the dispute. The Company believes that the resolution of
this matter will not have a material adverse effect on the financial
condition or operations of the Company.

d. Insurance Settlements
---------------------

The Company favorably negotiated an insurance settlement that netted $1.3
million to the Company. This amount is reflected in other receivables in the
accompanying December 31, 1996 Balance Sheet.

5. Segment and Customer Information
--------------------------------

The Company operates solely in the development, manufacture and sale of advanced
technical ceramics. In the years ended December 31, 1996, 1995 and 1994, export
sales were approximately $5,677,000, $6,179,000 and $4,584,000, respectively.

For the year ended December 31, 1996, the Company had one customer that
accounted for 17 percent of sales. For the year ended December 31, 1995,
there were no customers that accounted for 10 percent of sales. For the year
ended December 31, 1994, the Company had one customer that accounted for 13
percent of sales.

52
<PAGE>

6. Stock Options
-------------

The Company has a stock option plan, the 1994 Stock Incentive Plan. Also, the
Company had a 1994 Employee Stock Purchase Plan which expired on July 31, 1995.
At the Annual Meeting held on July 24, 1995, the Stockholders of the Company
approved the 1995 Employee Stock Purchase Plan. The Company accounts for these
plans under APB Opinion No. 25, under which no compensation cost has been
recognized. Had compensation cost for these plans been determined consistent
with FASB Statement No. 123, the Company's net income and earnings per share
would have been reduced to the following pro forma amounts:

<TABLE>
<CAPTION>
1996 1995
---------- ----------
<S> <C> <C> <C>
Net Income: As Reported $4,040,000 $2,089,000
Pro Forma 3,794,000 1,962,000

Primary EPS: As Reported $ .51 $ .32
Pro Forma .48 .30
</TABLE>

Because the Statement No. 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma compensation
cost may not be representative of that to be expected in future years.
Additionally, the 1996 and 1995 pro forma amounts include $47,924 and $35,798,
respectively related to the purchase discount offered under the 1995 Employer
Stock Purchase Plan and the 1994 Employee Stock Purchase Plan, respectfully.

The Company may sell up to 100,000 shares of stock to its full-time employees
under the 1995 Employee Stock Purchase Plan. The Company has sold 13,694 shares
in 1996 under the 1995 Employee Stock Purchase Plan. There were 13,090 shares
sold in 1995 under the 1994 Employee Stock Purchase Plan. Employees may
purchase shares at the lower of 85 percent of the quoted market value of the
shares as determined on the first or last day of the plan year. The weighted
average fair value of shares sold in 1996 and 1995 was $4.75 and $2.00,
respectively.

The Company may grant options for up to 450,000 shares under the 1994 Stock
Incentive Plan. The Company has granted options of 323,700 shares through
December 31, 1996. Options are granted at or above the fair market value at the
date of grant and generally become exerciseable over a five-year period.

53
<PAGE>

A summary of the status of the Company's stock option plan at December 31, 1994,
1995 and 1996 and changes during the years then ended is presented in the table
and narrative below:

Stock Options
-------------
Shares Price
-------- --------------
<S> <C> <C>
OUTSTANDING, December 31, 1993 363,700 $2.75 - $3.875

Granted 159,500 $2.00
Exercised (3,000) $2.75
Canceled (48,000) $2.00 - $3.875
-------- --------------
OUTSTANDING, December 31, 1994 472,200 $2.00 - $3.875

Granted 154,200 $4.00 - $5.125
Exercised (78,800) $2.00 - $2.75
Canceled (5,400) $2.00 - $2.75
-------- --------------
OUTSTANDING, December 31, 1995 542,200 $2.00 - $5.125
-------- --------------

Granted 25,000 $5.125 -$7.375
Exercised (160,645) $2.00 -$4.00
Canceled (22,505) $2.00 -$4.00
-------- --------------
OUTSTANDING, December 31, 1996 384,050 $2.00 -$7.375
======== ==============
</TABLE>
Of the 384,050 options outstanding at December 31, 1996, 216,850 have exercise
prices between $2.00 and $2.75, with a weighted average exercise price of $2.15
and a weighted average remaining contractual life of 6 years. The remaining
167,200 options have exercise prices between $3.875 and $7.375, with a weighted
average exercise price of $5.39 and a weighted average remaining contractual
life of 9 years.

The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1995 and 1996, respectively: risk free interest
rates of 5.91 and 6.29 percent; expected lives for 1995 and 1996 for 7 years;
expected volatility of 58.46 and 57.20 percent. The assumed dividend yield in
1995 and 1996 is zero percent.

54
<PAGE>

7. Supplemental Retirement Plan
----------------------------

In December 1988 the Board of Directors of the Company approved the adoption of
a supplemental retirement plan (Ceradyne SMART 401(K) Plan) in which
substantially all employees are eligible to participate after completing one
year of employment. Participation in the Plan is voluntary. An employee may
elect to contribute up to seven percent (7%) of the employee's pretax
compensation as a basic contribution. The Company may contribute any amount
which the Board of Directors annually determines appropriate. Company
contributions fully vest and are nonforfeitable after the participant has
completed five years of service. During the years ended December 31, 1996 and
1995, the related expense was approximately $117,000 and $92,000, respectively.
The Company made no contributions during the year ended December 31, 1994.

The Company's contribution is in the form of shares of its common stock. The
number of shares to be contributed will be determined by dividing the total
Company match for the Plan year by the higher of the market value per share of
common stock as of the end of that Plan year (December 31), or the audited book
value per share of common stock as of the end of that Plan year. The member's
cash contributions may be invested, at their discretion, in one or all of the
following: (1) Fixed Income Fund, (2) Bond and Mortgage Fund, (3) International
Stock Fund, or (4) Equity Fund. The member can elect to allocate the
accumulated and future contributions to their accounts among these funds in
increments of 10 percent.

The Company has reserved 250,000 shares of its common stock for possible
issuance under the Plan. At December 31, 1996, 167,379 shares were available
for issuance under the Plan.

8. Interim Financial Information (unaudited)
-----------------------------------------

The results by quarter for 1996 and 1995 are as follows:
<TABLE>
<CAPTION>

Quarter Ending
--------------
March 31, June 30, September 30, December 31,
1996 1996 1996 1996
---------- ---------- ----------- ------------
<S> <C> <C> <C> <C>

Net sales $6,329,000 $6,991,000 $7,385,000 $7,507,000
Net income 765,000 951,000 1,084,000 1,240,000
Net income per
share- $ .10 $ .12 $ .14 $ .15
========== ========== ========== ==========
</TABLE>

<TABLE>
<CAPTION>
Quarter Ending
--------------
March 31, June 30, September 30, December 31,
1995 1995 1995 1995
---------- ---------- ------------- ------------
<S> <C> <C> <C> <C>
Net sales $5,379,000 $5,757,000 $6,274,000 $5,994,000
Net income 351,000 453,000 564,000 721,000
Net income per
share $ .06 $ .07 $ .09 $ .10
========== ========== ========== ==========
</TABLE>

55
<PAGE>

9. Joint Venture and Joint Development Agreement
---------------------------------------------

On March 11, 1986, the Company sold 526,316 shares of its common stock to Ford
Motor Company (Ford) for a gross sales price of $10,000,000. In addition, Ford
and the Company formed a joint venture, Ceradyne Advanced Products, Inc. (CAPI),
in which the Company acquired a 20 percent interest for $200,000. Ford
contributed certain technology in exchange for its 80 percent interest in the
joint venture. The Company granted Ford an option to put Ford's 80 percent
interest in the joint venture to the Company in exchange for 608,020 shares of
the Company's common stock. Ford granted the Company an option to call Ford's
80 percent interest in the joint venture in exchange for 680,983 shares of the
Company's common stock.

On February 13, 1988, the Company exercised its call option and issued 680,983
shares of its common stock to Ford. The value of the shares issued ($2,043,000)
was allocated to the technology acquired and is being amortized over a 20 year
period utilizing the purchase method of accounting (see Note 1).

Ford and the Company have also entered into a joint development program to
develop a prototype production facility to produce ceramics with automotive
applications. Under the terms of the joint development agreement, Ford and the
Company share equally in the cost of this project. For the years ending
December 31, 1996, 1995 and 1994, Ford agreed to contribute $275,000, $200,000
and $250,000, respectively, which have been reflected as a reduction of the
expenses incurred or a reduction in the capitalized value of the fixed assets
acquired for this project in the accompanying consolidated financial statements.
Included in accounts receivable on the accompanying consolidated balance sheets
is approximately $69,000 and $50,000 due from Ford related to this agreement as
of December 31, 1996 and 1995, respectively.

56
<PAGE>

SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS
-------------------------------------------------

(Amounts in thousands)
<TABLE>
<CAPTION>

Balance Charged Balance
at to Costs at
Beginning and End of
Description of Period Expenses Deductions Period
- ----------- --------- -------- ---------- --------
<S> <C> <C> <C> <C>
For the Year Ending
December 31, 1996:
- -----------------

Allowance for
doubtful
accounts receivable $150 $ 0 $ 25 $125
==== === ==== ====

For the Year Ending
December 31, 1995:
- ------------------

Allowance for
doubtful
accounts receivable $199 $ 34 $ 83 $150
==== ==== ==== ====

For the Year Ending
December 31, 1994:
- ------------------

Allowance for
doubtful
accounts receivable $204 $ 79 $ 84 $199
==== ==== ==== ====
</TABLE>

57
<PAGE>

SIGNATURES

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

March 31, 1997 CERADYNE, INC.

By /s/JOEL P. MOSKOWITZ
-------------------
Joel P. Moskowitz
Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
<S> <C> <C>
/s/JOEL P. MOSKOWITZ Chairman of the Board, March 31, 1997
- ------------------------ Chief Executive Officer,
Joel P. Moskowitz President and Director
(Principal executive
officer)

/s/HOWARD F. GEORGE Chief Financial Officer March 31, 1997
- ------------------------ (Principal financial
Howard F. George and accounting officer)

/s/LEONARD M. ALLENSTEIN Director March 31, 1997
- ------------------------
Leonard M. Allenstein

/s/RICHARD A. ALLIEGRO Director March 31, 1997
- ------------------------
Richard A. Alliegro

/s/FRANK EDELSTEIN Director March 31, 1997
- ------------------------
Frank Edelstein

/s/PETER BEARDMORE Director March 31, 1997
- ------------------------
Peter Beardmore

/s/MELVIN A. SHADER Director March 31, 1997
- ------------------------
Melvin A. Shader

/s/MILTON L. LOHR Director March 31, 1997
- ------------------------
Milton L. Lohr

</TABLE>

<PAGE>

EXHIBIT 10.36

APPROVAL OF AMENDMENT TO THE 1994 STOCK INCENTIVE PLAN
------------------------------------------------------

WHEREAS, a total of 350,000 shares of common stock are currently
authorized for issuance and sale under stock options granted or to be granted
under the Corporation's 1994 Stock Incentive Plan (the "Plan"), and of such
amount, there currently remain available approximately 37,000 shares for
additional stock option grants under the Plan;

WHEREAS, it is desired and deemed to be in the best interest of the
Corporation to increase the number of shares that may be issued and sold under
the Plan by 100,000 shares, to an aggregate of 450,000 shares, in order to
continue to make the Plan available to the employees of the Corporation, thereby
furthering the purposes of the Plan to attract and retain the services of
qualified persons upon whose judgment, initiative and efforts the successful
conduct and development of the Corporation's business largely depends;

NOW, THEREFORE, BE IT RESOLVED, that the first sentence of Section 4.1
of the Plan be amended to read as follows:

4.1 Shares Subject to the Plan. A total of 450,000 shares of Common
--------------------------
Stock may be issued under the Plan, subject to adjustment as to the
number and type of shares pursuant to Section 4.2 hereof.

RESOLVED FURTHER, that the Secretary of the Corporation is hereby
authorized and directed to submit the foregoing amendment to the 1994 Stock
Incentive Plan to the stockholders of the Corporation for their approval at the
next annual meeting of stockholders;

RESOLVED FURTHER, that the officers of the Corporation be, and each of
them hereby is, authorized and directed to prepare, or cause to be prepared, and
file on behalf of this Corporation a Registration Statement on Form S-8 with the
Securities and Exchange Commission, and any and all applications, filings or
notices necessary or desirable to be filed with the California Commissioner of
Corporations or other state Blue Sky authorities in connection with the offer
and sale of shares of common stock pursuant to the 1994 Stock Incentive Plan.

<PAGE>

EXHIBIT 23.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
-----------------------------------------

As independent public accountants, we hereby consent to the incorporation of our
report dated March 20, 1997 included in this Form 10-K, into the Company's
previously filed Registration Statement File Nos. 33-61675 and 33-61677.

ARTHUR ANDERSEN LLP

Orange County, California
March 28, 1997

<PAGE>

<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM 10K - YEAR
ENDED DECEMBER 31, 1996, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 4,643
<SECURITIES> 0
<RECEIVABLES> 6,376
<ALLOWANCES> 125
<INVENTORY> 7,756
<CURRENT-ASSETS> 19,589
<PP&E> 24,331
<DEPRECIATION> 18,073
<TOTAL-ASSETS> 28,398
<CURRENT-LIABILITIES> 3,697
<BONDS> 0
0
0
<COMMON> 37,138
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 28,398
<SALES> 28,212
<TOTAL-REVENUES> 28,212
<CGS> 21,365
<TOTAL-COSTS> 25,773
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 162
<INCOME-PRETAX> 4,167
<INCOME-TAX> 127
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,040
<EPS-PRIMARY> .51
<EPS-DILUTED> .51

</TABLE>