HARMONY BROOK INC, 10KSB, 1997-03-20

HARMONY BROOK INC
10KSB, 1997-03-20
NONSTORE RETAILERS

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Conformed Copy With Exhibits

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

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FORM 10-KSB
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]

For the fiscal year ended DECEMBER 31, 1996 Commission File Number 0-21550

[ ] TRANSITION REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1943 [NO FEE REQUIRED]
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HARMONY BROOK, INC.

(Exact name of registrant as specified in its charter)

MINNESOTA 41-1648132
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

1030 LONE OAK ROAD, SUITE #110
EAGAN, MINNESOTA 55121
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(Address of principal executive offices and zip code)

(612) 681-9000
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(Registrant's telephone number, including area code)

SECURITIES REGISTERED UNDER SECTION 12(b) OF THE ACT:
None

SECURITIES REGISTERED UNDER SECTION 12(g) OF THE ACT:

Common Stock, No Par Value
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(Title of Class)

Check whether the Issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act during the past twelve 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.
X Yes No

Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation SB and no disclosure will be contained, to the best of registrant's
knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.
[X]

State issuer's revenues for its most recent fiscal year: $8,316,000.

The aggregate market value of voting stock held by nonaffiliates of the Issuer
on March 3, 1997 was $3,056,605.

The number of shares outstanding of the Issuer's only class of common stock on
March 3, 1997 was 8,045,161.

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DOCUMENTS INCORPORATED BY REFERENCE

The following portions of the Registrant's Proxy Statement for the 1996 Annual
Meeting of Shareholders (filed with the Commission on March 20, 1997) are
incorporated by the reference below as the Item of this Form 10-KSB indicated.

PART OF FORM 10-KSB PORTION OF PROXY STATEMENT
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<S> <C>
1. Part III, Item 9. 1. See caption entitled "Election of Directors".
Directors, Executive Officers, Promoters and Control
Persons; Section 16(a) Beneficial Ownership Reporting
Compliance

2. Part III, Item 10. 2. See caption entitled "Compensation of Executive
Executive Compensation Officers and Directors".

3. Part III, Item 11. 3. See caption entitled "Security Ownership of
Security Ownership of Certain Beneficial Owners and Management and Beneficial Ownership".
Management

4. Part III, Item 12. 4. See caption entitled "Certain Transactions".
Certain Relationships and Related Transactions

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PART I
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ITEM 1. BUSINESS

(a) BUSINESS DEVELOPMENT

Harmony Brook, Inc. (the "Registrant" or the "Company") was incorporated
under the laws of the State of Minnesota in 1989. Since the date of the
Registrant's initial filing on Form SB-2 on April 15, 1993, the Registrant has
not changed its form of organization nor mode of conducting business. The
Company acquired the assets of a principal supplier of bottles in February 1994.
In December 1995, the Company acquired 53 vending systems and spare parts
inventory from one of its dealers. Other than those transactions, the Company
has not acquired nor disposed of any material amount of assets other than in the
ordinary course of business.

(b) BUSINESS OF ISSUER

(1) PRODUCTS AND MARKETS. The Registrant's principal product line
consists of the Harmony Brook-Registered Trademark- Premium Drinking Water
system. This system produces and dispenses fresh premium quality water on a
self service basis and was designed specifically for use in supermarkets and
other retail locations. As of December 31, 1996, the Registrant had installed
its Harmony Brook-Registered Trademark- Premium Drinking Water Systems in
1,574 customer locations in 33 states, and 107 systems in Mexico. The
Registrant also sells to supermarket operators and others a complete line of
one, two, three and five gallon containers and distributes other water
treatment and dispensing equipment to food service organizations, and
residential and commercial users.

The Registrant markets its principal product program to supermarkets,
natural food stores, and other retail operators and its Harmony Brook-Registered
Trademark- Premium Drinking Water to retail customers. Sales and marketing to
supermarkets is accomplished primarily through direct selling activities. The
Registrant's officers, sales managers, and field sales personnel call directly
on supermarket operators. In addition, the Registrant typically exhibits its
product line at national, regional and local trade exhibitions. Sales to
consumers are accomplished principally through "point of sale" displays and
literature at the site of each dispensing cabinet. The Registrant also uses
traditional merchandising techniques such as free samples, coupons, special
pricing, and other in-store promotional techniques.

(2) DISTRIBUTION OF PRODUCTS. The Harmony Brook-Registered Trademark-
Premium Drinking Water systems are leased under revenue sharing leases to
supermarket and other retail store operators who pay a fee to the Registrant
based on the number of gallons of water used or dispensed by the system. Under
this program, the Registrant owns the dispensing system and provides all
required service and maintenance. An internal water meter is generally read
monthly by Company representatives, and an invoice is delivered to the store at
that time.

The revenue realized by the Registrant on each system is highly dependent
upon the overall volume of water sold through a particular location. In addition
to the revenue sharing leasing arrangements, the Registrant sells Harmony
Brook-Registered Trademark- Premium Drinking Water systems to licensed dealers
in the United States and exports equipment to international customers.

The retail customer typically pays a price to the retailer for water from
the Harmony Brook-Registered Trademark- Premium Drinking Water system ranging
generally from $.25 to $.39 per gallon, depending upon the location and the
retailer's overall pricing strategy. The importance and competitive nature of
product pricing varies by geographic location. Generally, it appears price is
becoming more of a competitive factor in the bulk water vending environment.
Product pricing in Mexico is structured to yield a comparable contracted revenue
share per gallon as in the United States.

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Certain supermarkets and natural food stores also connect the Harmony Brook
system for use in areas of the store such as the bakery and produce sections.
The Registrant invoices the customer for this in-store water usage monthly
depending on the particular store usage configuration and volume.

(3) STATUS OF NEW PRODUCTS. The Registrant has no new products that require
a material capital investment, or are otherwise material to the Registrant's
financial condition or results of operations.

(4) COMPETITIVE CONDITIONS. With respect to its principal product line, the
Registrant faces two levels of competition: (i) competition at the
supermarket/retailer level to secure placement of its systems in the store; and
(ii) competition at the retail customer level to convince consumers to purchase
its water versus other brands. To secure placement of its systems in the stores,
the Registrant competes with other vendors of similar systems, as well as with
other products which could displace the Harmony Brook-Registered Trademark-
Premium Drinking Water system in the store. The Registrant's strategy for
securing such placements is to emphasize product economics and its service;
quality of equipment; benefits of in-store use; delivery of empty containers to
the store on an as-needed basis; and a growing list of customers which leads to
expertise regarding state or local regulatory requirements. The Registrant is
not aware of any other companies which offer systems similar to Harmony Brook on
as broad a geographic scale as that covered by the Registrant. There are,
however, several large regional operators of drinking water vending machines. In
addition, other companies offer products similar in concept to those of the
Registrant on a local basis throughout the United States. The Company's local
and regional in-store competitors periodically adopt aggressive pricing
strategies, and one regional competitor has aggressively recruited Company
personnel.

The Registrant also competes on the retail consumer level with sellers of
bottled water found on the supermarket shelf as well as with home water delivery
and various forms of residential water treatment equipment including in-home
reverse osmosis devices.

To the extent the Registrant continues to develop its food service,
residential and commercial markets, it will face competition from numerous local
providers of bottled water or water treatment systems.

Certain of the Registrant's competitors are larger and have greater
financial resources than the Registrant. The Registrant's future success will
depend on its ability to continue to increase its share of the market and to
retain its existing customers.

(5) RAW MATERIALS AND SUPPLIES. The Registrant uses a variety of suppliers
and does not believe it is materially dependent upon any single supplier. The
Registrant believes that alternate sources of supply are available for all of
the critical components it purchases, and it maintains business income and
interruption insurance. The Registrant considers its relationships with its
suppliers to be good.

During 1994, the Registrant acquired certain assets of Imperial Bottle
Company, a distributor of reusable water bottles. The acquisition was made to
enable the Registrant to assume greater control over this integral component of
its water merchandising. Bottles are sold to supermarkets through the Harmony
Brook field sales organization as well as directly to other retail and wholesale
customers. The Company is working to expand its wholesale customer base.

(6) DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS. As of December 31, 1996, the
Registrant had installed and was operating systems in 1,574 stores in 33 states.
Approximately, 1,070 of the store locations consisted of installations with
chain supermarket, or natural food store operators (operations with more than
six stores in the chain). If these installations prove successful, the
Registrant believes it may have the opportunity to place systems in additional
stores owned by these same operators which number about 8,000 in total. There
can be no assurance, however, that the success of a system in one store will
lead to placement through-

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out an entire chain or that the Company will have sufficient capital resources
to fully meet potential demand for additional systems in these chains. In
certain chains, buying decisions are made on a national basis, while in other
chains purchasing decisions are made on a regional or store-by-store basis. As
of December 31, 1996 one chain supermarket operation represented approximately
14 percent of the Registrant's revenues.

In addition, the Company established a subsidiary in Mexico in the first
quarter of 1994, and is marketing its systems primarily to supermarkets in the
Mexico City area. As of December 31, 1996, 107 systems were in place.

(7) PATENTS, TRADEMARKS, LICENSES, FRANCHISES, AND CONCESSIONS. The
Registrant has registered with the U.S. Patent and Trademark Office the name
Harmony Brook-Registered Trademark- and the wooded stream trademarks. The
Registrant believes that its trademarks have significant value and are important
to its marketing efforts.

The Registrant currently holds no patents. The Registrant has applied for
two patents with the U.S. Patent and Trademark Office relating to certain
aspects of the Registrant's dispensing cabinet. There can be no assurance,
however, that the Registrant will be successful in obtaining such patents.

(8) GOVERNMENT APPROVAL. Governmental approval of the Registrant's
principal product is not required.

(9) GOVERNMENTAL REGULATION. Currently, the Registrant's business is
subject to various federal, state and local regulations relating to the quality
of drinking water. The Environmental Protection Agency ("EPA") has adopted
standards that regulate the quality of municipal drinking water. Those standards
regulate the quality of the water produced by the Registrant's equipment to the
extent that states do not otherwise regulate the Registrant's products. These
rules follow the standards set forth by the EPA in the Federal Safe Drinking
Water Act as it is applicable to community and noncommunity public water
supplies. Many state regulations require certain testing procedures to ensure a
specified degree of quality exists. In addition, certain states have enacted
regulations requiring certain labeling and restricting claims which may be made
in advertising. The Registrant believes it is in material compliance with all
applicable federal, state and local drinking water regulations. None of the
testing requirements and labeling laws have had, or are expected to have, a
material adverse effect on the Registrant's overall operations.

The Registrant's systems are certified by the National Automatic Merchandising
Association ("NAMA"). NAMA maintains a "vending machine" certification program
which evaluates food and beverage vending machines against current requirements
of the U.S. Public Health Service Ordinance and Code. The Registrant is also
required to register its manufacturing facility with the EPA under the
provisions of the Federal Insecticide, Fungicide and Rodenticide Act because
certain portions of the Registrant's systems are deemed to be "pesticidal
devices." The Registrant has registered the facility as required.

In addition to equipment certification, the Registrant has a policy of
using outside laboratories to periodically test the quality of the water
produced by Harmony Brook-Registered Trademark- Premium Drinking Water systems
around the country. The water produced by each system is also regularly tested
by outside laboratories for the presence of coliform bacteria.

(10) RESEARCH AND DEVELOPMENT. The Registrant's research and development
activities are comprised primarily of efforts to improve the quality and
performance of its dispensing units or reduce manufacturing costs. Employees are
assigned to research and development projects as necessary. During the past
fiscal year, expenditures for research and development were not material to the
Registrant's results of operations.

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(11) ENVIRONMENTAL MATTERS. Compliance with current federal, state and
local provisions regarding discharge of materials into the environment or
otherwise relating to the protection of the environment is not anticipated to
have any material effect upon the capital expenditures, earnings or competitive
position of the Registrant. The Registrant does not currently anticipate making
any material capital expenditures for environmental control facilities during
1997.

(12) EMPLOYEES. The number of persons employed by the Registrant as of
December 31, 1996, was 84 full-time employees and 6 part-time employees. None of
the Registrant's employees are covered by a collective bargaining agreement.

ITEM 2. PROPERTIES

The Registrant's headquarters and assembly operations are located in 20,295
square feet of leased space at 1030 Lone Oak Road, Eagan, Minnesota 55121 under
a lease which expires August 31, 1998. The Registrant's base rent under this
lease is $7,306 per month, and taxes and common area charges currently average
$3,809 per month.

The Registrant also has a month-to-month lease for approximately 8,600
square feet of office and warehouse space located at 5621 W. Reno, Oklahoma
City, Oklahoma, which expires May 31, 1997. This space is used as a distribution
center for the Registrant's container sales. The gross rent under this lease is
$1,595 per month.

In addition, the Registrant leases small storage facilities in 23 states
throughout the country for storage of the Registrant's products.

All of the Registrant's facilities are adequate and suitable for the
purposes they currently serve.

The Registrant also owns and leases office equipment and vehicles used for
servicing operations and equipment delivery. The Registrant believes that it
currently owns or can readily acquire equipment required for its current and
anticipated levels of operations.

ITEM 3. LEGAL PROCEEDINGS

The Registrant is not a party to any material litigation and is not aware
of any threatened litigation that would have a material adverse effect on its
results of operations or financial condition.

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

During the fourth quarter, no matter was submitted to a vote of security
holders.

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PART II
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ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock is traded on the NASDAQ SmallCap Market (since
April 1993) under the symbol "HBRK". The following table sets forth, for the
periods indicated, the range of high and low closing bid quotations of the
Company's Common Stock, as reported by NASDAQ:

Fiscal Years Ended December 31: BID PRICE 1995 BID PRICE 1996
HIGH LOW HIGH LOW
-------------------------------------
First Quarter $2.13 $1.50 $1.19 $0.88
Second Quarter $1.88 $1.00 $1.13 $0.69
Third Quarter $1.38 $0.88 $1.31 $0.75
Fourth Quarter $1.25 $0.75 $0.81 $0.50

The quotations reflect inter-dealer prices, without mark-up, mark-down or
commission and may not necessarily represent actual transactions. As of December
31, 1996, there were approximately 800 beneficial owners of the Common Stock.

The Company has never paid a cash dividend. It is the intention of the
Company's Board of Directors to retain all earnings to support the growth of the
Company's business. The Company is also precluded from paying dividends under
the terms of its credit facility with its principal bank lender. Any payment of
dividends in the future is dependent upon the financial condition and capital
requirements of the Company and such other factors as the Board of Directors may
deem relevant.

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ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATION

SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

The following table summaries certain selected financial and operating data
for the periods indicated. This information should be read in connection with
the following "Management's Discussion and Analysis of Financial Condition and
Results of Operation" and the Company's consolidated financial statements and
notes thereto included elsewhere herein.
<TABLE>
<CAPTION>

YEARS ENDED DECEMBER 31
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1996* 1995* 1994* 1993 1992 1991 1990
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(IN THOUSANDS EXCEPT PER SHARE AMOUNTS AND CUSTOMER LOCATION DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Revenues:
Contracted revenue sharing $ 6,012 $ 5,020 $ 3,606 $ 2,407 $ 1,380 $ 835 $ 280
Bottle sales 1,925 1,788 2,229 623 299 196 49
Equipment sales 379 367 322 561 537 319 -
------- ------- ------- ------- ------- ------- -------
Total revenues $ 8,316 $ 7,175 $ 6,157 $ 3,591 $ 2,216 $ 1,350 $ 329
------- ------- ------- ------- ------- ------- -------
------- ------- ------- ------- ------- ------- -------

Gross profit:
Contracted revenue sharing $ 3,690 $ 3,105 $ 2,200 $ 1,301 $ 712 $ 319 $ 51
Bottle sales 640 582 690 196 125 46 20
Equipment sales 103 71 69 116 199 110 -
------- ------- ------- ------- ------- ------- -------
Total gross profit 4,433 3,758 2,959 1,613 1,036 475 71

Selling, general and administrative expenses:
Field office 2,635 2,553 1,869 1,010 758 348 164
Corporate 1,636 1,611 1,410 1,199 1,086 719 509
Provision for doubtful accounts 12 135 9 12 12 10 3
Severance and other special charges - 193 - - - - -
------- ------- ------- ------- ------- ------- -------
Operating income (loss) 150 (734) (329) (608) (820) (602) (605)

Other expense, net (631) (666) (269) (82) (94) (106) (67)
------- ------- ------- ------- ------- ------- -------
Loss before cumulative effect of a change in
accounting principle (481) (1,400) (598) (690) (914) (708) (672)

Cumulative effect on prior years of changing
to a different depreciation method** - - - - 147 - -
------- ------- ------- ------- ------- ------- -------
Net loss $ (481) $(1,400) $ (598) $ (690) $ (767) $ (708) $ (672)
------- ------- ------- ------- ------- ------- -------
------- ------- ------- ------- ------- ------- -------
Loss per share $ (0.06) $ (0.26) $ (0.13) $ (0.17) $ (0.31) $ (0.47) $ (0.77)
------- ------- ------- ------- ------- ------- -------
------- ------- ------- ------- ------- ------- -------
Performa amounts assuming the new
depreciation method is applied
retroactively:
Net loss $ (914) (626) $ (672)
------- ------- -------
------- ------- -------
Loss per share $ (0.37) (0.42) $ (0.77)
------- ------- -------
------- ------- -------
Number of shares used to compute per share
amounts 7,982 5,377 4,718 4,104 2,486 1,493 869

CONSOLIDATED BALANCE SHEET DATA (AT YEAR-END):
Working capital (deficit) $ (189) $ 969 $ (87) $ 774 $ (681) $ (221) $ (121)
Total assets 11,927 12,953 10,948 7,721 4,759 2,171 1,060
Long-term liabilities 2,859 4,043 2,277 164 304 677 522
Shareholders' equity 6,925 7,218 6,908 6,882 3,122 874 220

SELECTED CONSOLIDATED OPERATING DATA:
Customer locations under revenue-
sharing leases 1,681 1,613 1,407 1,010 685 384 173

</TABLE>

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* The Company began operations in Mexico in early 1994, and acquired certain
assets of Imperial Bottle Company (IBC) on February 7, 1994. The results
of the Mexican subsidiary and IBC's operations have been included since the
purchase date. See Notes 1 and 2 of Notes to Consolidated Financial
Statements.

** The retroactive application of the new method of depreciation with respect
to dispensing equipment was recognized as of January 1, 1992.

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RESULTS OF OPERATIONS

FISCAL YEAR 1996 COMPARED TO FISCAL YEAR 1995

The following table sets forth, for the periods indicated, certain items in
the Company's Consolidated Statements of Operations as a percentage of total
revenues and also shows the percentage change in the dollar amounts of those
items from 1995 to 1996.

PERCENTAGE
CHANGE
------------
1996 1995 1995 TO 1996
------ ------ ------------

PERCENTAGE OF TOTAL REVENUES:
Contracted revenue sharing 72.3% 70.0% 19%
Bottle sales 23.1 24.9 8
Equipment sales 4.6 5.1 3
------ ------
Total revenues 100.0% 100.0% 16
------ ------
------ ------
Gross profit 53.3% 52.4% 18

Field office S,G&A 31.7 35.6% 3
Corporate S,G&A 19.7 22.4 2
Provision for doubtful accounts 0.1 1.9 (91)
Severance and other special charges - 2.7 nm
------ ------
0perating expenses 51.5% 62.6% (5)
------ ------
Operating income (loss) 1.8 (10.2%) nm

Other expense, net (7.6) (9.3) (5)
------ ------
Net loss (5.8%) (19.5%) (66)
------ ------
------ ------
nm - not meaningful

GROSS PROFIT PERCENTAGE OF RELATED REVENUES:

Contracted revenue sharing 61.4% 61.9%
Bottle sales 33.2 32.5
Equipment sales 27.2 19.3

REVENUES

Total revenues are realized from contracted revenue sharing, bottle sales,
and equipment sales.

Contracted revenue sharing consists of revenues derived from the sale of
treated water by the gallon to supermarkets or other retail operators, who sell
the water to the public or use the water themselves. Revenues from contracted
revenue sharing have grown primarily as a result of the Company's system removal
and relocation program and secondly as a result of the increase in the number of
customer locations under contract. The weighted average number of customer
locations during 1996 was 1,521, an increase of two percent from the 1995
weighted average of 1,489. These customer locations produced average annualized
contracted revenue sharing of $3,588 per location, an increase of six percent
from the 1995 annualized revenue per location of $3,386.

The Company's domestic customers increased three percent from 1,528 at the
end of 1995 to 1,574 at the end of 1996. Behind this net increase of 46
customers, the Company actually removed 207 customer

<PAGE>

locations and installed 253 new customer locations during 1996. Of the 207
systems removed during 1996, 34 were from a supermarket chain that closed or
sold substantially all its West Coast locations, 24 were from a Midwest division
of a supermarket chain that was lost to a competitor in late 1996, leaving 149
systems which were primarily removed at the Company's discretion due to poor
return on investment. Systems that are removed are refurbished, if needed, and
then reinstalled in locations based on retailer demand, volume potential and fit
to established routes.

Domestic customer locations that were installed for all of 1995 and 1996
grew seven percent in dollars and 12 percent in gallons for dispenser gallons
only. The primary difference between the dollar growth and dispensed gallons
growth is price concessions given to customers as a direct result of
competition. One regional competitor in the Midwest has competed for the
Company's customers using lower pricing as its primary selling point. While the
Company believes competition on the basis of providing superior service and
overall value is the appropriate long-term strategy, future potential price
concessions coupled with the potential for other competitors with greater
financial resources to enter the Company's markets could adversely effect the
Company's future operating results and financial position.

Revenues from bottle sales are a composite of field bottle sales and
wholesale bottle sales. Field bottle sales increased 12 percent from $992,000 in
1995 to $1,109,000 in 1996. This increase is due to the increase in the number
of contracted revenue sharing customer locations to which field bottle sales are
made, coupled with a continuing emphasis placed on this product line by
management as a catalyst for increased contracted revenue sharing sales volume.
Wholesale bottle sales increased three percent from $794,000 in 1995 to $816,000
in 1996. This increase is attributable primarily to the Company's efforts to
rebuild its wholesale bottle customer base.

Equipment sales consist primarily of revenues from the sale of Harmony
Brook-Registered Trademark- Premium Drinking Water systems to third party
dealers, both domestic and overseas. Revenues increased slightly in 1996 from
this segment without an increase in resources devoted to generating these
revenues.

GROSS MARGINS

The Company's total gross margin for 1996 increased nearly one percentage
point over 1995. This increase is due to better management of costs associated
with both bottle and equipment sales.

Contracted revenue sharing gross margin, as a percent of sales, decreased
due primarily to the cost of certain refurbishments performed on removed systems
during 1996. The gross margin percent on bottle sales increased slightly due to
a shift in product mix towards larger containers that yield a higher margin.
Gross margin on equipment sales increased due primarily to a small price
increase combined with a reduction in manufacturing overhead costs in 1996.

EXPENSES

Field office selling, general and administrative expenses increased three
percent in 1996, significantly less than the percentage increase in overall
revenue. This increase is due primarily to the addition of staff to service
major chain customers in the Midwest. The Company's primary focus for 1997
continues to consist of increasing market penetration in its existing geographic
territories versus development of new geographic territories.

Corporate selling, general and administrative costs increased slightly
during 1996 due to added administrative staff in Mexico. This slight increase
continues to reflect the Company's efforts to control its discretionary
spending.

<PAGE>

The Company's operating expenses for 1995 included one-time charges of
$193,000 related to officer severance and other special charges reflecting
changes in certain business strategies. Also in 1995, the Company recorded a
charge of $123,000 related to an uncollectible receivable from its largest
wholesale bottle customer. These charges totaled $316,000, or $.06 per share.

OPERATING INCOME AND NET LOSS

The Company recorded its first full year of operating income in 1996.
Operating income increased $884,000 from a 1995 operating loss of $734,000 to
1996 operating income of $150,000. This increase of $884,000 compares to an
increase of $1,141,000 in sales resulting in an incremental margin of 77
percent. Taking into account the one-time and special charges of $316,000 in
1995, the comparable operating income increase would be $568,000 with an
incremental margin of 50 percent.

The net loss for 1996 is the difference between operating income and other
income and expenses, which consist primarily of interest expense.

FISCAL YEAR 1995 COMPARED TO FISCAL YEAR 1994

PERCENTAGE
CHANGE
------------
1995 1994 1994 to 1995
------ ------ ------------
PERCENTAGE OF TOTAL REVENUES:
Contracted revenue sharing 70.0% 58.6% 39%
Bottle sales 24.9 36.2 (20)
Equipment sales 5.1 5.2 14
------- -------
Total revenues 100.0% 100.0% 17
------- -------
------- -------
Gross profit 52.4% 48.1% 27

Field office S,G&A 35.6% 30.3% 37
Corporate S,G&A 22.4 22.9 14
Provision for doubtful accounts 1.9 0.2 nm
Severance and other special charges 2.7 - nm
------- -------
Operating expenses 62.6% 53.4% 37
------- -------
Operating loss (10.2%) (5.3%) 123

Other expense, net (9.3) (4.4) 148
------- -------
Net loss (19.5%) (9.7%) 134
------- -------
------- -------
nm - not meaningful

GROSS PROFIT PERCENTAGE OF RELATED REVENUES:

Contracted revenue sharing 61.9% 61.0%
Bottle sales 32.5 30.9
Equipment sales 19.3 21.6

<PAGE>

REVENUES

Revenues from contracted revenue sharing grew as a result of the increase
in the number of customer locations under contract. The weighted average number
of customer locations during 1995 was 1,489, an increase of 26 percent from the
1994 weighted average of 1,185. These customer locations produced average
annualized contracted revenue sharing of $3,386 per location, an increase of 11
percent from the 1994 annualized revenue per location of $3,047.

Revenues from bottle sales declined in 1995. Field bottle sales increased
31 percent from $727,000 in 1994 to $954,000 in 1995. This increase was due to
the increase in the number of contracted revenue sharing customer locations to
which field bottle sales are made coupled with a continued emphasis placed on
this product line by management as a catalyst for increased contracted revenue
sharing sales volume. Wholesale bottle sales decreased 45 percent from
$1,500,000 in 1994 to $833,000 in 1995. This decrease was attributable primarily
to the loss of the Company's largest wholesale bottle customer in early 1995 due
to that customer's insolvency, as well as to a slowing down of the purchasing
activity of the larger remaining customers.

GROSS MARGINS

The Company's total gross margin for 1995 increased four percentage points
over 1994. This increase was essentially due to higher contracted revenue
sharing revenues in comparison to total revenues. The gross margin increase on
contracted revenue sharing resulted from the higher number of customer
installations in place during 1995, which improved the Company's ability to
cover its fixed costs related to this portion of its revenues.

The gross margin on bottle sales increased slightly due to a shift in
product mix towards larger containers that yield a higher margin. Gross margin
on equipment sales decreased due to lower production levels in 1995, which
resulted in greater fixed overhead costs being allocated to each unit produced.

EXPENSES

Field office selling, general and administrative expenses increased faster
than overall revenue, but slightly slower than contracted revenue sharing
revenues. This increase was primarily due to a full year's effect of the
Company's extensive geographic expansion that occurred throughout 1994. Also
contributing to this increase was a full year of operations in 1995 from both
the wholesale bottle segment plus the Company's wholly owned Mexican subsidiary.

Corporate selling, general and administrative costs increased at less than
half the rate of field office selling, general and administrative expenses,
reflecting the Company's efforts to control its discretionary spending.

The Company's operating loss increased from 1994 to 1995 primarily due to
the one-time special charges, the uncollectible receivable write-off, the
decline in wholesale bottle sales and the increase in field office selling,
general and administrative expenses. Excluding the one-time special charges and
the uncollectible receivable write-off from 1995's operating loss results in an
adjusted operating loss of $418,000 compared to $329,000 in 1994, a 27 percent
increase.

Other expense consisted primarily of interest expense which increased
significantly due to increased debt financing of the Company's growth.

<PAGE>

MEXICAN SUBSIDIARY

The following table summarizes the Company's Mexican subsidiary results of
operations for the periods presented and the percentage change from 1995 to 1996
and 1994 to 1995.
<TABLE>
<CAPTION>

PERCENTAGE PERCENTAGE
CHANGE CHANGE
-------------- --------------
1996 1995 1994 1995 TO 1996 1994 TO 1995
------ ------ ------ -------------- --------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Total revenues $491 $293 $106 68% 176%
Gross profit (loss) 305 175 (45) 74 nm
Total expenses 302 250 196 21 28
Operating income (loss) 3 (75) (241) nm (69)

nm - not meaningful

</TABLE>

Mexican operations began in early 1994. At year-end 1994, the subsidiary
had 60 units installed with most of these installations occurring in the last
half of the year. At the end of 1995 the Company had 85 total units installed,
an increase of 42 percent over year-end 1994. At the end of 1996 the Mexican
subsidiary had 107 customer locations installed, an increase over year-end 1995
of 26 percent.

Although the Company believes that potential exists for profitable growth
in the Mexican market, the devaluation of the Mexican New Peso, which began in
December 1994, and the resulting adverse economic conditions that occurred
throughout 1995 and 1996 have caused management to re-evaluate its strategy for
Mexican growth. Management does not intend to provide a significant amount of
additional equipment to the Mexican subsidiary for the foreseeable future due
primarily to limited capital resources, but also due to the unstable conditions
existing in the Mexican economy. In addition, one of the Company's senior
lenders (see section "Liquidity and Capital Resources" and Note 4 to the
Consolidated Financial Statements) has negotiated a restrictive covenant with
the Company limiting the amount of equipment that can by supplied to its Mexican
subsidiary.

The Company continues to believe in this subsidiary's ability to become a
significant contributor to operating profits in future periods.

FOREIGN CURRENCY TRANSLATION

As discussed in Note 1 to the Consolidated Financial Statements, operations
of the Company's Mexican subsidiary have been measured in local currency and
translated into U.S. dollars for the inclusion in the Company's consolidated
financial statements. The Company has advanced funds to purchase equipment and
support operations during its development stage. These advances are not expected
to be repaid in the foreseeable future. The exchange gains and losses arising
from fluctuations in the rate of exchange between U.S. dollars and New Pesos
have therefore been recorded as a separate component of shareholders' equity.
The business transactions in Mexico including sales, payment of wages and
salaries, auto costs, etc., are all conducted in New Pesos.

Effective January 1, 1997, the functional currency of the Mexican
subsidiary has changed for accounting purposes from the Mexican New Peso to the
U.S. dollar due to the Mexican economy meeting the definition of a highly
inflationary economy under generally accepted accounting principles. As a result
of this change, future transaction and translation gains and losses will be
included in the Company's statements of operations resulting from changes in the
exchange rate applied to inventories, fixed assets and dollar denominated
inter-company debt. The Mexican subsidiary's exchange gains and losses computed
on the subsidiary's dollar denominated debt owed to the Company have been
included as a separate component of shareholder's equity through December 31,
1996.

<PAGE>

LIQUIDITY AND CAPITAL RESOURCES

During 1996, the Company generated $1,193,000 in cash from operating
activities compared to $246,000 used in operating activities in 1995. The
principal sources of operating funds in 1996 were the reduction in the net loss
of $919,000 coupled with positive working capital changes primarily in accounts
receivable, accounts payable, and accrued expenses.

Sources of cash from operating activities related to components of working
capital reflect certain strategies put in place by management in the second
quarter of 1995. The Company has put in place a strategy to grow revenues at a
slower rate and keep geographic expansion to a minimum in order to attain
profitability earlier than if the Company continued an aggressive growth
strategy. The above mentioned sources of cash reflect this new strategy of
"managed growth."

During 1996, the Company invested $1,350,000 in property and equipment, a
40 percent decrease from the 1995 investment of $2,251,000. This decrease
reflects the Company's current business strategy mentioned in the preceding
paragraph. The 1996 investment in property and equipment consisted of both new
installations of manufactured Harmony Brook-Registered Trademark- Premium
Drinking Water systems and capital refurbishment of existing systems.

The Company used $547,000 of cash in financing activities in 1996 compared
to $3,539,000 provided by financing activities in 1995. The Company financed its
investing activities of $1,365,000 and principal payments on debt of $935,000
with both cash provided by operating activities and its cash on hand of
$1,101,000 at the end of 1995.

At the end of 1994, the Company had slightly over $1,000,000 of borrowing
capacity remaining on a term loan facility with its principal bank lender. In
the first quarter of 1995 this amount had been fully borrowed. On April 26,
1995, the Company entered into a bridge loan agreement with the same bank under
which the bank amended its term loan agreement and agreed to provide an
additional $1,000,000. The bridge loan was repayable on or before August 31,
1995, and bore interest at the bank's reference rate plus four percent. The full
amount of the bridge loan was borrowed by the end of the third quarter of 1995.

On August 1, 1995, the Company entered into a bridge loan agreement to
borrow up to $200,000 from the Chairman of its Board of Directors at a 13
percent rate of interest. On October 12, 1995, the Company borrowed $100,000
under this arrangement. This loan was repaid on October 25, 1995, in conjunction
with the sales of the Company's common stock as discussed in the following
paragraph.

On October 25, 1995, the Company sold 2,400,000 shares of its common stock
at $.75 per share for a total amount of $1,800,000. As part of this sale of
common stock, the $100,000 borrowed from the Company's Chairman under the bridge
loan agreement was converted to 133,333 shares of common stock. The net cash
received by the Company after offering costs of approximately $125,000 and the
conversion of the $100,000 bridge loan was approximately $1,600,000.

On November 9, 1995, the Company entered into an agreement to restructure
the outstanding balance of its debt with its principal lender. The restructuring
agreement combined a term loan with a balance of $2,000,000, a revolving credit
loan with a balance of $350,000 and a vehicle loan with a balance of $83,000
into a five-year term loan with an interest rate stated at the bank's reference
rate plus 3.25 percent. Also, the restructuring agreement converted the
$1,000,000 bridge loan which was due on August 31, 1995, into a term loan with a
five-year amortization schedule, but required payment of the remaining principal
balance after 24 months. The converted term loan bore interest at the bank's
reference rate plus seven percent. The principal lender received a fee of
$20,000 under this restructuring agreement.

<PAGE>

On January 5, 1996, the Company entered into an agreement with another
senior lender to extend the payment schedule and adjust the principal payments
of a term loan with a principal balance of $1,600,000. The adjusted repayment
terms provide for an escalating principal payment schedule with the final
payment made by June 1999. As compensation for this extended payment schedule
the senior lender received a fee of $5,000 and a new warrant for 300,000 shares
of common stock. A prior warrant issued to this senior lender for 200,000 shares
was canceled and replaced by this new warrant.

On March 11, 1996, the Company sold an additional 350,000 shares of its
common stock at $.75 per share for $263,000. The net cash received by the
Company after offering costs of $33,000 was $230,000.

During 1996 the Company entered into various sale/leaseback agreements with
shareholders of the Company for dispensing equipment (see Note 5 to the
Consolidated Financial Statements). The Company received $158,000 in cash from
these transactions and must make monthly minimum payments of $4,000 under an
operating lease agreement. The terms of each individual agreement are sixty
months.

On February 18, 1997, the Company and its principal lender amended and
restated the Company's term loan agreement. The agreement combined both
outstanding term loans into one term loan facility to be repaid in equal monthly
principal installments plus accrued interest with a final principal payment plus
accrued interest due in February 2000. The amended term loan bears interest at
the bank's reference rate plus 3.75 percent. In addition, the bank received a
fee of $15,000.

As part of the amended and restated term loan agreement, the bank required
the Company to raise at least $1,000,000 by March 1, 1997 with 30 percent of the
gross proceeds to be specifically applied to the principal balance of
outstanding bank debt. In February 1997, the Company negotiated a private
placement of $1,000,000 of subordinated notes payable with shareholders and
accredited investors. The notes bear interest at 14 percent, payable monthly and
are due March 2000. In addition, warrants were issued in connection with the
notes at the rate of one warrant for each $5.00 of subordinated debt. The notes
are collateralized by a lien on all the Company's assets, subordinate to the
interests of the Company's two senior lenders. As of February 28, 1997 the
Company had closed on and received cash sufficient to meet the bank's
requirements. The balance of the proceeds are expected to be received by the end
of April 1997.

The Company believes that the proceeds from the subordinated notes payable
will provide sufficient capital to fund the Company's current growth strategy
through the middle of 1997. Additional capital will be needed under the current
growth strategy for the last half of 1997 and for all of 1998 primarily to fund
the Company's continued investment in dispensing units. The Company estimates
that these additional capital needs would be the last significant financing
required in the foreseeable future if financing were to be obtained in the
amounts and under the terms internally forecasted by management under the
Company's current growth strategy. While the Company believes it will be able to
obtain additional financing, there can be no assurance that such financing will
be available or available on terms acceptable to the Company. In the event such
financing is not available, the Company has the ability to revise its growth
strategy to decrease or eliminate investment in dispensing equipment to focus
its cash flow from operating activities to meet debt service requirements.

IN ADDITION TO THE HISTORICAL INFORMATION CONTAINED HEREIN, THE FOREGOING
DISCUSSION INCLUDES FORWARD LOOKING STATEMENTS THAT INVOLVE A NUMBER OF RISKS
AND UNCERTAINTIES. AMONG THE FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY ARE THE FOLLOWING: THE COMPANY'S INABILITY TO PROCURE ADDITIONAL OR
REPLACEMENT FINANCING; CHANGES IN GROWTH IN THE TREATED WATER AND SPECIALTY
BEVERAGE INDUSTRY; THE CONDITION OF THE GENERAL ECONOMY; COMPETITIVE FACTORS
SUCH AS AGGRESSIVE PRICING BY REGIONAL COMPETITORS AND ENTRY OF WELL CAPITALIZED
COMPETITORS INTO TERRITORIES SERVED BY THE COMPANY; INCREASED LOCAL, STATE OR
FEDERAL REGULATION OF THE TREATED WATER INDUSTRY; CHANGES IN PRODUCT MIX;
INCREASES IN THE RAW MATERIAL COSTS RELATED TO THE COMPANY'S BOTTLE BUSINESS;
AND THE RISK FACTORS LISTED FROM TIME TO TIME IN THE COMPANY'S REPORTS FILED
WITH THE SECURITIES AND EXCHANGE COMMISSION.

<PAGE>

ITEM 7. FINANCIAL STATEMENTS

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

PAGE

Report of Independent Accountants. . . . . . . . . . . . . . . . . . . . . .17

Consolidated Balance Sheets as of December 31, 1996 and 1995 . . . . . . . .18

Consolidated Statements of Operations for the years ended
December 31, 1996 and 1995 . . . . . . . . . . . . . . . . . . . . . . . . .19

Consolidated Statements of Cash Flows for the years ended
December 31, 1996 and 1995 . . . . . . . . . . . . . . . . . . . . . . . . .20

Consolidated Statements of Shareholders' Equity for the years
ended December 31, 1996 and 1995 . . . . . . . . . . . . . . . . . . . . . .21

Notes to Consolidated Financial Statements for the years ended
December 31, 1996 and 1995 . . . . . . . . . . . . . . . . . . . . . . . . .22

<PAGE>

REPORT OF INDEPENDENT ACCOUNTANTS

To the Shareholders and Board of Directors of Harmony Brook, Inc.:

We have audited the accompanying consolidated balance sheets of Harmony
Brook, Inc. and Subsidiary as of December 31, 1996 and 1995, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
the years then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

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

Minneapolis, Minnesota COOPERS & LYBRAND L.L.P.
February 7, 1997,
except as to note four,
for which the date is
March 4, 1997.

<PAGE>

HARMONY BROOK, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
As of December 31, 1996 and 1995
(in thousands)

1996 1995
-------- --------
ASSETS
Current assets:
Cash and cash equivalents $ 377 $ 1,101
Accounts receivable, net 1,096 1,081
Inventories 435 424
Other current assets 46 55
-------- --------
Total current assets 1,954 2,661

Property and equipment, net 9,251 9,394
Other assets 722 898
-------- --------
Total assets $ 11,927 $ 12,953
-------- --------
-------- --------

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt $ 1,241 $ 887
Current portion of capitalized lease obligations 2 25
Accounts payable 474 425
Accrued expenses 410 355
Current portion of deferred income 16 -
-------- --------
Total current liabilities 2,143 1,692

Long-term debt, less current portion 2,799 4,039
Capitalized lease obligations, less current portion 1 4
Deferred income, less current portion 59 -
-------- --------
Total liabilities 5,002 5,735
-------- --------

Commitments (see note 5)

Shareholders' equity:
Common stock, no par value, 20,000 shares
authorized; 8,045 and 7,695 issued
and outstanding at December 31, 1996 and
1995, respectively 11,321 11,091
Cumulative foreign currency translation adjustments (460) (418)
Accumulated deficit (3,936) (3,455)
-------- --------
Total shareholders' equity 6,925 7,218
-------- --------
Total liabilities and shareholders' equity $ 11,927 $ 12,953
-------- --------
-------- --------

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THIS FINANCIAL STATEMENT.

<PAGE>

HARMONY BROOK, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
for the years ended December 31, 1996 and 1995
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

1996 1995
------- -------
Revenues:
Contracted revenue sharing $ 6,012 $ 5,020
Bottle sales 1,925 1,788
Equipment sales 379 367
------- -------
8,316 7,175
Cost of revenues:
Contracted revenue sharing 2,322 1,915
Bottle sales 1,285 1,206
Equipment sales 276 296
------- -------
Gross profit 4,433 3,758

Selling, general and administrative expenses:
Field office 2,635 2,553
Corporate 1,636 1,611
Provision for doubtful accounts 12 135
Severance and other special charges - 193
------- -------
Operating income (loss) 150 (734)

Other income (expense):
Interest expense (636) (640)
Interest income 24 18
Other, net (19) (44)
------- -------
Net loss (481) $(1,400)
------- -------
------- -------

Loss per share $ (0.06) $ (0.26)
------- -------
------- -------

Number of shares used to compute
per share amounts 7,982 5,377
------- -------
------- -------

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THIS FINANCIAL STATEMENT.

<PAGE>

HARMONY BROOK, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the years ended December 31, 1996 and 1995
(IN THOUSANDS)
<TABLE>
<CAPTION>

1996 1995
------- -------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (481) $(1,400)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
(Gain) loss on disposal of assets (7) 16
Depreciation and amortization 1,526 1,284
Amortization of deferred income (6) (41)
Amortization of discount on notes payable
and issuance costs 24 24
Provision for doubtful accounts 12 135
Provision for inventory obsolescence 48 65
Severance cost paid through issuance of common stock - 20
Changes in operating assets and liabilities:
Accounts receivable 21 (131)
Inventories (59) (55)
Other current assets 9 27
Accounts payable 50 (307)
Accrued expenses 56 117
------- -------
Net cash provided by (used in) operating activities 1,193 (246)
------- -------

Cash flows from investing activities:
Purchase of property and equipment (1,350) (2,076)
Business acquisition - (175)
Proceeds from the sale of assets 12 -
Other (27) -
------- -------
Net cash used in investing activities (1,365) (2,251)
------- -------

Cash flows from financing activities:
Proceeds from issuance of long term debt and warrants - 2,549
Principal payments on long-term debt
and capitalized lease obligations (935) (534)
Net proceeds from sales of common stock 230 1,576
Proceeds from sale/leaseback transactions 158 -
Other - (52)
------- -------
Net cash (used in) provided by financing activities (547) 3,539
------- -------

Effect of exchange rate changes on cash (5) (5)
------- -------
Net (decrease) increase in cash and cash equivalents (724) 1,037

Cash and cash equivalents at beginning of year 1,101 64
------- -------
Cash and cash equivalents at end of year $ 377 $ 1,101
------- -------
------- -------
Supplemental cash flow information:

Cash paid during the year for interest charges $ 636 $ 648
------- -------
------- -------

</TABLE>

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THIS FINANCIAL STATEMENT.

<PAGE>

HARMONY BROOK, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
for the years ended December 31, 1996 and 1995
(IN THOUSANDS)
<TABLE>
<CAPTION>

CUMULATIVE
FOREIGN
COMMON STOCK COMMON CURRENCY
----------------------- STOCK TRANSLATION ACCUMULATED
SHARES AMOUNT ISSUABLE ADJUSTMENTS DEFICIT TOTAL
-------- -------- -------- ----------- ------------ --------
<S> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1994 4,724 $ 8,736 $ 409 $ (182) $ (2,055) $ 6,908

Issuance of common stock in
connection with purchase of
Imperial Bottle Company 218 409 (409) -

Issuance of common stock in
connection with severance
of an executive officer 20 20 20

Issuance of common stock
in connection with sales of
common stock, net of
offering costs of $124 2,400 1,676 1,676

Issuance of common stock in
connection with purchase of
Certified Pure Water 333 250 250

Translation adjustments (236) (236)

Net loss (1,400) (1,400)
-------- -------- -------- -------- -------- --------

BALANCE, DECEMBER 31, 1995 7,695 11,091 - (418) (3,455) 7,218

Issuance of common stock
in connection with sales of
common stock, net of
offering costs of $33 350 230 230

Translation adjustments (42) (42)

Net loss (481) (481)
-------- -------- -------- -------- -------- --------

BALANCE, DECEMBER 31, 1996 8,045 $ 11,321 $ - $ (460) $ (3,936) $ 6,925
-------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- --------

</TABLE>

THE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARE AN INTEGRAL PART
OF THIS FINANCIAL STATEMENT.

<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BUSINESS DESCRIPTION

Harmony Brook, Inc. (the Company) develops, manufactures, markets,
distributes and operates equipment which processes ordinary tap water into
high-quality drinking water at the point of use. The Company's principal product
line consists of the Harmony Brook-Registered Trademark- Premium Drinking Water
system, a self-serve dispensing system for use in supermarkets and other retail
locations. In January 1994, the Company established a wholly owned subsidiary in
Mexico where the Company has installed its equipment in supermarket and retail
store locations.

The Company commenced operations in late 1989. Under the Company's revenue
sharing leases, systems are leased to supermarkets and other retailers who pay a
fee based on the amount of water used or dispensed. In addition to such leasing
arrangements, the Company engages in the sale of its manufactured equipment to
licensed dealers. The Company maintains field offices in various parts of the
United States and Mexico, and also distributes its products through a network of
independent dealers. The Company sells a line of one, two, three and five gallon
containers to be used with its systems and sells containers to third parties on
a wholesale basis.

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements for the years ended December 31, 1996
and 1995, include the accounts of the Company and its wholly-owned Mexican
subsidiary. All significant intercompany accounts and transactions have been
eliminated in consolidation.

FOREIGN CURRENCY TRANSLATION

Financial position and results of operations of the Company's Mexican
subsidiary are measured using local currency as the functional currency. Assets
and liabilities of the subsidiary are translated at the exchange rate in effect
at the end of the period.

Statement of operations accounts are translated at the average rates of
exchange prevailing during the period. Translation adjustments arising from the
use of differing exchange rates are included in the cumulative foreign currency
translation adjustments account in shareholders' equity. Sales by the Company's
Mexican subsidiary are negotiated, invoiced and paid in New Pesos.

Effective January 1, 1997, the Mexican subsidiary will be accounted for as
a hyperinflationary economy and use the U.S. dollar as the functional currency.
Therefore, certain assets and liabilities will be translated at historical
exchange rates and all translation gains and losses included in the Company's
Consolidated Statement of Operations.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. The most
significant areas which require the use of management's estimates relate to the
determination of allowances for uncollectible accounts receivable and obsolete
inventories, estimated useful lives of dispensing equipment for computing
depreciation and amortization, recoverability of long-lived assets, and the
valuation allowance for deferred tax assets.

<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

CASH AND CASH EQUIVALENTS

Cash and cash equivalents consist of checking accounts and a money market
fund, substantially all of which are held in one depository institution. The
Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.

INVENTORIES

Inventories consist of bottles and also raw materials and spare parts
expected to be used in the production of equipment for sale to dealers and are
stated at the lower of cost or market. Cost is determined using standard costs,
which approximate the first-in, first-out method.

PROPERTY AND EQUIPMENT

Property and equipment, which includes raw materials and spare parts
expected to be used in the production of dispensing equipment to be placed in
customer locations under revenue sharing leases and dispensing equipment
awaiting installation, are stated at cost. The cost of dispensing equipment
includes actual raw material costs plus an allocation of labor and overhead
costs. Except for dispensing equipment, depreciation and amortization is
computed using the straight-line method over estimated useful asset lives of
three to seven years. Depreciation and amortization of dispensing equipment
begins once the equipment is installed and is computed using the greater of an
amount calculated using the units-of-production (i.e., gallons of water
produced) method or 25% of that which would have been recorded using the
straight-line method based on an estimated useful life of 12 years.

When property and equipment is retired from service or otherwise disposed
of, the cost and related accumulated depreciation and amortization are removed
from the asset accounts with the resulting gain or loss included in operations.
Expenditures for maintenance and repairs which do not improve or extend the life
of the respective assets are expensed as incurred. The Company reviews property
and equipment on a quarterly basis in order to assess recoverability based on
projected income and related cash flows on an undiscounted basis.

OTHER ASSETS

Other assets consist primarily of the excess of acquisition cost over the
fair value of the net assets acquired (goodwill), which is amortized on a
straight-line basis over 10 years. The Company reviews goodwill on a quarterly
basis in order to assess recoverability based on projected income and related
cash flows on an undiscounted basis.

PREFERRED STOCK

The Company's Articles of Incorporation, as amended on March 1, 1993,
authorizes the issuance of 5,000,000 shares of preferred stock. The rights,
preferences and privileges of the authorized shares may be established by the
Board of Directors without further action by the holders of the Company's common
stock. As of December 31, 1996, none has been issued.

<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

REVENUE RECOGNITION

Contracted revenue sharing, which represents revenues from dispensing
equipment under operating lease agreements, is recognized as the water is sold
to the customer. Revenues from bottle sales and equipment sales are recognized
upon shipment or delivery of services. Accounts receivable from customers are
uncollateralized.

INCOME TAXES

The Company utilizes the asset and liability method of accounting for
income taxes whereby deferred taxes are determined based on the difference
between the financial reporting and tax bases of assets and liabilities using
enacted tax rates applicable to the periods in which the differences are
expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to the amount expected to be realized.
Income tax expense is the tax payable for the period and the change during the
period in deferred tax assets and liabilities.

LOSS PER SHARE

Loss per share is computed using the weighted average number of shares of
common stock outstanding. Common stock equivalents are anti-dilutive.

2. ACQUISITION

On December 14, 1995, the Company acquired certain assets of Certified Pure
Water of Illinois, Inc. (Certified Pure Water), an owner and operator of
self-serve point of use water treatment equipment in northern Illinois with 49
existing customer locations, in exchange for 333,333 shares of common stock
(valued at $250,000) and cash of $175,000. The acquisition has been accounted
for as a purchase and, accordingly, the results of the operation of these units
since December 14, 1995 have been included in the Company's financial
statements.

Unaudited pro forma data, as though the acquisition of Certified Pure
Water's assets had been effective at the beginning of 1995 are as follows:

1995
--------
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)

Total revenues $ 7,400
Net Loss $(1,290)
Loss per share ($.24)

<PAGE>
HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. SELECTED BALANCE SHEET INFORMATION

The following is selected balance sheet information as of December 31, 1996
and 1995:

1996 1995
-------- --------
(IN THOUSANDS)
Accounts receivable:
Trade $ 1,113 $ 1,105
Other 13 12
-------- --------
1,126 1,117
Less allowance for doubtful accounts (30) (36)
-------- --------
Accounts receivable, net $ 1,096 $ 1.081
-------- --------
-------- --------
Inventories:
Bottles $ 353 $ 346
Raw materials and spare parts 82 78
-------- --------
Inventories $ 435 $ 424
-------- --------

Property and equipment:
Dispensing equipment $ 11,111 $ 10,204
Furniture and office equipment 378 328
Vans and trucks 417 418
Other, primarily manufacturing equipment 325 324
-------- --------
12,231 11,274

Less accumulated depreciation
and amortization (3,657) (2,574)
-------- --------
8,574 8,700
Raw materials and spare parts 549 570
Dispensing equipment awaiting installation 128 124
-------- --------
Property and equipment, net $ 9,251 $ 9,394
-------- --------
-------- --------

Other assets:
Goodwill $ 782 $ 782
Other 238 372
-------- --------
1,020 1,154

Less accumulated amortization (298) (256)
-------- --------
Other assets, net $ 722 $ 898
-------- --------
-------- --------
Accrued expenses:
Accrued salaries and bonuses $ 125 $ 79
Accrued vacation 99 75
Other accrued expenses 186 201
-------- --------
Accrued expenses $ 410 $ 355
-------- --------
-------- --------

Included in property and equipment above are dispensing and office
equipment under capital lease obligations of $214,000, net of accumulated
amortization of $131,000 at December 31, 1995.

25
<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4. FINANCING ARRANGEMENTS

Long-term debt at December 31, 1996 and 1995, consists of the following:
<TABLE>
<CAPTION>

1996 1995
------- -------
(IN THOUSANDS)
<S> <C> <C>
Note payable to leasing company, net of unamortized discount
of $32,000 and $56,000 at December 31, 1996 and 1995,
respectively, due in variable monthly principal installments
through June, 1999, including accrued interest with a stated
rate of 12.5% (effective rate of 16.5%), collateralized by
specific dispensing equipment and related customer lease
agreements. A board member and shareholder in the leasing
company is also Chairman of the Board and a significant
shareholder of the Company (see Note 11). $ 1,411 $ 1,611

Term loan payable to bank, due in varying monthly install-
ments through September 2000, including accrued interest at
the bank's reference rate (8.25% at December 31, 1996 and
8.50% at December 31, 1995) plus 3.25% (agreement
amended and restated in February, 1997). 1,862 2,348

Term loan payable to bank, due in varying monthly installments
through August 1997 and one final payment of the remaining
principal balance in September 1997, including accrued interest
at the bank's reference rate (8.25% at December 31, 1996 and
8.50% at December 31, 1995) plus 7% (agreement amended and
restated in February, 1997). 767 967
------- -------
4,040 4,926
Less current portion (1,241) (887)
------- -------
$ 2,799 $ 4,039
------- -------
------- -------
</TABLE>

Prior to the amendment and restatement described in the following
paragraphs, the bank agreement contained restrictive financial covenants which
included, among others, requirements that the Company maintain a current ratio
of at least .75 to 1, maintain an annual minimum coverage ratio of 1.1 to 1,
achieve annual net income of at least $50,000 in 1996 and $300,000 in each
successive year thereafter, maintain minimum levels of capital base, and
maintain a minimum cash balance of $150,000 on deposit with the bank at all
times, and which prohibited the Company from paying any dividends. At December
31, 1996, the Company was in violation of the net income, current ratio,
cumulative net loss, minimum capital base and minimum coverage ratio covenants.
The Company has obtained a written waiver from the bank waiving its right to
accelerate repayment as part of an amended and restated loan agreement dated
February 18, 1997 (see following two paragraphs).

On February 18, 1997, the Company and the bank amended and restated its
term loan agreement. The agreement combined both outstanding term loans into one
term loan facility to be repaid in equal monthly principal installments plus
accrued interest at the bank's reference rate plus 3.75 percent, with a final
principal payment plus accrued interest due in February 2000. Borrowings under
the amended and restated term loans are collateralized by substantially all of
the Company's assets, subordinate to a leasing company's collateral interest in
certain leased dispensing equipment. In addition, the bank agreement contains
restrictive financial covenants which include, among others, that the Company
maintain a current ratio of at least .75 to 1, maintain an annual minimum
coverage ratio of 1.05 to 1, maintain a minimum cash balance of $150,000 on
deposit with the bank at all times, and which prohibits the Company from paying
any dividends.

26
<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The amended and restated term loan agreement has a provision that if the
Company did not obtain commitments for at least $1,000,000 of new subordinated
debt financing by March 1, 1997, an event of default would occur. The agreement
also requires that 30 percent of the gross proceeds of the subordinated debt are
to be used to pay down the principal balance with its bank lender (see following
paragraph).

In February 1997, the Company obtained commitments for the purchase of a
series of subordinated notes payable from shareholders and accredited investors
sufficient to meet the provisions of the amended and restated term loan
agreement. The notes bear interest at 14 percent payable monthly and are due in
March 2000. In addition, warrants were offered in conjunction with the notes at
the rate of one warrant for each $5.00 in notes payable. The notes are
collateralized by a second lien on all of the Company's assets, subordinate to
the bank and leasing company's interests.

On July 28, 1995, the Company entered into a $200,000 bridge loan agreement
bearing interest at 13% per annum with its Chairman. The Company borrowed
$100,000 pursuant to this agreement on October 12, 1995. The entire principal
balance was repaid on October 25, 1995 in conjunction with the sales of its
common stock.

On January 5, 1996, the Company and a leasing company amended their loan
agreement. The amended loan agreement extended the payment terms and provides
for escalating monthly principal payments plus accrued interest through June
1999. The leasing company received a new warrant for 300,000 shares of common
stock which replaced a warrant for 200,000 shares of common stock that was
canceled as part of this amended loan agreement (see Note 7).

The Company believes that the amount recorded as long-term debt
approximates its fair value at December 31, 1996.

Principal maturities of long-term debt at December 31, 1996, which reflect
the maturities in the February 1997 financing transactions, are as follows:

YEARS ENDING
DECEMBER 31, (IN THOUSANDS)
1997 $ 1,241
1998 1,055
1999 759
2000 985
--------
$ 4,040
--------
--------

5. LEASES

AS LESSOR

The Company leases dispensing equipment with a carrying value of $7,099,000
net of accumulated depreciation of $2,651,000 at December 31, 1996, to customers
under cancelable operating leases with one to five year terms. Terms of the
lease agreements provide both the Company and the lessee with the option to
remove the equipment if, after six months, water sales are less than minimum
levels. Monthly lease payments are based on actual usage and are subject to
minimum payment amounts. The leases also require the Company to service and
maintain the equipment.

27
<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS LESSEE

Certain office and production facilities, vehicles and office equipment are
leased under noncancelable operating leases expiring at various dates through
2000. The minimum monthly rentals under these agreements vary from month-to-
month because certain leases require the Company to pay a pro rata share of the
lessor's operating costs. Also, certain leases are renewable at the Company's
option. Future minimum lease payments on these leases are $192,000, $146,000,
$58,000, $23,000 and $1,000 in 1997, 1998, 1999, 2000, and 2001, respectively.

During 1996, the Company entered into various sale/leaseback agreements
with certain shareholders and board members for dispensing equipment. These
agreements were approved by the Company's principal bank lender under the terms
that the equipment be installed and operated with one named chain customer and
that the installations consist of newly manufactured equipment. Under the terms
of the agreements, 27 systems were sold for $171,000 ($6,345 per system) and
were leased back by the Company pursuant to five-year operating leases for
placement and operation in one supermarket chain. The leases require a monthly
payment of $4,000 ($140 per system) and requires the Company to service and
maintain the equipment. The monthly payment per system can increase based on
increases in the prime interest rate. In addition, the Company has the option to
purchase the equipment at the end of the lease term for its fair market value.
Deferred income of $82,000 is being amortized as a reduction of cost of revenues
on a straight-line basis over the lease terms. At December 31, 1996, the
unamortized portion of this deferred income included on the Company's balance
sheet was $75,000.

During 1991 and 1990, the Company entered into various sale-leaseback
agreements with certain shareholders and Board members for dispensing equipment.
All of these leases expired during 1996 and the Company exercised its option to
purchase the equipment from the lessors at its fair market value for a total
purchase price of $148,000.

Rent expense was approximately $267,000 in 1996 and $514,000 in 1995, of
which approximately $29,000 in 1996 and $250,000 in 1995 related to the sale-
leaseback agreements with certain shareholders and Board members.

The Company also leased certain property and equipment pursuant to terms of
a master sale-leaseback agreement with a leasing company. A board member and
shareholder in the leasing company is also Chairman of the Board and a
significant shareholder of the Company. The capital lease agreements expired in
December 1995 and March 1996.

6. INCOME TAXES

The following summarizes the status of the Company's deferred income tax
balances as of December 31:

1996 1995
------- ------
(IN THOUSANDS)

Deferred tax asset $ 3,426 $3,039
Deferred tax liability (2,114) (1,789)
-------- -------
1,312 1,250

Valuation allowance (1,312) (1,250)
-------- -------
Net deferred tax asset $ - $ -
-------- -------
-------- -------

28
<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The tax effect of temporary differences which give rise to deferred income
taxes at December 31, are as follows:

1996 1995
---- ----
(IN THOUSANDS)

Net operating loss carryforwards $ 3,332 $ 2,971
Excess of tax over book depreciation (2,094) (1,775)
Other, principally allowance for
doubtful accounts and
accrued expenses 74 54
-------- --------
$ 1,312 $ 1,250
-------- --------
-------- --------

At December 31, 1996, the Company has approximately $8,398,000 of net
operating loss carryforwards for federal income tax reporting purposes which
expire from 2007 to 2011. Certain corporate stock transactions into which the
Company has entered will limit the amount of net operating loss carryforwards
which may be utilized on an annual basis to offset taxable income in future
periods.

7. STOCK OPTIONS AND WARRANTS

On April 25, 1996, the Company adopted the 1996 Stock Option Plan (1996
Plan) which provides for a maximum of 350,000 shares of common stock available
for grant. On April 20, 1995, the Company adopted the 1995 Stock Option Plan
(1995 Plan) which provides for a maximum of 150,000 shares of common stock
available for grant. On March 1, 1993, the Company adopted the 1993 Stock Option
Plan (1993 Plan) which provides for a maximum of 150,000 shares of common stock
available for grant. The 1996 Plan, 1995 Plan and the 1993 Plan (collectively
"the Option Plans") are administered by the Compensation Committee of the Board
of Directors (the Committee). The Option Plans provide that options granted
thereunder may be either incentive stock options (ISOs) as defined by the
Internal Revenue Code, or nonqualified stock options. Options may be granted to
key employees and officers of the Company. The Committee determines who will
receive options under the Option Plans and sets the terms. Options may have a
maximum term of no more than ten years and have vesting periods of three years.
The exercise price of all ISOs granted under the Option Plans must be at least
equal to the fair market value of the Company's common stock on the date of
grant. The exercise price may be paid in cash, options, or shares of previously
owned common stock. If an option expires, terminates or is canceled, the shares
not purchased thereunder may become available for additional option awards under
the Option Plans. The 1996 Plan, 1995 Plan and the 1993 Plan expire on April 24,
2006, April 19, 2005 and February 28, 2003, respectively.

On March 1, 1993, the Company also adopted the Outside Directors'
Nonqualified Stock Option Plan (the Directors Plan) which is administered by the
Board of Directors (the Board). Options are to be granted to only those
directors of the Company who are not members of management. The maximum number
of shares of common stock available for grant under the Directors Plan is
75,000. The Directors Plan provides for automatic annual grants to each outside
director of options to purchase 2,000 shares with an exercise price equal to the
fair market value on the date of grant. Options may have a term of no more than
ten years and vest at the rate of 20% of the original grant per year. The
exercise price may be paid in cash, options or shares of previously owned common
stock. The Directors Plan expires on February 28, 2003.

In addition, the Board granted to certain directors nonqualified stock
options to purchase 60,000 shares of the Company's common stock at $3.00 per
share on March 1, 1993. In 1994, 10,000 of these stock options were forfeited.
These options were not granted under any of the plans discussed above and vest
at the rate of 20% per year over five years.

29
<PAGE>
HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Option activity is summarized below. Aggregate activity related to the 1996
Plan, 1995 Plan, 1993 Plan and Directors Plan is presented separately from other
option activity.
<TABLE>
<CAPTION>

OPTIONS OUTSTANDING
OPTIONS AVAILABLE ------------------------ WEIGHT AVERAGE
FOR GRANT PLANS OTHER PRICE PER SHARE
------------------ -------- -------- ---------------
<S> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1994 152,000 73,000 50,000 $2.95
Options available under 1995 Plan 150,000
Granted (234,800) 234,800 $1.34
Forfeited 20,200 (20,200) $.94
-------- -------- --------

BALANCE AT DECEMBER 31, 1995 87,400 287,600 50,000 $1.63
Options available under 1996 Plan 350,000
Granted (340,600) 340,600 $.89
Forfeited 17,467 (17,467) $1.00
-------- -------- --------

BALANCE AT DECEMBER 31, 1996 114,267 610,733 50,000 $1.27
-------- -------- --------
-------- -------- --------
</TABLE>

The following summarizes information about stock options outstanding at December
31, 1996:

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------------------- ---------------------------------
WEIGHTED-AVG.
RANGE OF EXERCISE NUMBER REMAINING WEIGHTED-AVG. NUMBER WEIGHTED-AVG.
PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
-------------- ----------- --------------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$0.69 to $1.38 520,733 9.2 years $0.95 63,876 $1.05
$1.75 to $3.00 140,000 7.1 years $2.46 64,667 $2.63
---------- ----------
$0.69 to $3.00 660,733 8.0 years $1.27 128,543 $1.84
---------- ----------
---------- ----------
</TABLE>
In October 1995, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 123, a new standard of accounting and
reporting for stock-based compensation plans. The Company has adopted this new
standard in 1996. The Company has continued to measure compensation cost for its
stock option plans using the intrinsic value-based method of accounting it has
historically used and, therefore, the new standard has no effect on the
Company's operating results.

Had the Company used the fair value-based method of accounting for its
stock option plans beginning in 1995 and charged compensation cost against
operations over the vesting period, based on the fair value of options at the
date of grant, net loss and net loss per share for 1996 and 1995 would have been
the following pro forma amounts:

1996 1995
-------- ----------
(IN THOUSANDS)
Net loss $ (599) $ (1,463)
Net loss per share $ (0.08) $ (0.27)

The pro forma information above only includes stock options granted in 1995
and 1996. Compensation expense under the fair value-based method of accounting
will increase over the next few years as additional stock option grants are
considered.

30
<PAGE>
HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company used the Black-Scholes option pricing model to value its
options using the following assumptions: risk free interest rates ranging from
5.7% to 7.8%, expected life of the options of five years, expected volatility of
54.5%, and no expected dividends. The weighted average fair value of options on
the date of grant was $0.79 and $0.48 for options granted in 1995 and 1996,
respectively.

On December 6, 1996, the Company's Board of Directors authorized the
cancellation of outstanding incentive stock options and reissuance of new
options to current employees excluding those employees who are also Directors.
This action by the Board is subject to acceptance by each employee. The reissued
options will have an exercise price of $.63 per share. If all employees elect to
cancel their outstanding options in return for new options, options covering
249,733 shares at a weighted average exercise price of $.63 per share would
replace options covering 249,733 shares at a weighted average exercise price of
$.99 per share. All reissued options will be ten-year options with a vesting
period of three years beginning on December 6, 1996.

The Company has issued stock warrants to shareholders and others in
conjunction with various financing activities. Net proceeds from the issuance of
the note payable and related warrants in 1994 were allocated based on the
relative fair values on the issue date. All warrants are fully vested with the
holder.

Warrant activity is summarized as follows:

WEIGHT AVERAGE
WARRANTS OUTSTANDING PRICE PER SHARE
--------------------- ---------------
BALANCE AT DECEMBER 31, 1994 792,387 $3.02
Expired (35,555) $2.81
----------

BALANCE AT DECEMBER 31, 1995 756,832 $3.03
Cancelled (200,000) $3.31
Reissued 300,000 $1.05
-----------

BALANCE AT DECEMBER 31, 1996 856,832 $2.27
-----------
-----------

At December 31, 1996, warrants for 300,000 shares were exercisable at $1.05
per share.

On January 5, 1996, the Company entered into an agreement with a leasing
company (see Note 4) which included canceling a prior warrant for 200,000 shares
exercisable at $3.31 per share and reissuing a new warrant for 300,000
exercisable at $1.05 per share.

8. NON-CASH INVESTING AND FINANCING ACTIVITIES

During 1995, the Company had the following non-cash investing and financing
activities costs:

- In connection with the acquisition of Certified Pure Water (see Note
2) the Company issued 333,333 shares of common stock (valued at
$250,000) as partial consideration.

- In November 1995, the Company restructured its outstanding debt with
its principal lender to combine a term loan with a balance of
$2,000,000, a revolving credit loan balance of $350,000 and a vehicle
loan balance of $83,000 into a five year term loan. In addition, a
$1,000,000 bridge loan agreement was converted into a term loan.

31
<PAGE>

HARMONY BROOK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

- As part of the sale of the Company's common stock, the $100,000
borrowed from the Company's Chairman under a bridge loan agreement was
converted to 133,333 shares of common stock (see Note 4).

- In connection with the acquisition of Imperial Bottle Company in
February 1994 the Company issued 217,422 shares of common stock
(valued at $409,000) as additional consideration.

9. EMPLOYEE BENEFIT PLAN

The Company sponsors a defined contribution benefit plan which qualifies
under section 401(k) of the Internal Revenue Code and covers employees who meet
certain age and service requirements. Employee contributions are limited to 15%
of their compensation, subject to yearly limitations. Employer contributions are
made at the discretion of the Company's Board of Directors. Company
contributions in 1996 and 1995 were $4,000 and $3,000, respectively.

10. CONCENTRATION OF CREDIT RISK AND SIGNIFICANT CUSTOMER

The Company's largest customer accounted for approximately 12% and 10% of
accounts receivable as of December 31, 1996 and 1995, respectively. This
customer also accounted for approximately 14% of revenues in 1996 and less than
10% in 1995.

11. OTHER RELATED PARTY TRANSACTIONS

During 1996 and 1995, the Company had equipment sales of $7,000 and
$74,000, respectively, to a leasing company whose Board member and shareholder
is also Chairman of the Board and a significant shareholder of the Company.
Accounts receivable from this customer at both December 31, 1996 and 1995 were
$0.

12. GEOGRAPHIC SEGMENTS

The Company operates in one industry segment as described in Note 1.
Financial information, summarized by geographic area, is as follows:

1996 1995
---------- ----------
(IN THOUSANDS)
Total Revenues
U.S. $ 7,825 $ 6,882
Mexico 491 293
---------- ----------
Total $ 8,316 $ 7,175
---------- ----------
---------- ----------

Operating income (loss)
U.S. $ 147 $ (659)
Mexico 3 (75)
---------- ----------
Total $ 150 $ (734)
---------- ----------
---------- ----------
Identifiable Assets
U.S. $ 11,262 $ 12,357
Mexico 665 596
---------- ----------
Total $ 11,927 $ 12,953
---------- ----------
---------- ----------

32
<PAGE>

13. QUARTERLY DATA (UNAUDITED AND UNREVIEWED)

FIRST SECOND THIRD FOURTH YEAR
--------- -------- -------- ---------- --------
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
Revenues
1996 $1,882 $2,107 $2,288 $2,039 $8,316
1995 $1,562 $1,773 $2,068 $1,772 $7,175

Gross Profit
1996 $1,003 $1,113 $1,250 $1,067 $4,433
1995 $ 807 $ 906 $1,081 $ 964 $3,758

Operating Income (Loss)
1996 $ (58) $ 89 $ 168 $ (49) $ 150
1995 $ (330) $ (342) $ 37 $ (99) $ (734)

Net (Loss) Income
1996 $ (225) $ (73) $ 17 $ (200) $ (481)
1995 $ (455) $ (512) $ (156) $ (277) $(1,400)

Loss Per Share
1996 $(0.03) $(0.01) $ 0.00 $(0.02) $(0.06)
1995 $(0.09) $(0.10) $(0.03) $(0.04) $(0.26)

</TABLE>

33
<PAGE>

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

No changes in accountants or disagreements between the Registrant and its
accountants regarding accounting principles or financial statement disclosures
have occurred within the twenty-four months prior to the date of Registrant's
most recent financial statements.

PART III

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

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

See the Registrant's Proxy Statement for the 1997 Annual Meeting of
Shareholders filed with the Commission on March 20, 1997, referenced on page 2
of this Form 10-KSB.

ITEM 10. EXECUTIVE COMPENSATION

See the Registrant's Proxy Statement for the 1997 Annual Meeting of
Shareholders filed with the Commission on March 20, 1997, referenced on page 2
of this Form 10-KSB.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

See the Registrant's Proxy Statement for the 1997 Annual Meeting of
Shareholders filed with the Commission on March 20, 1997, referenced on page 2
of this Form 10-KSB.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

See the Registrant's Proxy Statement for the 1997 Annual Meeting of
Shareholders filed with the Commission on March 20, 1997, referenced on page 2
of this Form 10-KSB.

34
<PAGE>

ITEM 13. EXHIBITS LIST AND REPORTS ON FORM 8-K

(a) Exhibits.

The following exhibits are included with this Annual Report on Form 10-KSB
(or incorporated by reference) as required by Item 601 of Regulation S-B.

EXHIBIT NO. DESCRIPTION
- ------------ ------------

(3.1) Restated Articles of Incorporation of Harmony Brook, Inc.
effective March 1, 1993. (Incorporated by reference to
Exhibit 3.1 to the Registrant's Registration Statement on
Form SB-2, Registration No.33-59330C the "Registrant's
Registration Statement".)
(3.2)* Articles of Amendment of the Restated Articles of
Incorporation of Harmony Brook, Inc. effective April 25,
1996.
(3.3) Second Amended and Restated By-Laws of Harmony Brook, Inc.
effective January 21, 1994. (Incorporated by reference to
Exhibit 3 to the Registrant's Quarterly Report on form 10-
QSB for the quarter ended March 31, 1994.)
(4.1) Restated Articles of Incorporation and Second Amended and
Restated By-Laws of Harmony Brook, Inc. (See Exhibits 3.1,
3.2 and 3.3.)
(4.2) Specimen of Common Stock Certificate. (Incorporated by
reference to Exhibit 4.2 to Amendment No. 1 to the
Registrant's Registration Statement on Form SB-2,
Registration No. 33-59330C filed April 8, 1993 ("Amendment
No. 1 to the Registrant's Registration Statement").)
(4.3) Loan Agreement dated February 1, 1994 between Harmony Brook,
Inc. and Sunrise Leasing Corporation including Warrant.
(Incorporated by reference to Exhibit 4.3 to the
Registrant's Annual Report on Form 10-KSB for the year ended
December 31, 1993.)
(4.4)* Second Amended and Restated Letter Loan Agreement dated as
of February 18, 1997 between Harmony Brook, Inc. and First
Bank National Association, including Term Note.
(10.1) Warrant to purchase 110,166 shares of Common Stock dated
April 23, 1993 granted to John G. Kinnard and Company,
Incorporated. (Incorporated by reference to Exhibit 1.1 to
Amendment No. 2 to Registrant's Registration Statement on
Form SB-2 filed April 22, 1993.)
(10.2) Warrant to purchase 133,333 shares (pre-split) of Common
Stock dated June 11, 1992 granted to John G. Kinnard and
Company, Incorporated. (Incorporated by reference to Exhibit
10.1 to the Registrant's Registration Statement.)
(10.3) Warrant to purchase 44,444 shares (pre-split) of Common
Stock dated December 10, 1992 granted to Donald R. Brattain.
(Incorporated by reference to Exhibit 10.3 to the
Registrant's Registration Statement.)
(10.4) Warrant and First Amendment to Warrant each dated February
22, 1993, granted to Donald R. Brattain. Warrants and First
Amendments that were identical to Mr. Brattain's were also
granted to the other persons referenced in the description
of Exhibit 10.4 above, except that the number of Warrants
granted were, respectively 40,000 for Linnea Van Dyne,
20,000 for Bill G. Johnson, 80,000 for Founding Partners II
Limited Partnership, 40,000 for W. William Bednarczyk,
40,000 for Karen Ohman, 10,000 for Michael R. Knox, 40,000
for Cherry Tree Ventures IV and 4,000 for Craig Forsman.
(Incorporated by reference to Exhibit 10.6 to the
Registrant's Registration Statement.)
(10.5) Harmony Brook, Inc. Outside Directors Nonqualified Stock
Option Plan. (Incorporated by reference to Exhibit 10.10 to
the Registrant's Registration Statement.)
(10.6) Office/Warehouse Lease dated July 22, 1993, between Harmony
Brook, Inc. and Opus Corporation. (Incorporated by reference
to Exhibit 10.13 to the Registrant's Annual Report on
Form 10-KSB for the year ended December 31, 1993.)
(10.7) Master Lease Agreement dated November 21, 1991, between
Harmony Brook, Inc. and Sunrise Leasing Corporation.
(Incorporated by reference to Exhibit 10.17 to the
Registrant's Registration Statement.)
(10.8) Form of Lease Agreement (Bulk Water Processing and
Dispensing Equipment). (Incorporated by reference to Exhibit
10.23 to the Registrant's Registration Statement.)
(10.9) Form of Non-Exclusive Dealer Agreement. (Incorporated by
reference to Exhibit 10.24 to the Registrant's Registration
Statement.)
(10.10) Form of Service Distributor Agreement. (Incorporated by
reference to Exhibit 10.25 to the Registrant's Registration
Statement.)
(10.11) Option Agreement to Purchase 10,000 shares between Harmony
Brook, Inc. and Donald R. Brattain dated March 1993. Option
Agreements to Purchase that were identical to Mr. Brattain's
were also entered into with Messrs. Gordon F. Stofer,
Patrick J. Norton, Bill G. Johnson, Burton J. McGlynn and
David A. Henderson. (Incorporated by reference to Exhibit
10.28 to Amendment No. 1 to the Registrant's Registration
Statement.)

35
<PAGE>

(10.12) First Amendment to Loan Agreement dated January 5, 1996,
between Harmony Brook, Inc. and Sunrise Financial Resources,
Inc. (Incorporated by reference to Exhibit 10.25 to
Registrant's Registration Statement on Form SB-2,
Registration No. 33-96078.)
(10.13) Warrant to purchase 300,000 shares of Common Stock, dated
January 5, 1996 granted to Sunrise Financial Resources, Inc.
(Incorporated by reference to Exhibit 10.26 to Registrant's
Registration Statement on Form SB-2, Registration No. 33-
96078.)
(13)* Annual Report to Shareholders for period ended December 31,
1996.
(16) Letter on Change in Accounting Principles. (Incorporated by
reference to Exhibit 10.29 to Amendment No. 1 to
Registrant's Registration Statement.)
(21) Subsidiaries of Registrant, Harmony Brook de Mexico, S.A. de
C.V. (Incorporated by reference to Exhibit 21 to
Registrant's Annual Report on Form 10-KSB for the year ended
December 31, 1993.)
(24)* Powers of Attorney
(27)* Financial Data Schedule

(b) REPORTS ON FORM 8-K.
None

* Denotes previously unfiled documents.

36
<PAGE>

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the Registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

HARMONY BROOK, INC.

By /s/ James C. Hawley
------------------------
James C. Hawley,
President and
Chief Executive Officer

Dated: March 12, 1997.

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

/s/ James C. Hawley Dated: March 12, 1997
- ---------------------------------------------
James C. Hawley, President and Chief Executive
Officer, Chief Financial Officer and Director
(principal executive officer)

/s/ Donald R. Brattain Dated: March 12, 1997
- ---------------------------------------------
Donald R. Brattain, Director

/s/ Carl J. Werner Dated: March 12, 1997
- ---------------------------------------------
Carl J. Werner, Controller
(principal accounting & financial officer)

Bill G. Johnson )
David Henderson )
Gordon F. Stofer ) Directors*
Burton J. McGlynn )
William R. Griffin )

* This Annual Report on Form 10-KSB has been signed by the undersigned as
attorneys-in-fact on behalf of each person so indicated pursuant to a power of
attorney duly executed by each such person.

By /s/ James C. Hawley By /s/ Donald R. Brattain
------------------------------- ----------------------------
James C. Hawley Donald R. Brattain
Attorney-in-Fact Attorney-in-Fact

37
<PAGE>

INDEX TO EXHIBITS

EXHIBIT NO. DESCRIPTION OF EXHIBIT PAGE NO.
- ----------- ---------------------- --------

(3.1) Restated Articles of Incorporation of Harmony Brook, Inc.
effective March 1, 1993 (Incorporated by reference to
Exhibit 3.1 to the Registrant's Registration Statement on
Form SB-2, Registration No. 33-59330C the "Registrant's
Registration Statement".)
(3.2)* Articles of Amendment of the Restated Articles of
Incorporation of Harmony Brook, Inc. effective April 25,
1996.
(3.3) Second Amended and Restated By-Laws of Harmony Brook, Inc.
effective January 21,1994. (Incorporated by reference to
Exhibit 3 to the Registrant's Quarterly Report on Form 10-
QSB for the quarter ended March 31, 1994.)
(4.1) Amended and Restated Articles of Incorporation and Second
Restated By-Laws of Harmony Brook, Inc. (See Exhibits 3.1,
3.2 and 3.3.)
(4.2) Specimen of Common Stock Certificate. (Incorporated by
reference to Exhibit 4.2 to Amendment No. 1 to the
Registrant's Registration Statement on Form SB-2,
Registration No. 33-59330C filed April 8, 1993 ("Amendment
No. 1 to the Registrant's Registration Statement").)
(4.3) Loan Agreement dated February l, 1994 between Harmony Brook,
Inc. and Sunrise Leasing Corporation including Warrant.
(Incorporated by reference to Exhibit 4.3 to the
Registrant's Annual Report on Form 10-KSB for the year ended
December 31, 1993.)
(4.4)* Second Amended and Restated Letter Loan Agreement dated as
of February 18, 1997 between Harmony Brook, Inc. and First
Bank National Association, including Term Note.
(10.1) Warrant to purchase 110,166 shares of Common Stock dated
April 23, 1993 granted to John G.Kinnard and Company,
Incorporated. (Incorporated by reference to Exhibit 1.1 to
Amendment No. 2 to Registrant's Registration Statement on
Form SB-2 filed April 22, 1993.)
(10.2) Warrant to purchase 133,333 shares (pre-split) of Common
Stock dated June ll, 1992 granted to John G. Kinnard and
Company, Incorporated. (Incorporated by reference to Exhibit
10.1 to the Registrant's Registration Statement.)
(10.3) Warrant to purchase 44,444 shares (pre-split) of Common
Stock dated December 10, 1992 granted to Donald R. Brattain.
(Incorporated by reference to Exhibit 10.3 to the
Registrant's Registration Statement.)
(10.4) Warrant and First Amendment to Warrant each dated February
22, 1993, granted to Donald R. Brattain. Warrants and First
Amendments that were identical to Mr. Brattain's were also
granted to the other persons referenced in the description
of Exhibit 10.4 above, except that the number of Warrants
granted were, respectively, 40,000 for Linnea Van Dyne,
20,000 for Bill G. Johnson, 80,000 for Founding Partners II
Limited Partnership, 40,000 for W. William Bednarczyk,
40,000 for Karen Ohman, 10,000 for Michael R. Knox, 40,000
for Cherry Tree Ventures IV and 4,000 for Craig Forsman.
(Incorporated by reference to Exhibit 10.6 to the
Registrant's Registration Statement.)
(10.5) Harmony Brook, Inc. Outside Directors Non-qualified Stock
Option Plan. (Incorporated by reference to Exhibit 10.10 to
the Registrant's Registration Statement.)
(10.6) Office/Warehouse Lease dated July 22, 1993, between Harmony
Brook, Inc. and Opus Corporation. (Incorporated by reference
to Exhibit 10.13 to the Registrant's Annual Report on Form
10-KSB for the year ended December 31, 1993.)
(10.7) Master Lease Agreement dated November 21, 1991, between
Harmony Brook, Inc and Sunrise Leasing Corporation.
(Incorporated by reference to Exhibit 10.17 to the
Registrant's Registration Statement.)
(10.8) Form of Lease Agreement (Bulk Water Processing and
Dispensing Equipment) (Incorporated by reference to Exhibit
10.23 to the Registrant's Registration Statement.)
(10.9) Form of Non-Exclusive Dealer Agreement. (Incorporated by
reference to Exhibit 10.24 to the Registrant's Registration
Statement.)
(10.10) Form of Service Distributor Agreement. (Incorporated by
reference to Exhibit 10.25 to the Registrant's Registration
Statement.)
(10.11) Option Agreement to Purchase 10,000 shares between Harmony
Brook, Inc. and Donald R. Brattain dated March 1993. Option
Agreements to Purchase that were identical to Mr. Brattain's
were also entered into with Messrs. Gordon F. Stofer,
Patrick J. Norton, Bill G. Johnson, Burton J. McGlynn and
David A. Henderson. (Incorporated by reference to Exhibit
10.28 to Amendment No. 1 to the Registrant's Registration
(10.12) First Amendment to Loan Agreement dated January 5, 1996,
between Harmony Brook, Inc. and Sunrise Financial Resources,
Inc. (Incorporated by reference to Exhibit 10.25 to
Registrant's Registration Statement on Form SB-2,
Registration No. 33-96078.)

38
<PAGE>

(10.13) Warrant to purchase 300,000 shares of Common Stock, dated
January 5,1996 granted to Sunrise Financial Resources, Inc.
(Incorporated by reference to Exhibit 10.26 to Registrant's
Registration Statement on Form SB-2, Registration No. 33-
96078.)
(13)* Annual Report to Shareholders for the year ended December
31, 1996.
(16) Letter on Change in Accounting Principles. (Incorporated by
reference to Exhibit 10.29 to Amendment No. 1 to
Registrant's Registration Statement.)
(21) Subsidiaries of Registrant, Harmony Brook de Mexico, S.A. de
C.V. (Incorporated by reference to Exhibit 21 to
Registrant's Annual Report on Form 10-KSB for the year ended
December 31, 1993.)
(24)* Powers of Attorney.
(27)* Financial Data Schedule

* Denotes previously unfiled documents.

<PAGE>
EXHIBIT 3.2

ARTICLES OF AMENDMENT
OF THE
RESTATED ARTICLES OF INCORPORATION
OF
HARMONY BROOK, INC.

The undersigned corporation, for the purpose of amending its Articles of
Incorporation and pursuant to the provisions of Section 302A.139 of the
Minnesota Business Corporation Act, hereby executes the following Articles of
Amendment:

1. The name of the corporation is Harmony Brook, Inc.

2. On April 25, 1996, the shareholders of the Corporation duly amended
Article VIII of the Restated Articles of Incorporation of the Corporation as
follows:

ARTICLE VIII

The aggregate number of common shares which this Corporation shall have
authority to issue is 20,000,000 shares which shall be known as "Common Shares."

(a) The holders of Common Shares shall be entitled to receive, when
and as declared by the Board of Directors, out of earnings or
surplus legally available therefor, dividends, payable either in
cash, in property, or in shares of the capital stock of the
Corporation.

(b) The Common Shares may be allotted as and when the Board of
Directors shall determine, and, under and pursuant to the laws of
the State of Minnesota, the Board of Directors shall have the
power to fix or alter, from time to time, in respect to shares
then unallotted, any or all of the following: the voting rights;
the dividend rate; the redemption price; the liquidation price;
the liquidation rights and the sinking or purchase fund rights of
shares of any class, or of any series of any class. The Board of
Directors shall also have the power to fix the terms, provisions
and conditions of options to purchase or subscribe for shares of
any class or classes, including the price and conversion basis
thereof, and to authorize the issuance thereof.

EXHIBIT 3.2

(d) No holder of Common Shares of the Corporation shall have any
preferential, preemptive or other right of subscription to any
shares of any class of stock of the Corporation allotted or sold
or to be allotted or sold and now or hereafter authorized, or to
any right of subscription to any part thereof.

IN WITNESS WHEREOF, the undersigned Corporation has caused these Articles
of Amendment to be executed in its name by its Chief Executive Officer and
attested by its Secretary this 6th day of May, 1996.

HARMONY BROOK, INC.

By James C. Hawley
-----------------------------
James C. Hawley,
Chief Executive Officer

ATTEST:

Nancy A. Quam
- --------------------------
Nancy A. Quam, Secretary

<PAGE>
EXHIBIT 4.4
Conformed Signature Copy

February 18, 1997
(Closing Date)

Harmony Brook, Inc.
1030 Lone Oak Road
Eagan, Minnesota 55121

Re: Second Amended and Restated Letter Loan Agreement

Dear Mr. Hawley:

Reference is made to that Amended and Restated Letter Loan Agreement
dated November 9, 1995 between First Bank National Association (the "Bank") and
Harmony Brook, Inc., a Minnesota corporation (the "Borrower")(the "Prior Letter
Agreement"). This Second Amended and Restated Letter Loan Agreement (the
"Agreement") amends and restates the Prior Letter Agreement.

1. (a) TERM NOTE. Upon the terms and subject to the conditions hereof,
on the Closing Date, the outstanding principal balance of the Facility A Term
Note and the Facility B Term Note (as such terms, the Facility A Term Note and
Facility B Term Note are defined in the Prior Letter Agreement) shall be
consolidated into one term loan (the "Term Loan"). The Term Loan shall be
evidenced by the Term Note substantially in the form of Exhibit A attached
hereto (the "Term Note"). On the Closing Date the Borrower shall pay all
accrued and outstanding interest on the Facility A Term Note and the Facility B
Term Note. The Term Note is issued in substitution and replacement, but not in
payment, of the Facility A Term Note and the Facility B Term Note. Interest on
the Term Note shall accrue at the rate and shall be payable at the times set
forth therein. Principal on the Term Note shall be payable in equal consecutive
monthly installments of $37,865 commencing March 1, 1997 and continuing on the
first day of each month thereafter through January 1, 2000, and one final
payment of the entire outstanding principal balance on February 1, 2000. Upon
the occurrence and during the continuation of any Event of Default all amounts
outstanding under the Term Note shall bear interest at the rate otherwise
applicable thereto, plus 2% per annum.

(b) FACILITY A RESTRUCTURING FEE. The Borrower shall pay to the Bank
a Restructuring Fee of $15,000 in three installments of $5000 each due and
payable on March 1, 1997, June 1, 1997 and September 1, 1997.

2. DOCUMENTATION. The Bank shall have no obligation to enter into the

<PAGE>

restructuring as provided regarding Facility A and Facility B herein until the
Bank has received all of the following, in form and substance satisfactory to
the Bank.

(i) The Agreement executed by the Borrower.

(ii) The Term Note, in the form of Exhibit A attached
hereto, executed by the Borrower.

(iii) Current searches of the records in appropriate
offices, in Minnesota only, indicating that no
financing statements or tax liens are on file
against the Borrower or any of the Borrower's
assets, except financing statements in favor of
the Bank and prior financing statements in favor
of Sunrise Leasing Corporation and Sunrise
Financial Resources, Inc., and a subsequent
financing statement in favor of Citicorp Dealer
Finance.

(iv) Certified resolutions of the Borrower's board of
directors authorizing the Borrower to enter into
this Agreement and to sign the Term Note, and all
other instruments and agreements provided for in
this Agreement, together with a certificate of
incumbency identifying the officer or officers
authorized to execute this Agreement and the
documents related hereto, including a specimen
signature of each officer so authorized.

(v) Copies of the Borrower's articles of incorporation
and all amendments thereto certified by the
Minnesota Secretary of State and a copy of the
Borrower's bylaws and all amendments thereto,
certified as current and complete as of the
Closing Date by the Secretary or an Assistant
Secretary of the Borrower or, in the alternative,
a certificate of an officer of the Borrower
certifying there has been no change in the
Articles and Bylaws of the Borrower since the same
were last certified to the Bank.

(vi) A Certificate of Good Standing issued by the
Minnesota Secretary of State certifying that the
Borrower is in good standing under the laws of the
State of Minnesota, dated within 15 days of the
Closing Date.

(vii) The Restructuring Fee as set forth in paragraph
1(b) hereof.

(viii) Such other documents or requirements as the Bank
may reasonably require.

3. SECURITY. The Borrower acknowledges and agrees that the obligations

<PAGE>

and indebtedness of the Borrower under the Term Note are secured by the Security
Agreement dated October 17, 1994 from the Borrower to the Bank as well as any
prior security agreement from the Borrower to the Bank, a Collateral Assignment
of Trademarks dated April 26, 1995, and a Borrower's Pledge Agreement dated
April 26, 1995.

4. REPRESENTATIONS The Borrower represents and warrants to the Bank
as follows:

(a) The Borrower is a corporation duly organized, validly
existing and in good standing under the laws of the
State of Minnesota.

(b) The Borrower's execution, delivery and performance of
this Agreement, the Term Note and all other instruments
and agreements executed in connection with the Agreement
(the "Loan Documents") have been properly authorized by
all necessary corporate action and do not require
governmental approval.

(c) The Loan Documents have been properly executed and
constitute the Borrower's legal, valid and binding
obligations, enforceable against the Borrower in
accordance with their terms, subject to limitations as
to enforceability which might result from bankruptcy,
insolvency, moratorium and other similar laws affecting
creditors' rights generally and subject to limitations
on the availability of equitable remedies.

(d) The financial statements that the Borrower has furnished
to the Bank fairly represent the financial condition of
the Borrower on the date of those statements and the
results of the Borrower's operations for the periods
referred to in those statements. The Borrower's
statements were prepared in accordance with generally
accepted accounting principles. There have been no
material adverse changes in the properties or financial
condition of the Borrower since the date of the latest
statements furnished to the Bank.

(e) There are no actions, suits or proceedings pending or
threatened against or affecting the Borrower or the
Borrower's properties before any court or governmental
agency, which if determined adversely to the Borrower
would have a material adverse effect on the financial
condition of the Borrower and its subsidiaries taken as
a whole.

(f) The Borrower has filed all required tax returns and has
paid all taxes due (including payroll and withholding
taxes).

(g) There are no mortgages or security interests on any of
the Borrower's assets, except for the security interests
in favor of the Bank and except with respect to assets
being acquired under a capitalized lease or installment
sales contract and except for the security interests as
currently

<PAGE>

in effect in favor of Sunrise Leasing Corporation,
Sunrise Financial Resources, Inc. and Citicorp Dealer
Finance.

(h) The Borrower does not maintain any defined benefit
employee retirement benefit plans for any of the
Borrowers' employees.

5. REPORTING. The Borrower will deliver to the Bank the following
financial statements in a form acceptable to the Bank:

(a) As soon as available and in any event within 120 days
after the end of each fiscal year of the Borrower,
audited financial statements of the Borrower consisting
of at least statements of income, cash flow and
stockholders' equity, and a balance sheet as at the end
of such year, setting forth in each case in comparative
form corresponding figures from the previous annual
financial statements, audited by independent certified
public accountants selected by the Borrower and
acceptable to the Bank; and a Compliance Certificate,
including a statement signed by the chief financial
officer of the Borrower stating that as at the end of
such fiscal year there did not exist any Default or
Event of Default or, if such Default or Event of Default
existed, specifying the nature and period of existence
thereof and what action the Borrower proposes to take
with respect thereto.

(b) As soon as available and in any event within 30 days
after the end of each fiscal month, internally prepared
financial and operating statements, substantially
similar to the annual audited statements, signed by the
chief financial officer or controller of the Borrower;
together with a Compliance Certificate, including a
statement signed by the chief financial officer or
controller of the Borrower stating that as at the end of
such month there did not exist any Default or Event of
Default or, if such Default or Event of Default existed,
specifying the nature and period of existence thereof
and what action the Borrower proposes to take with
respect thereto.

(c) Immediately upon any officer of the Borrower becoming
aware of any Default or Event of Default, a notice
describing the nature thereof and what action the
Borrower proposes to take with respect thereto.

(d) As soon as available and in any event within 180 days
after the end of each fiscal year of the Borrower, a
copy of the auditor's management letter prepared by the
auditor of the statements provided in 6(a) above.

The Borrower will also notify the Bank in writing within 30 days after any
lawsuit or other legal proceeding in which the damages sought exceed $25,000 has
been commenced against the Borrower.

6. OTHER AFFIRMATIVE COVENANTS. The Borrower will:
<PAGE>

(a) Pay the Borrower's taxes (including payroll and
withholding taxes) when due, and pay all charges when
due that may become a lien on any of the Borrower's
assets, provided that the Borrower may contest taxes in
good faith by proceedings diligently pursued, so long as
the Borrower maintains a cash reserve sufficient to pay
such taxes and any penalties, interest or other charges
assessed in respect thereto.

(b) Keep adequate financial records, and permit the Bank,
upon reasonable notice, to examine those records and
inspect and audit the Borrower's inventory and other
assets and discuss the Borrower's affairs with any of
the Borrower's officers at any reasonable time, and
permit the Bank or its representative to perform
collateral audits twice a year at the Borrower's
expense.

(c) Maintain the Borrower's properties in good condition,
repair and working order, keep the Borrower's properties
and business adequately insured, and maintain the
insurance required under any security agreement or
mortgage, against such loss and damage and in such
amount as is customarily insured against by persons
operating similar properties and/or engaged in similar
businesses to, the Borrower, with loss payee
endorsements in favor of the Bank.

(d) Comply in all material respects with all applicable
laws, rules and regulations to which the Borrower may be
subject.

(e) Maintain the Borrower's existence as a corporation in
good standing under the laws of the State of Minnesota.

(f) Maintain a minimum Capital Base of not less than (i)
$7,000,000 at all times through March 1, 1997, and (ii)
$7,500,000 at all times thereafter. All accounting
terms capitalized in this Agreement and not otherwise
defined shall be defined in accordance with GAAP except
that Net Worth shall be determined exclusive of currency
adjustments for foreign assets. Capital Base shall mean
Net Worth plus Subordinated Debt. Subordinated Debt
shall mean indebtedness of the Borrower the repayment of
which is specifically subordinated to repayment of the
Borrower's indebtedness to the Bank on terms
satisfactory to the Bank.

(g) Maintain a ratio of the Borrower's Current Assets to the
Borrower's Current Liabilities of not less than 0.75 to
1.0 tested monthly as of the last day of each month.

(h) Maintain a minimum coverage ratio of not less than 1.05
to 1.0 for each twelve month period ending December 31,
beginning with the twelve month period ending December
31, 1997. The Borrower's coverage ratio

<PAGE>

is the ratio of its Cash Flow to Debt Service. "Cash
Flow" means the Borrower's Net Income plus the sum of
the Borrower's Depreciation, Amortization, and any other
non-cash expenses, plus the Borrower's Interest Expense,
plus the amount paid on any lease obligations, less the
Borrower's non-cash revenues. "Debt Service" means the
amount of Interest and Principal paid by the Borrower on
any indebtedness plus the amount of rent paid on any
lease obligations.

(i) Not allow its Net Loss for the fiscal year ending
December 31, 1997 to exceed $350,000, and will maintain
a minimum Net Income of not less than $100,000 for the
fiscal year ending December 31, 1998 and will maintain a
Net Income of not less than $250,000 for each fiscal
year thereafter.

(j) Maintain on deposit with the Bank the balance of any
proceeds received by the Borrower from any offerings of
capital, except to the extent such proceeds are used for
general corporate purposes.

(k) Maintain a cash balance on deposit with the Bank at all
times of no less than $150,000.

(l) Obtain commitments for at least $1,000,000 in
Subordinated Debt or additional equity on or before
March 1, 1997, with at least $700,000 of such
Subordinated Debt or equity to be paid in to the
Borrower on or before February 28, 1997, with the
remainder to be paid by no later than April 30, 1997,
and the Borrower will pay 30% of the proceeds of such
Subordinated Debt or equity to the Bank, as the same is
received for application on the Term Note. The
Subordinated Debt will permit no payments of principal
until at least one month after final maturity of the
Term Loan.

7. NEGATIVE COVENANTS. Without the Bank's written consent, the
Borrower will not:

(a) Grant any mortgage, security interest, assignment or any
other lien on any of the Borrower's assets (including
capitalized leases), or permit any such lien to exist or
continue, or subordinate any rights the Borrower may
have, except for liens in the Bank's favor and the
existing liens in favor of Sunrise Leasing Corporation,
Sunrise Financial Resources, Inc., and Citicorp Dealer
Finance, or liens in favor of a subordinate lender that
are subordinate to the liens of the Lender.

(b) Borrow any money, or sign any promissory note, or permit
any such loan or note to remain outstanding, in an
amount exceeding $50,000 in the aggregate in any fiscal
year, except for loans from the Bank and notes to the
Bank, and indebtedness secured by liens permitted under
7(a) above.
<PAGE>

(d) Sell any of the Borrower's assets except in the ordinary
course of business.

(e) Consolidate or merge with any other corporation or
partnership.

(f) Engage in any line of business substantially different
from the Borrower's current business.

(g) Make or keep outstanding loans or advances to any of the
Borrower's officers, shareholders or employees over
$5,000 in each case, and except as in effect on the date
of this Agreement.

(h) Pay any cash dividends or shareholder distributions, or
redeem any stock for cash in any fiscal year.

(i) Make any investments or loans other than investments in
bank accounts or certificates and federal government
securities of a maturity of one year or less.

(j) Spend more than (i) $1,200,000 in cash plus that portion
of any amount of additional equity or Subordinated Debt
raised in excess of $1,000,000 from January 1, 1997
through December 31, 1997 (less the amount required to
be paid to the Bank under paragraph 8 below), and (ii)
$400,000 in cash plus any amount of additional equity or
Subordinated Debt raised during any fiscal year
thereafter, for capital expenditures; provided that the
Borrower will not spend more than $25,000 of such
expenditures in any fiscal year for new equipment
located in, or to be located in, Mexico (although the
Borrower may send used or refurbished equipment to its
Mexican subsidiary up to an aggregate value of $100,000
per fiscal year). For purposes of this covenant capital
expenditures shall mean the change during the period of
determination in the Borrower's gross fixed assets as
reflected on its financial statements, including the
inventory reclassification category.

8. MANDATORY PREPAYMENTS. If at any time after the date of this
Agreement through December 31, 1997, the Borrower raises capital
through Subordinated Debt, 30% of the proceeds received by the
Borrower on account of such Subordinated Debt shall immediately
be paid to the Bank for reduction of principal on the
indebtedness under the Term Note as set forth in this Agreement.
<PAGE>

9. RIGHT TO CHARGE CHECKING ACCOUNT. The Borrower authorizes the
Bank to charge the Borrower's checking account with the Bank for
any amounts due on the Term Note.

10. EVENTS OF DEFAULT; REMEDIES.

A. The occurrence of any one or more of the following
events shall constitute an Event of Default:

(1) The Borrower shall fail to make when due (whether
by acceleration or otherwise) or within 5 days
thereafter, any payment of principal of or
interest on the Term Note, or any other
obligations of the Borrower to the Bank pursuant
to this Agreement.

(2) Any representation or warranty made by or on
behalf of the Borrower in this Agreement or by or
on behalf of the Borrower in any certificate,
statement, report or document herewith or
hereafter furnished to the Bank pursuant to this
Agreement shall prove to have been false or
misleading in any material respect on the date as
of which the facts set forth are stated or
certified.

(3) The Borrower shall fail to comply with any
agreement, covenant, condition, provision or term
contained in this Agreement (except for those set
forth in subsections (1) and (2) above) and such
failure to comply shall continue for twenty
calendar days.

(4) The Borrower shall generally not pay its debts as
they mature or shall apply for, shall consent to,
or shall acquiesce in the appointment of a
custodian, trustee or receiver of the Borrower or
for a substantial part of its property, in the
absence of such application, consent or
acquiescence, a custodian, trustee or receiver
shall be appointed for the Borrower or for a
substantial part of its property and shall not be
discharged within 45 days, or the Borrower shall
make an assignment for the benefit of creditors.

(5) Any bankruptcy, reorganization, debt arrangement
or other proceedings under any bankruptcy or
insolvency law shall be instituted by or against
the Borrower and, if instituted against the
Borrower, shall have been consented to or
acquiesced in by the Borrower or shall remain
undismissed for 45 days, or an order for relief
shall have been entered against the Borrower.

(6) Any dissolution or liquidation proceeding shall be
instituted by or against the Borrower and, if
instituted against the Borrower shall

<PAGE>

be consented to or acquiesced in by the Borrower
or shall remain undismissed for 45 days.

(7) The audited Financial Statements furnished to the
Bank pursuant to Section 5(a) of this Agreement
for the period ended December 31, 1996, shall
prove to be materially worse than the year-end
financial statements prepared by the Borrower and
furnished to the Bank.

(8) A judgment or judgments for the payment of money
in excess of the sum of $75,000 in the aggregate
shall be rendered against the Borrower and the
Borrower shall not discharge the same or provide
for its discharge in accordance with its terms, or
procure a stay of execution thereof, prior to any
execution on such judgment by such judgment
creditor, within 45 days from the date of entry
thereof, and within said period of 45 days, or
such longer period during which execution of such
judgment shall be stayed, appeal therefrom and
cause the execution thereof to be stayed during
such appeal.

(9) The maturity of any indebtedness of the Borrower,
other than indebtedness under this Agreement to
the Bank shall be accelerated, or the Borrower
shall fail to pay any such indebtedness when due
(after the lapse of any applicable grace period)
or any event shall occur or condition shall exist
and shall continue for more than the period of
grace, if any, applicable thereto and shall have
the effect of causing, or permitting the holder of
any such indebtedness to cause, such indebtedness
to become due prior to its stated maturity or to
realize upon any collateral given as security
therefor.

(10) Any execution or attachment shall be issued
whereby any substantial part of the property of
the Borrower shall be taken or attempted to be
taken and the same shall not have been vacated or
stayed within 30 days after the issuance thereof.

(11) The occurrence of an Event of Default under the
Term Note or under any other agreement between the
Borrower and the Bank.

B. If (i) any Event of Default described in Sections 10A
(4), (5) or (6) shall occur with respect to the
Borrower, all other obligations of the Borrower to the
Bank under this Agreement and the Term Note shall
automatically become immediately due and payable, or
(ii) any other Event of Default shall occur and be
continuing, then the Bank may declare the Term Note and
all other obligations of the Borrower to the Bank under
this Agreement to be forthwith due and payable,
whereupon the same shall

<PAGE>

immediately become due and payable, in each case without
presentment, demand, protest or other notice of any
kind, all of which are hereby expressly waived, anything
in this Agreement or in the Term Note to the contrary
notwithstanding, and enforce all rights and remedies
under any applicable law.

11. EXPENSES. The Borrower agrees to pay on demand all of the costs
and expenses incurred by the Bank in connection with any audits
and the negotiation, preparation, execution, perfection,
administration, amendment, and enforcement of this Agreement and
the other Loan Documents, including reasonable attorneys' fees
and expenses for lawyers employed by the Bank or the Bank's
affiliates.

12. MISCELLANEOUS.
(a) If the Bank does not exercise a right it has against the
Borrower, or if the Bank delays in exercising a right,
that does not mean that the Bank gives up that right.

(b) No Loan Document can be changed unless the Bank signs a
written amendment.

(d) Any notice or other communication to any party in
connection with this Agreement shall be in writing and
shall be sent by manual delivery, telegram, telex,
facsimile transmission, overnight courier or United
States mail (postage prepaid) addressed to such party at
the address specified on the signature page hereof, or
at such other address as such party shall have specified
to the other party hereto in writing. All periods of
notice shall be measured from the date of delivery
thereof if manually delivered, from the date of sending
thereof if sent by telegram, telex or facsimile
transmission, from the first business day after the date
of sending if sent by overnight courier, or from two
days after the date of mailing if mailed.

e) The Bank may assign this Agreement to any successor bank
or any affiliate. This Agreement will be enforceable
against the Borrower and the Borrower's successors.

13. WAIVER. Upon execution of this Agreement and compliance by the
Borrower with all conditions set forth in paragraph 2, the Bank
waives the Events of Default that occurred under the Prior Letter
Agreement due to the Borrower's failure to comply with the
provisions of the financial covenants set forth therein in
<PAGE>

paragraphs 7(f), 7(h), 7(i) and 7(j) for all periods ended prior
to execution of this Agreement and waives compliance with the
provisions of paragraph 6(k) of this Agreement from the execution
of this Agreement until March 1, 1997. Such waivers are
limited to the terms hereof and to the periods so specified and
do not extend to any other Events of Default or any other
periods.

Please indicate your acceptance of this Agreement by signing the enclosed copy
of this letter and returning it to the undersigned.

Very truly yours,

FIRST BANK NATIONAL ASSOCIATION

By /S/ FREDERICK H. LADNER
-------------------------------
Its Vice President
-------------------------------

Accepted and agreed to this 17th day
of February, 1997 .

HARMONY BROOK, INC.

By /s/ James C. Hawley
------------------------------
Its President
------------------------------

<PAGE>

Exhibit A

TERM NOTE

$2,571,902.00 February 18, 1997

FOR VALUE RECEIVED, HARMONY BROOK, INC. (the "Borrower") hereby promises to pay
to the order of FIRST BANK NATIONAL ASSOCIATION (the "Lender") the principal sum
of TWO MILLION FIVE HUNDRED SEVENTY-ONE THOUSAND NINE HUNDRED TWO AND NO/100
DOLLARS ($2,571,902.00) together with interest (calculated on the basis of
actual days elapsed and a year of 360 days) on the unpaid principal balance
hereof at the rate or rates set forth below. Payments will be made to the
Lender at its office at Edina, Minnesota or at such other place as the Lender
may from time to time hereafter designate to the Borrower in writing in
immediately available, lawful money of the United States of America.

INTEREST RATE

The unpaid principal balance hereof from time to time outstanding shall bear
interest at a floating rate per annum equal to the sum of the "Reference Rate"
of the Lender plus 3.75% PROVIDED, HOWEVER, that in the event that Borrower's
net income from operations as of any fiscal year end (as reported in Borrower's
annual certified financial statements as required by Section 5(a) of the Loan
Agreement (defined below)) is at least $0, and there are no outstanding Events
of Default, then the interest rate per annum shall be the Reference Rate plus
3.25% from and after the first day of the first calendar month following the
date of Lender's receipt of the certified audit report, but in any event not
sooner than March 1, 1998 and shall continue at the Reference Rate plus 3.25% as
long as Borrower's net income from operations as of any subsequent fiscal year
end (as report in Borrower's annual certified financial statement, as required
by Section 5(a) of the Loan Agreement (defined below)) remains at least $0. In
the event of any changes in the Reference Rate, the rate applicable hereto shall
change effective as of such change in the Reference Rate. The Reference Rate is
the rate publicly announced by the Lender from time to time as its Reference
Rate; the Lender may lend to its customers at rates that are at, above or below
the Reference Rate.

Upon the occurrence and during the continuation of any Event of Default the
outstanding principal hereunder shall bear interest at a rate per annum equal to
the rate of interest otherwise applicable thereto, plus 2.0%.

REPAYMENT

The principal hereof is payable in consecutive monthly installments of $37,865
each on the first day of each month, commencing March 1, 1997 through January 1,
2000 and one final payment on February 1, 2000 in the amount of the entire
remaining principal balance.

<PAGE>

Interest hereon shall be payable in arrears on the same days as principal is
payable.

This Note may be prepaid by the Borrower at any time in whole or from time to
time in part (in minimum partial payments of at least $10,000) without premium
or penalty. Any partial prepayment shall be applied first against accrued and
unpaid interest and the balance shall be applied against the installments hereon
in the inverse order of maturity.

BORROWER ACCOUNT; PAYMENT DATES

The Lender is authorized to charge any account maintained by the Borrower with
the Lender for payment of any amount owing on this Note when due. Whenever any
payment to be made on this Note shall be stated to be due on a Saturday, Sunday
or legal holiday, such payment shall be made on the next succeeding business day
and such extension of time, in the case of a payment of principal, shall be
included in the computation of any interest on such principal payment.

OTHER AGREEMENTS

This Note is issued pursuant to an Second Amended and Restated Letter Loan
Agreement of even date herewith (as the same may hereafter be amended, modified
or supplemented, or any agreement entered into in substitution or replacement
thereof, the "Loan Agreement") between the Borrower and the Lender and is
secured pursuant to documents described in the Loan Agreement (as the same may
hereafter be amended, modified or supplemented, or any agreement entered into in
substitution or replacement therefor, the "Security Documents") given by the
Borrower to the Lender. The Note is issued in substitution and replacement, but
not in payment, of certain notes as described in the Loan Agreement.

EVENTS OF DEFAULT; REMEDIES OF LENDER

The occurrence of any one or more of the following events shall constitute an
Event of Default, and upon the occurrence of any Event of Default the Lender may
declare this Note to be, and the same shall forthwith become, immediately due
and payable and the Lender may exercise all rights and remedies under the Loan
Agreement and the Security Documents and as may otherwise be allowed by law:

(a) The Borrower shall fail to make any payment of principal or interest
hereon when due and such failure shall continue for 5 days after the due
date thereof.

(b) The Borrower shall fail to comply with any other term of this Note .

c) The Borrower shall submit to Lender any credit application, financial
statement or other written information which shall prove to be incorrect in
any material respect when made, or the Borrower shall fail to provide
financial statements upon request or as otherwise required.
<PAGE>

d) Any default or Event of Default shall occur under the Loan Agreement or
any of the Security Documents and shall continue beyond the period of
grace, if any, applicable thereto.

If any Event of Default occurs the Borrower agrees to pay all costs of
collection, including attorneys' fees, and the Lender shall have the right to
set off any indebtedness of the Lender to the Borrower against the indebtedness
on this Note.

OTHER TERMS

This Note cannot be amended or modified, or any provisions hereof waived, except
pursuant to a writing signed by the Lender. The Lender does not, by failing to
exercise or delaying in exercising any right against the Borrower give up that
right. The Lender has no obligation to renew or extend this Note. If part of
this Note is unenforceable, the rest of it will still be enforceable. The
Lender may assign this Note or grant participations herein at any time without
the Borrower's consent and share information about the Borrower in connection
therewith.

THE VALIDITY, CONSTRUCTION AND ENFORCEABILITY OF THIS NOTE SHALL BE GOVERNED BY
THE INTERNAL LAWS OF THE STATE OF MINNESOTA, WITHOUT GIVING EFFECT TO CONFLICT
OF LAWS PRINCIPLES THEREOF BUT GIVING EFFECT TO FEDERAL LAWS OF THE UNITED
STATES APPLICABLE TO NATIONAL BANKS.

AT THE OPTION OF THE LENDER THIS NOTE MAY BE ENFORCED IN ANY FEDERAL COURT OR
MINNESOTA STATE COURT SITTING IN HENNEPIN COUNTY, MINNESOTA; AND THE BORROWER
CONSENTS TO THE JURISDICTION AND VENUE OF ANY SUCH COURT AND WAIVES ANY ARGUMENT
THAT THE VENUE IN SUCH FORUMS IS NOT CONVENIENT. IF THE BORROWER COMMENCES ANY
ACTION IN ANOTHER JURISDICTION OR VENUE UNDER ANY TORT OR CONTRACT THEORY
ARISING DIRECTLY OR INDIRECTLY FROM THE RELATIONSHIP CREATED BY THIS NOTE, THE
LENDER AT ITS OPTION SHALL BE ENTITLED TO HAVE THE CASE TRANSFERRED TO ONE OF
THE JURISDICTIONS AND VENUES ABOVE-DESCRIBED, OR, IF SUCH TRANSFER CANNOT BE
ACCOMPLISHED UNDER APPLICABLE LAW, TO HAVE SUCH CASE DISMISSED WITHOUT
PREJUDICE.

EACH OF THE BORROWER AND THE LENDER, BY ITS ACCEPTANCE OF THIS NOTE, IRREVOCABLY
WAIVES ANY AND ALL RIGHT TO TRIAL BY JURY IN ANY LEGAL PROCEEDING ARISING OUT OF
OR RELATING TO THIS NOTE OR THE TRANSACTIONS CONTEMPLATED HEREBY.

<PAGE>

The Borrower hereby waives presentment for payment, notice of dishonor, protest
and notice of protest.

HARMONY BROOK, INC.

By Exhibit Copy
----------------------
Title
----------------------

<PAGE>
Exhibit B
COMPLIANCE CERTIFICATE

This certificate is signed on ______________, 199__. The figures on this
certificate were determined as of _________, 199__.

This certificate is delivered under a loan agreement dated February ______,
1997, between First Bank National Association and the Company named below.

I certify that the following amounts were correctly determined according to
the loan agreement.

Covenants: Required Actual
-------- ------

Capital Base
through 3-1-97 $7,000,000
thereafter $7,500,000

Current Ratio-minimum 0.75:1.0

Net Loss (FYE 12/31/97)-max $350,000
Net Income (FYE 12/31/98)-min $100,000
and thereafter-minimum $250,000

Coverage Ratio
(annual only, beginning with
FYE 12/31/96) 1.05:1.0

CAPEX
Max 1-1-97 through 12-31-97 $1,200,000
each fiscal year thereafter $400,000
(limitation of $25,000 per fiscal
year expended for new equipment
for Mexican subsidiary and $100,000
for used or refurbished equipment
transferred to the Mexican
subsidiary.) Limit increased by (a)
Sub Debt in excess of $1,000,000 raised
in 1997 (exclusive of amount
that must be paid to Bank),
and (b) Sub Debt raised thereafter.

<PAGE>

Required Actual
-------- ------
Cash balance on Deposit with
Bank-minimum $150,000

HARMONY BROOK, INC.

By
---------------------------
Its
-----------------------

<PAGE>
EXHIBIT 13

CONTENTS

LETTER TO SHAREHOLDERS . . . . . . . . . . . . . . . . . . . . . . . . 1A
BUSINESS DESCRIPTION &
CORPORATE INFORMATION . . . . . . . . . . . . . . . . . . . . . . .3
MANAGEMENT'S DISCUSSION AND ANALYSIS . . . . . . . . . . . . . . . . . .8
REPORT OF INDEPENDENT ACCOUNTANTS. . . . . . . . . . . . . . . . . . . 17
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . 18
NOTES TO FINANCIAL STATEMENTS. . . . . . . . . . . . . . . . . . . . . 22
1996 FACTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3A
CORPORATE & INVESTOR INFORMATION . . . . . . . . . . . . . . . . . . . 4A
WATER PROCESS DIAGRAM &
MISSION STATEMENT . . . . . . . . . . . . . . . . .INSIDE BACK COVER

FINANCIAL HIGHLIGHTS
SUMMARY FINANCIAL INFORMATION
<TABLE>
<CAPTION>

IN THOUSANDS EXCEPT AMOUNTS PER SHARE
FOR YEARS ENDED DECEMBER 31 1996 1995 1995 TO 1996 % CHANGE
- -----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
TOTAL REVENUES $8,316 $7,175 16%

OPERATING INCOME (LOSS) 150 (734) NM

NET LOSS (481) (1,400) (66)%

NET LOSS PER SHARE (0.06) (0.26) (77)%

TOTAL ASSETS 11,927 12,953 (8)%

TOTAL SHAREHOLDERS' EQUITY 6,925 7,218 (4)%
- ---------------------------------------------------------------------------------------------------------
AVERAGE SHARES OUTSTANDING 7,982 5,377 48%

NM-NOT MEANINGFUL
</TABLE>

TOTAL REVENUES
BY SOURCE $ IN MILLIONS

92 2.22
93 3.59
94 6.16
95 7.18
96 8.32 (REVENUE SHARING/BOTTLE SALES/EQUIPMENT SALES)

CONSOLIDATED GROSS MARGIN PERCENTAGE
% OF REVENUES

92 46.8
93 44.9
94 48.1
95 52.4
96 53.3

OPERATING INCOME (LOSSES)
$ IN THOUSANDS

92 (820)
93 (608)
94 (329)
95 (734)
96 150

<PAGE>
A LETTER TO OUR SHAREHOLDERS

Harmony Brook attained some important milestones in 1996. We reported our first
ever net income for a quarter in the third quarter. For the first time since
Harmony Brook was founded in 1989, we were able to show operating income for the
year rather than an operating loss. And also for the first time, we reduced our
debt balance instead of adding to it.
While Harmony Brook has not yet achieved net income for a full year, we
made significant progress in that direction with a 66 percent reduction in net
loss in 1996 compared to 1995. Another way to look at this is that approximately
80 cents of every dollar of increased revenues dropped through to the bottom
line - with the top line improved by 16 percent or $1.141 million and the bottom
line improved by $919,000.
Cash flows from operating activities in 1996 swung to a positive $1.2
million from a negative $250,000 in 1995. One key measure of a company's
performance used by banks and other financial institutions is EBITDA, or
earnings before interest, taxes, depreciation and amortization. That figure for
Harmony Brook in 1996 was a little more than $1.5 million, an increase of $1
million over the previous year.

TRANSITIONAL PERIOD CONTINUES. In last year's annual report, we made the
statement that Harmony Brook was in the midst of transition as it launched into
1996. Prior to 1995, the company's revenues had been growing at a rate well in
excess of 40 percent, driven by expansion into new territories and the
manufacture and installation of new water dispensing systems. Expansion was both
people and capital intensive. The lure was - and is - demand. Consumers want
good-tasting water at a reasonable price, and retailers are attracted by the
high dollar volume per square foot of floor space our systems generate.
But the time had come to reorient Harmony Brook to a philosophy of growth
within our means. Beginning in 1995 and continuing throughout 1996, we have
placed emphasis on strengthening core territories while serving our existing
customer base, and on the attainment of operating profitability and positive
cash flow from operations. A transitional phase such as this is not unlike a
decision to slow the rate of ascent on a long, uphill climb, to regain resources
and get in position to prudently resume the steeper course. For Harmony Brook,
this phase has been successful so far in terms of meeting our objectives, and it
is a phase that is not yet complete.
RECENT REVENUES GROWTH RATE AVERAGES 16 PERCENT. The 16 percent increase in
revenues in 1996 followed a similar increase of 17 percent in 1995. The compound
average growth rate in revenues for the last five years was 43 percent. While
revenue growth has deliberately been slowed, it is still aggressive: market
research data indicate that sales of bottled water in U.S. supermarkets
increased between seven and eight percent in 1995.
Our core business, contracted revenue sharing, which is the portion of our
revenues based on water dispensed from our systems installed in retail outlets,
increased 20 percent in 1996. The total number of our drinking water systems
installed increased a net four percent.
The increase in the U.S. for contracted revenue sharing was 17 percent. The
number of systems installed in the U.S. at the end of the year was 1,574
compared to 1,528 at the end of 1995. In addition to new systems installed, 207
systems were redeployed. Gallons of water dispensed from systems installed in
the U.S. for more than one year increased 12 percent, while revenues from these
same installations grew seven percent. The difference between volume growth and
revenue growth from these installations was due in part to our volume-based
pricing scale, but it was also due to an increasingly competitive environment.
Activity in the U.S. reflects the current strategy to build Harmony Brook's
presence in established territories. We eliminated two full-time routes in 1996,
one on each coast, and replaced them with just one full-time and one part-time
route in the Midwest.
Sales of bottles increased eight percent in 1996. We continue to be
encouraged by sales through our own field organization, which grew ten percent,
but have been disappointed with our ability to rebuild wholesale sales after the
loss of a major customer early in 1995 due to that customer's insolvency.
The bottle business, which Harmony Brook acquired in 1994, effectively
complements our core water dispensing business, and fits well as part of our
emphasis on strengthening
territories and serving existing
customers.

INSTALLED CUSTOMER LOCATIONS AT YEAR-END

92 685
93 1,010
94 1,407
95 1,613
96 1,681

1A
<PAGE>

REVENUES
PER EMPLOYEE
$ IN THOUSANDS

92 61
93 65
94 89
95 91
96 98

NET LOSS IS REDUCED SUBSTANTIALLY. The net loss for 1996 was $481,000 or $0.06
per share. In 1995, the net loss was $1,400,000 or $0.26 per share - including
one-time and special charges that totaled $316,000. On an ongoing basis, the
year to year bottom line improvement therefore amounted to $603,000.
As a result of a slightly improved gross margin percentage and tight
control of selling, general and administrative (SG&A) expenses, Harmony Brook
enjoyed its first year ever of operating income, which amounted to $150,000.
This compares to an operating loss in 1995 of $734,000 - or $418,000 on an
ongoing basis. We added just $100,000 to SG&A, an increase of three percent on a
16 percent revenue increase, primarily for added customer service support.
Other expense, which is almost entirely interest expense, prevented us from
reporting net income for the year. It was at a level comparable to a year ago:
$631,000 in 1996 versus $666,000 in 1995. Interest expense in the fourth quarter
was $151,000 or an annualized rate around $600,000, an indication that this
expense is coming down as the company addresses management of its debt balance.
OPERATIONS OF MEXICAN SUBSIDIARY ARE PROFITABLE. The operations of our
subsidiary in Mexico were profitable for the year despite that country's
challenging economic environment. The subsidiary, established in 1994, began
reporting monthly operating profits in the fourth quarter of 1995. Revenues in
Mexico increased 68 percent and accounted for six percent of consolidated
revenues. At the end of the year 107 systems were installed in Mexico compared
with 85 systems at the end of 1995.
THERE ARE SIGNS OF FINANCIAL PROGRESS. With the improvement in the bottom
line, combined with a continuing rise in depreciation and amortization, Harmony
Brook's operations generated cash this year rather than using it. The trend for
depreciation and amortization is noteworthy: these items totaled $1.5 million
in 1996, $1.3 million in 1995 and $1 million in 1994.
Capital expenditures in 1996 amounted to $1.4 million compared to $2.1
million in 1995. We built 77 new systems during the year and refurbished 111
systems. While refurbishment costs were for the most part capitalized, more than
$100,000 of such costs were expensed and included in cost of sales.
The company reduced its debt balance by $900,000 to $4 million. The second
phase of an equity financing begun in 1995 was completed in the first quarter of
1996, with net proceeds of $230,000.
No other financings were done in 1996. In February 1997, the company closed
on the first phase of a private placement of subordinated debt, with proceeds to
be used to reduce outstanding debt with our principal lenders and for capital
expenditure needs in 1997. Combined cash already received and firm commitments
for this private placement total $1.0 million. The company's principal bank
lender, in conjunction with this transaction, agreed to certain restructurings
and extensions of its loans to the company. All of this is explained in more
detail in the "Management's Discussion and Analysis of Financial Condition and
Results of Operations" section of the accompanying annual report on Form 10-KSB.
The effect is to provide additional capital and reduce the portion of long term
debt that is current or would soon become current. And it is an indication that
new and old financing "stakeholders" in Harmony Brook look favorably on the
company's recent performance and its strategy.
CURRENT STRATEGY IS MAINTAINED, OBJECTIVES MET. Thanks to the efforts and
dedication of Harmony Brook's employees, the company stayed on its current
strategic course and attained its key objectives in 1996. They deserve
recognition for a successful year. Tempering this positive assessment of
operating performance was the disappointment of the performance of the company's
stock, which declined 36 percent in value from December 31, 1995, to December
31, 1996. As we move ahead into 1997, we remain convinced our strategy is valid
- - that it can lead to a company able to finance its growth with cash flows from
operations and reward its shareholders accordingly. Underlying this is the
certainty that demand for good-tasting water is not going to diminish. Harmony
Brook is grateful to its shareholders for their continued support and patience.

JAMES C. HAWLEY
PRESIDENT AND CHIEF
EXECUTIVE OFFICER

DONALD R. BRATTAIN
CHAIRMAN

2A
<PAGE>

1996 FACTS

GALLONS OF WATER PROCESSED IN 1996: UNITED STATES MEXICO TOTAL
------------- ----------- -------------
<S> <C> <C> <C>
Retail Through Dispenser 25,854,397 1,846,147 27,700,544
In-Store Water Usage* 27,841,705 1,085,875 28,927,580
------------- ------------ ------------
Total Gallons 53,696,102 2,932,022 56,628,124

STORES WITH IN-STORE WATER USAGE* 766 85 851

UNITED STATES ONLY DATA:

CONTRACT REVENUE SHARING:
Average Revenue Sharing of Ten Largest Locations in 1996 $ 20,834
Average Revenue Sharing per Location in 1996 $ 3,588
Average Revenue Sharing per Location in 1995 $ 3,386

NUMBER OF REUSABLE CONTAINERS SOLD IN 1996 1,075,000

UNITED STATES REVENUES PER U.S. EMPLOYEE IN 1996 $ 116,800

NUMBER OF COMPANY-OWNED & OPERATED ROUTES (FULL-TIME EQUIVALENT):
December 31, 1996 29
December 31, 1995 29
AVERAGE NUMBER OF LOCATIONS PER ROUTE:
December 31, 1996 44
December 31, 1995 45
NUMBER OF COMMISSIONED SERVICE DISTRIBUTORS (SERVICING HARMONY BROOK
OWNED UNITS):
December 31, 1996 11
December 31, 1995 9
LOCATIONS SERVICED BY COMMISSIONED SERVICE DISTRIBUTORS:
December 31, 1996 252
December 31, 1995 231

NEW INSTALLATIONS: NEW LOCATIONS RELOCATIONS ACQUIRED LOCATIONS
------------- ----------- ------------------
1996 253 207 --
1995 222 80 49
</TABLE>

* Certain customers will request the Harmony Brook system be connected to areas
of the store such as the bakery and produce sections.

Harmony Brook charges the customers for this in-store usage based on the
particular store's water consumption.

HARMONY BROOK 1996 YEAR-END COVERAGE
(U.S. POSTAL ZIP CODES WITH CUSTOMER)

[MAP]
3A
<PAGE>

<TABLE>

<S> <C>
CORPORATE OFFICERS CORPORATE COUNSEL

JAMES C. HAWLEY Henson & Efron, P.A.
President and Chief Executive Officer 1200 Title Insurance Bldg.
400 Second Avenue South
PAULA M. NELSON Minneapolis, Minnesota 55401
Vice President of Sales
INDEPENDENT ACCOUNTANTS
NANCY A. QUAM
Corporate Secretary Coopers & Lybrand L.L.P.
650 Third Avenue South
DIRECTORS Minneapolis, Minnesota 55402

DONALD R. BRATTAIN TRANSFER AGENT
Chairman of the Board of the Company
President, Brattain and Associates, LLC., Norwest Bank Minnesota, N.A.
a management investment company P.O. Box 738
161 North Concord Exchange
WILLIAM R. GRIFFIN South St. Paul, Minnesota 55075
Former President and Chief Executive Officer
of Roto Rooter, Inc., a plumbing, drain For interim reports contact Investor
cleaning and appliance repair service company Relations at (612) 681-9000

JAMES C. HAWLEY Annual Meeting will be held at
President and Chief Executive Officer The Marquette, Minneapolis, on
of the Company Thursday, April 24, 1997 at 3:30 pm

DAVID A. HENDERSON
Managing General Partner of Founding
Partners and Founding Partners II, business
development companies and venture capital funds

BILL G. JOHNSON
President of Johnson Enterprises, a supplier to
the grocery industry

BURTON J. MCGLYNN
Chairman of the Board of McGlynn Bakeries,
Inc., a retail bakery company

GORDON F. STOFER
Managing General Partner of Cherry Tree
Investment Company, a venture capital
investment company

</TABLE>

4A
<PAGE>

THE HARMONY BROOK PROCESS

THE HARMONY BROOK WATER TREATMENT PROCESS
is not patented. Nevertheless, it is state-of-the-art in terms of materials,
chemistry and engineering. Local municipal water is treated as follows:
- Micron filtration removes small particles (sediment).
- Activated carbon removes or reduces chlorine and other chemical
compounds that affect taste or odor.
- Reverse osmosis removes or reduces salts, heavy metals, or dissolved
minerals.
- Very fine micron filtration acts as a barrier to cysts or other
particles as small as one micron in diameter.
- Ultraviolet light kills or neutralizes bacteria.

Consumers recognize Harmony Brook water as an outstanding value. It is
fresh, it tastes good and the price is always attractive. Since it is processed
as vended, it is fresher than bottled water, whether bought in a store or
delivered. Water purification systems or faucet attachments installed in the
home need to be maintained, and many do not provide all the steps that are part
of the Harmony Brook treatment system.
For retailers, a Harmony Brook system can deliver one of the highest dollar
volumes per square foot of floor space. The system does not have the inventory
carrying costs of bottled water. There is minimal capital outlay, since Harmony
Brook owns the system. Harmony Brook competes with other providers of water
vending equipment based on its state-of-the-art treatment process; the safety
and ease of use of its design; its service standards and knowledge of federal,
state and local regulations; its marketing support; and fairness of its price.

MISSION STATEMENT

HARMONY BROOK, INC. IS DEDICATED TO BE THE LEADER IN THE SELF-SERVE PREMIUM
DRINKING WATER INDUSTRY BY PROVIDING SUPERIOR PRODUCTS AT AFFORDABLE PRICES.

WE WILL GROW OUR BUSINESS THROUGH:
- HONESTY AND INTEGRITY IN COMMUNICATION
AND PERFORMANCE.
- BOUNDLESS DEDICATION TO CUSTOMER SERVICE.
- INNOVATIVE APPROACHES TO EQUIPMENT DESIGN
AND OPERATIONS.

AS WE BUILD OUR BUSINESS WE WILL CONTINUOUSLY REMEMBER THAT OUR SHAREHOLDERS
HAVE INVESTED IN US AND ARE ENTITLED TO A FAIR RETURN.

<PAGE>

HARMONY BROOK, INC. CORPORATE OFFICE
1030 Lone Oak Road, Suite 110
Eagan, Minnesota 55121
tel: 612.681.9000

HARMONY BROOK DE MEXICO, S.A. DE C.V.
Bolivard Adolfo Ruiz Cortinez, #5415
Periferico Sur, Col. Isidro Favela, 14030
D.F., Mexico
tel: 011.525.666.2420

<PAGE>
EXHIBIT 24

HARMONY BROOK, INC.
POWER OF ATTORNEY
KNOW ALL THESE MEN BY THESE PRESENTS, that the undersigned director of
Harmony Brook, Inc., a Minnesota corporation, does hereby make, constitute and
appoint James C. Hawley and Donald R. Brattain, and each or any of them, his
true and lawful attorneys-in-fact, with full power of substitution, for him and
in his name, place and stead to sign and affix his name as director of said
Corporation to the Annual Report of the Corporation on Form 10-KSB for the
fiscal year ended December 31, 1996, to be filed by said Corporation with the
Securities and Exchange Commission, Washington, D.C. within the next sixty (60)
days and to file the same, with all exhibits thereto and other supporting
documents, said Commission, granting unto such attorneys-in-fact, and each of
them, full power and authority to do and perform any and all acts necessary or
incidental to the performance and execution of the powers herein expressly
granted.

IN WITNESS WHEREOF, the undersigned has hereunder set his hand this 21 day
of February, 1997.

/s/ Donald R. Brattain
-------------------------
Donald R. Brattain, Director

<PAGE>
EXHIBIT 24

HARMONY BROOK, INC.
POWER OF ATTORNEY

KNOW ALL THESE MEN BY THESE PRESENTS, that the undersigned director of
Harmony Brook, Inc., a Minnesota corporation, does hereby make, constitute and
appoint James C. Hawley and Donald R. Brattain, and each or any of them, his
true and lawful attorneys-in-fact, with full power of substitution, for him and
in his name, place and stead to sign and affix his name as director of said
Corporation to the Annual Report of the Corporation on Form 10-KSB for the
fiscal year ended December 31, 1996, to be filed by said Corporation with the
Securities and Exchange Commission, Washington, D.C. within the next sixty (60)
days and to file the same, with all exhibits thereto and other supporting
documents, said Commission, granting unto such attorneys-in-fact, and each of
them, full power and authority to do and perform any and all acts necessary or
incidental to the performance and execution of the powers herein expressly
granted.

IN WITNESS WHEREOF, the undersigned has hereunder set his hand this 21 day
of February, 1997.

/s/ David Henderson
-------------------------
David Henderson, Director
<PAGE>
EXHIBIT 24

HARMONY BROOK, INC.
POWER OF ATTORNEY

IN WITNESS WHEREOF, the undersigned has hereunder set his hand this 21 day
of February, 1997.

/s/ Gordon F. Stofer
-----------------------------
Gordon F. Stofer, Director

<PAGE>
EXHIBIT 24

HARMONY BROOK, INC.
POWER OF ATTORNEY

IN WITNESS WHEREOF, the undersigned has hereunder set his hand this 21 day
of February, 1997.

/s/ William R. Griffin
-----------------------------
William R. Griffin, Director

<PAGE>
EXHIBIT 24

HARMONY BROOK, INC.
POWER OF ATTORNEY

IN WITNESS WHEREOF, the undersigned has hereunder set his hand this 27th
day of February, 1997.

/s/ Burton J. McGlynn
-----------------------------
Burton J. McGlynn, Director

<PAGE>
EXHIBIT 24

HARMONY BROOK, INC.
POWER OF ATTORNEY

IN WITNESS WHEREOF, the undersigned has hereunder set his hand this 28th
day of February, 1997.

/s/ Bill G. Johnson
-----------------------------
Bill G. Johnson, Director

<PAGE>
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