HENLEY HEALTHCARE INC, 10KSB40/A, 1999-01-28

HENLEY HEALTHCARE INC
10KSB40/A, 1999-01-28
SURGICAL & MEDICAL INSTRUMENTS & APPARATUS

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-KSB/A-2

---------

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the Fiscal Year ended December 31, 1997

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

Commission File Number 0-28566

HENLEY HEALTHCARE, INC.
(Name of small business issuer in its charter)

TEXAS 76-0335587
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

120 INDUSTRIAL BOULEVARD, SUGAR LAND, TEXAS 77478-3128
(Address of principal executive offices) (Zip code)

Issuer's telephone number: 281-276-7000

Securities registered under Section 12(g) of the Exchange Act:

COMMON STOCK, $.01 PAR VALUE
(Title of Class)

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

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

The issuer's revenues for its most recent fiscal year are $24,257,014.

The aggregate market value of voting stock held by non-affiliates of
the registrant on March 25, 1998, based upon the average bid and ask price as
reported on the Nasdaq SmallCap Market, was $23,259,534. The number of shares of
the issuer's common stock, $.01 par value, outstanding as of March 25, 1998 was
5,383,205.

Documents incorporated by reference: None.

Transitional Small Business Disclosure Format (check one):
Yes [ ] No [x]
<PAGE>
THIS REPORT INCLUDES "FORWARD LOOKING STATEMENTS" WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. ALL STATEMENTS OTHER THAN
STATEMENTS OF HISTORICAL FACT INCLUDED IN THIS REPORT ARE FORWARD LOOKING
STATEMENTS. SUCH FORWARD LOOKING STATEMENTS INCLUDE, WITHOUT LIMITATION,
STATEMENTS UNDER (A) "BUSINESS" REGARDING THE COMPANY'S EXPECTATIONS FOR FUTURE
PRODUCT DEVELOPMENT AND RELATED EXPENDITURES, AND (B) "MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- LIQUIDITY AND
CAPITAL RESOURCES" REGARDING THE COMPANY'S ESTIMATE OF SUFFICIENCY OF EXISTING
CAPITAL RESOURCES AND ITS ABILITY TO RAISE ADDITIONAL CAPITAL TO FUND CASH
REQUIREMENTS FOR FUTURE OPERATIONS AND ACQUISITIONS. ALTHOUGH THE COMPANY
BELIEVES THE EXPECTATIONS REFLECTED IN SUCH FORWARD LOOKING STATEMENTS ARE
REASONABLE, IT CAN GIVE NO ASSURANCE THAT SUCH EXPECTATIONS REFLECTED IN SUCH
FORWARD LOOKING STATEMENTS WILL PROVE TO HAVE BEEN CORRECT. THE ABILITY TO
ACHIEVE THE COMPANY'S EXPECTATIONS IS CONTINGENT UPON A NUMBER OF FACTORS WHICH
INCLUDE (I) ONGOING COST OF RESEARCH AND DEVELOPMENT ACTIVITIES, (II) TIMELY
APPROVAL OF THE COMPANY'S PRODUCT CANDIDATES BY APPROPRIATE GOVERNMENTAL AND
REGULATORY AGENCIES, (III) EFFECT OF ANY CURRENT OR FUTURE COMPETITIVE PRODUCTS,
(IV) THE COMPANY'S ABILITY TO MANUFACTURE AND MARKET ITS PRODUCTS COMMERCIALLY,
(V) THE RETENTION OF KEY PERSONNEL AND (VI) CAPITAL MARKET CONDITIONS. THIS
REPORT MAY CONTAIN TRADEMARKS AND SERVICE MARKS OF OTHER COMPANIES.

PART I

ITEM 1. BUSINESS

GENERAL

Henley Healthcare, Inc., formerly Lasermedics, Inc. (the "Company" or
"Henley"), was incorporated in November 1990 as a Texas corporation, and is a
manufacturer, provider and marketer of diversified products and services in the
pain management industry. The Company provides high quality products and
services to healthcare professionals and aims to become an industry leader by
consolidating the otherwise largely-fragmented pain management industry. The
Company has operating units which are categorized by the type of service
provided and type of product manufactured or distributed. The pain management
unit comprises the Clinical, Homecare and MicroLight operations. The Clinical
operations manufacture and market a diversified line of pain management products
used in clinical settings for both physical therapy and rehabilitation as well
as other applications. The Homecare operations manufacture and market products
used for patient care in the home setting. The MicroLight operations are
involved in the development and application of portable, hand-held,
battery-operated, low-energy laser devices used to treat soft tissue. The
training unit, Health Career Learning Systems ("HCLS"), provides training and
safety products and technical support necessary to meet federal Occupational
Safety and Health Act ("OSHA") compliance standards and also coordinates the
training of medical professionals in the use of various other products offered
by the Company.

The Company's long-term strategic objectives are to (i) expand
distribution channels and explore new markets, (ii) consolidate the
highly-fragmented physical therapy and rehabilitation industry by pursuing
strategic acquisitions that complement existing product lines and increase
market share, (iii) maximize the utilization of existing facilities for
increased productivity, (iv) improve profitability, (v) reduce long-term
indebtedness, and (vi) obtain market clearance from the United States Food and
Drug Administration ("FDA") for the MicroLight 830(TM).

ACQUISITIONS

Prior to April 30, 1996, the Company was primarily engaged in the
development and application for marketing clearance of the MicroLight 830(TM).
On April 30, 1996, the Company acquired substantially all of the assets of (and
assumed certain liabilities associated with) the Henley Healthcare Division (the
"Henley Division") of Maxxim Medical, Inc. ("Maxxim") a Delaware corporation, as
more fully described in the Notes to the Financial Statements. This acquisition
provided the Company with an expanded and stable base of products and customers
as well as manufacturing and marketing infrastructure. Beginning with the
acquisition of Maxxim's Henley Division, the Company has pursued a strategy of
consolidating the highly-fragmented physical therapy and rehabilitation
industry. Since that time, the Company has grown significantly as a result of
the acquisitions discussed below.

On November 12, 1996, the Company acquired substantially all of the
assets of MJH Medical Equipment, Inc., a privately-held medical supplies and
equipment distributor, which added distribution channels to the Company's then

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existing marketing outlets. On November 27, 1996, the Company acquired all of
the issued and outstanding common stock of Health Career Learning Systems, Inc.,
("HCLSI"), which provides training and safety products and technical support
necessary to meet OSHA compliance standards. The Company's HCLS training unit
includes the operations of HCLSI, which continues to expand its products and
service offerings to fully integrate all of the Company's training activities.

During 1997, the Company continued to broaden and diversify its
products offering through acquisitions. In January 1997, the Company completed
the acquisitions of (i) all of the issued and outstanding common stock of Texas
T.E.N.S., Inc. ("Tens"), and (ii) the inventory, distribution systems and
customers associated with the Homecare division of Gatti Medical Supply, Inc.
("Gatti"). Both Tens and Gatti are engaged in the marketing and distribution of
medical supplies and devices.

In May 1997, the Company acquired all of the issued and outstanding
shares of common stock of Med-Quip, Inc. ("Medquip"), a privately-owned Georgia
corporation, engaged in the marketing and distribution of physical therapy and
rehabilitation products.

In October 1997, the Company acquired all of the ownership interests in
Summer Medical ("SM"), an unincorporated Florida sole proprietorship engaged in
the marketing and distribution of pain management and rehabilitation products.

In December 1997, the Company acquired all of the issued and
outstanding common stock of NCI, Inc., a Michigan corporation engaged in the
training of medical professionals.

In January 1998, the Company acquired all of the outstanding shares of
common stock of Garvey Company, a Minnesota corporation engaged in the marketing
and distribution of pain management and rehabilitation products.

In February 1998, the Company purchased substantially all of the assets
and assumed certain liabilities associated with AMC Acquisition Corp., a Texas
corporation engaged in the marketing and distribution of durable medical
equipment and devices.

On March 6, 1998, the Company entered into a definitive purchase
agreement with Delft Instruments N.V., an international conglomerate with
headquarters in The Netherlands and key operations in medical, defense,
aerospace, industrial and scientific industries, to acquire its Enraf-Nonius,
B.V. ("Enraf") wholly-owned subsidiary. Enraf specializes in the development,
manufacture and sale of medical products, including ultra-sound and electrical
stimulation, used in pain management, physical therapy and rehabilitation. The
proposed acquisition is subject to various conditions including obtaining
sufficient financing by the Company and approvals of the Boards of Directors of
both companies. However, there can be no assurance that the Company will obtain
the necessary financing for the acquisition or that the acquisition will be
completed under its current terms, if at all.

OPERATIONS

CLINICAL. The Company's Clinical operations market a line of physical
therapy and rehabilitation products, and develop, manufacture, distribute and
market various products and related accessories used for control of acute or
chronic pain delivered by non-invasive methods to facilitate the healing of
wounds. Physical therapy involves the treatment of disabilities or injuries with
therapeutic exercise and the application of various heat, hydrotherapy,
traction, ultrasound or other modalities. The Clinical products are marketed
principally through national and international sales forces consisting of
dedicated sales persons, dealers and sales representatives.

HOMECARE. Henley's Homecare operations market and distribute a variety
of pain management and wound care products that are designed for patient care at
home. The Homecare products include a full range of nerve and muscle
stimulators, portable therapy units as well as drug delivery gels and pads.
Muscle stimulators are portable

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stimulators used to retard disuse atrophy and enhance patient rehabilitation.
Transcutaneous electrical nerve stimulation therapy involves the transmission of
electrical impulses on a localized basis as a treatment for pain. The Homecare
products are marketed principally through the Company's distribution outlet in
Ohio.

MICROLIGHT. The Company's MicroLight operations are engaged in the
development and application of the MicroLight 830(TM) to treat soft tissue. The
Company is currently seeking approval from the FDA to sell the MicroLight
830(TM) in commercial quantities for human application. See "Business-Government
Regulation." Based upon the results of recent studies, including those by
General Motors Corporation ("GM") and the Mayo Clinic, the Company believes,
although no assurances can be given, that the MicroLight 830(TM) is an effective
treatment for carpal tunnel syndrome ("CTS"). See "Business-Research and
Development."

The MicroLight 830(TM) is manufactured by CB Svendsen a/s ("CBS"), a
Danish company, which has sold its low level laser devices in more than 20
foreign countries to physicians, physical therapists, dermatologists and
veterinarians, for use in connection with wound healing, pain reduction and
anti-inflammatory indications. The Company has worked on the development and
marketing of the MicroLight 830(TM) with CBS since June 1991. In March 1997, the
Company and CBS entered into new agreements pursuant to which the Company paid
$100,000 to CBS and obtained unto perpetuity the sole and exclusive world-wide
distribution rights to all low level laser devices manufactured by or for CBS.
Also pursuant to the agreements, the Company obtained unto perpetuity the
exclusive world-wide manufacturing rights to all low level laser devices
manufactured by or for CBS subject to the payment to CBS of $175,000 by June 15,
1998.

HEALTH CAREER LEARNING SYSTEMS. The Company's HCLS training unit sells
training and safety products and provides technical support necessary to meet
OSHA compliance standards. The HCLS system is designed to ease the task of
implementing OSHA requirements in the workplace by providing a simple,
thoroughly planned training program. The system consists of all needed
information relevant to Blood borne Pathogens Standard, Hazard Communication
Standards, Safety Regulations and State-Specific Regulations. It is the
Company's intention that the Group will continue to expand its training
activities to include various other products offered by the Company.

PRINCIPAL PRODUCTS

The Company develops, manufactures and markets a variety of products
and related accessories used for the control of acute or chronic pain by
non-invasive methods, to facilitate healing of wounds, for physical therapy and
in the treatment of disabilities or injuries with therapeutic exercise and the
application of various hydrotherapy, heat, traction, ultrasound or other
modalities. The Company also licenses products developed or manufactured by
other companies which are implemented into its existing and expanding
distribution system.

FLUIDOTHERAPY UNITS. Fluidotherapy is a patented dry heat treatment
that uses finely divided cellulose particles suspended and circulated in a
heated air stream to apply heat, stimulation and pressure to a specific area of
the body. Patients receive such therapy by placing the area to be treated (e.g.,
hand, ankle or knee) into the unit in which the cellulose particles circulate at
the appropriate temperature, speed and density. Fluidotherapy enables physical
therapists to provide their patients with a combination of heat, stimulation,
pressure and other therapies designed to treat the symptoms of various ailments
and conditions including arthritis, circulatory disorders and certain
sports-related injuries. The Company currently manufactures, markets and
distributes several models of Fluidotherapy units.

TRU-TRAC TRACTION MACHINES AND TABLES. The Company develops,
manufactures, markets and distributes its Tru-Trac line of intermittent traction
machines, currently consisting of four models, including a clinical model and
three portable models. The Company also manufactures, markets and distributes a
proprietary line of Tru-Trac traction and therapy tables used in a variety of
physical therapy applications.

HYDRA-FITNESS EXERCISE AND REHABILITATION EQUIPMENT. Through its
Hydra-Fitness line of products, the Company develops, manufactures and sells
hydraulic exercise and rehabilitation systems. Hydraulic resistance is provided
by manipulating the size of the aperture in a patented, fluid-filled hydraulic
cylinder. Such hydraulic resistance provided by the machine is totally
accommodating throughout the full range of motion for each individual user and
the resistance stops when force is no longer applied. This contrasts with free
weight or weight stack equipment that must return to the starting point before
the resistance is zero. For this reason, Hydra-Fitness products can be utilized
for both

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medical and exercise purposes. The majority of the Company's sales of
Hydra-Fitness products is for medical use by handicapped and rehabilitating
patients and in geriatrics. The Company manufactures numerous models of
Hydra-Fitness machines.

NORM(TM) TESTING AND REHABILITATION SYSTEM. In September 1997, the
Company acquired the manufacturing, marketing and distribution rights to the
multi-joint, isokinetic NORM(TM) testing and rehabilitation system, a
state-of-the-art extremity testing and rehabilitation system, from Cybex. The
Company began manufacturing, marketing and distributing this product shortly
thereafter. The system utilizes isokinetic resistance to provide accurate and
reproducible measurement of dynamic performance and functional capability.
Isokinetic resistance is an automatically accommodating resistance which varies
in opposition to the amount of force applied against it. NORM(TM), which stands
for Normative Outcomes for Rehabilitation Management, provides clinicians with
instant access to the world's largest on-line isokinetic normative database
which provides immediate objective documentation to assess patient needs. The
NORM(TM) and the other products acquired from Cybex are well established in the
market place. The Company makes available to customers extensive literature
including published results by accredited researchers attesting to the accuracy,
effectiveness, validity and reproducibility of the results of these products.

ISOKINETIC ERGOMETERS. The Company began manufacturing, marketing and
distributing the Fitron isokinetic cycle ergometer ("Fitron") and the Upper Body
Ergometer ("UBE") in October 1997. Both the Fitron and UBE are designed with a
wide range of exercise speeds, work rates and anatomical range of motion for
physical therapy, athletic rehabilitation, performance training and
cardiovascular conditioning. The Fitron is principally a versatile lower-limb
cycle ergometer while the UBE incorporates all of the proven benefits of the
Fitron into a versatile ergometer for the upper body.

KINETRON TRAINING SYSTEM. The Kinetron closed kinetic chain training
system ("Kinetron") is an exercise system for the treatment of patients
requiring gradual, stabilized and counterbalanced weight bearing exercise
treatment. Kinetron is designed to provide a safe, non-threatening exercise
environment for patients at any level. Speed and weight bearing conditions are
controlled by the clinician in order to allow rehabilitation to begin earlier
than with other body treatment systems. It is used to treat orthopedic,
neurological, acute care and sports medicine patients and can progress patients
in speed, force, range-of-motion, timing and coordination while building their
confidence. The Company began manufacturing, marketing and distributing the
Kinetron in October 1997.

NERVE STIMULATORS. The Company markets and distributes nerve
stimulators that provide transcutaneous electrical nerve stimulation therapy,
sometimes known as "TENS" therapy. This treatment involves the continuous or
intermittent transmission of low voltage electrical impulses in different wave
forms, on a localized basis, as a treatment for chronic or acute pain resulting
from a variety of medical conditions. The therapy is provided through a small,
portable, battery-powered stimulator (resembling a paging device) connected by
wires to two or more small electrode pads placed at or near the site of the
patient's pain. For most patients, use of this therapy creates an analgesic
effect that assists in the reduction or elimination of localized pain. To the
extent this therapy is effective for a patient, it offers greater patient
comfort and mobility than competing remedies and elimination or reduction of
medications, and results in increased patient alertness, fewer side effects and
lower overall costs than prolonged medication. The Company currently sells
several different models of TENS devices and believes that the potential market
for these devices is growing. The Company purchases these nerve stimulators from
various suppliers.

JELTRODE ELECTRODES. The Company manufactures, markets and distributes
its proprietary Jeltrode electrodes for use with the Company's nerve stimulators
in a variety of nerve and muscle stimulation and electrotherapy applications.
The Company believes that traditional electrodes used in these therapies often
irritate the skin, are messy to apply and painful to remove. A Jeltrode
electrode uses a unique adhesive gel, is hypoallergenic, virtually painless to
apply and remove and can be re-hydrated, cleaned and re-used. Since the adhesive
gel is water-based, electrical resistance between the electrode and skin is
reduced, resulting in enhanced product performance and prolonged battery life.

IOTRODE IONTOPHORESIS ELECTRODES. Iontophoresis is a process which uses
electric current to assist drug transfer through the skin. The Company
manufactures, markets and distributes its Iotrode iontophoresis electrode for
use with its Dynaphor iontophoresis device. Using the electrodes, clinicians are
able to deliver small molecule drugs that can be ionized for the treatment of
pain and inflammation through the skin. For many applications, the use of
iontophoresis

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is superior because it is non-invasive, allows medications to be dispersed over
a wider range of tissue and avoids many of the systemic and localized side
effects associated with oral medications and injections.

MEDIPADS/MEDIGELS. The Company's Medipads and Medigels are manufactured
at the Company's Sugar Land, Texas, facilities. These products are marketed and
distributed as drug-impregnated, water-based gels and gel pads used for delivery
of drugs directly through the skin on a localized basis. The Medipads and
Medigels can be used topically with various non-prescription dosages of drugs
such as hydrocortisone and lidocaine.

WOUND CARE PRODUCTS. The Company recently obtained FDA market clearance
for the manufacture and sale of two sterile wound care products - Dermaheal gel
and Dermaheal impregnated gauze. These products are PVP/aloe vera-based,
ultrasound transparent and electrically conductive. The Company has not yet
begun to commercially manufacture these wound care products.

THE MICROLIGHT 830(TM). The MicroLight 830(TM) is a portable,
hand-held, battery-operated low energy laser with an output which does not
exceed 100 milliwatts. The Company currently distributes the MicroLight 830(TM)
to various clinicians participating in the Company's current research program
under its Investigational Device Exemption ("IDE") as allowed by FDA
regulations. Lasers that do not exceed 100 milliwatts have no thermal effect on
living tissue. However, depending on the wavelength, the low level laser light
will penetrate and act on the tissue underlying the skin. The specific
wavelength of the laser incorporated within the MicroLight 830(TM) penetrates
the dermis, epidermis and subcutaneous layers of the skin entering surrounding
tissue. Along its path, the laser deposits photons into the cells, which is
believed to stimulate nerve regeneration, reduce swelling and improve
micro-circulation by bringing increased oxygen and blood flow to the problem
area.

The Company believes, although no assurances can be given, that the
MicroLight 830(TM) is an effective treatment for CTS, which is the tendon and
nerve damage that results from the fast, forceful wrist and hand motions that
are repeated in production and manufacturing workplaces many times in each day,
such as operating a computer, cutting meat, cutting or plucking poultry or
assembling automobiles. Conventional surgical and non-surgical treatments for
CTS and other repetitive stress injuries have been for the most part
unsuccessful in allowing CTS sufferers to continue with or return to productive
employment. As a result of the limited success of these treatments, CTS
frequently results in temporary or permanent disability at substantial economic
costs. The Company believes that the potential market for the MicroLight 830(TM)
includes hospitals, clinics, medical doctors, chiropractors, physical
therapists, dentists, veterinarians and, ultimately, individuals. However, the
Company has not yet received clearance from the FDA to sell the MicroLight
830(TM) in commercial quantities for human application.

DISTRIBUTION AND MARKETING

The Company's products are marketed through a network of national and
international independent dealers and distributors, direct salespersons and
commissioned sales representatives to physicians, physical therapists,
chiropractors and their patients as well as to clinics and healthcare networks.
In conjunction with sales, marketing and manufacturing, the Company also has a
network for direct billing to insurance claims offices, Medicare carriers and
managed healthcare programs. The Company believes that its approach to sales and
marketing is supported by the desire of its customers to identify with
individual account managers and product specialists. This enables the Company to
provide better customer service and to maintain specialized expertise in each
product line. As medical products are increasingly being purchased on a national
account or centralized basis by healthcare networks, Company salespersons must
also maintain relationships with purchasing managers within these networks.

The Company has product distribution centers in Ohio, Minnesota,
Georgia and Texas and approximately 160 dealers and distributors, 30 sales
representatives and 25 direct salespersons representing its product within the
United States. The Company has both telemarketing and direct-mail programs for
its HCLS-related products and services and for the marketing and distribution of
medical supplies related to its TENS, wound-healing and other products.

Additionally, the Company sells many of its products to over 140
distributors and representatives in various countries around the world. The
products manufactured or sold by the Company in Europe are subject to the
European Community regulations for medical devices, including product
certification ("CE Marking"). The European Community has imposed a deadline of
June 1998, after which products without a CE Marking may not be sold in Europe.
The

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Company has obtained CE Marking on all of its traction machines and anticipates
obtaining the CE Marking prior to the deadline, on the remainder of its products
that are sold in the European Community. The Company believes that its network
of international distributors will enhance its marketing and distribution
efforts as it seeks to extend its market share of the international marketplace.

The Company began marketing the LASERMEDICS VMD 830(TM) laser for
veterinary application in November 1993. Sales are made to veterinarians through
a network of distributors and sales representatives for use in wound healing and
the treatment of muscle afflictions on horses and other animals. Research
studies have demonstrated the positive photobiostimulation effects of the
LASERMEDICS VMD 830(TM) cold laser technology on animal muscle ailments such as
bowed tendon, check ligament and plantar desmitis. Clinical results also show
that soft tissue healing on horses is accelerated with repeated applications of
the LASERMEDICS VMD 830(TM).

MANUFACTURING

The Company operates two manufacturing facilities in Belton and Sugar
Land, Texas. Most of the Company's Clinical products are manufactured at the
Belton, Texas facility while the manufacturing operations for some of the
Company's Homecare products are located at the Sugar Land, Texas facility.

COMPETITION

Competition in the medical device and physical medicine markets is
intense. The Company's products compete with the products of many other
companies in the business of developing, manufacturing, distributing and
marketing physical therapy and rehabilitation products. Many of these companies
may have substantially greater financial and other resources than the Company,
and may have established reputations for success in the development, sale and
service of their products. The Company believes that the principal competitive
factors in each of its markets are product features and benefits, customer
service and pricing. Although the Company's products are not the lowest-priced
in its markets, the Company endeavors to maintain a competitive edge by
emphasizing overall value through a combination of competitive pricing, product
quality and customer service.

While the Company is currently awaiting FDA approval for the MicroLight
830(TM) and cannot commence commercial sales until such approval is received,
there are several foreign as well as U.S. manufacturers of low energy lasers
using similar technology to the MicroLight 830(TM). However, these competitive
lasers may emit light of a different wavelength, are not generally portable and
may be more expensive than the Company's product. Consequently, if the Company
receives FDA approval, the Company anticipates future competition relating to
the MicroLight 830(TM). Furthermore, there may be no effective barrier to
competitors using other wavelengths of low-level laser light inasmuch as the
manufacture of the MicroLight 830(TM) does not incorporate any patented
inventions, and qualified companies could reverse engineer such product and
market it, subject to obtaining the requisite FDA pre-marketing approval
("PMA"), for human use. Although there may be no absolute barriers to entry for
competitive lasers, the Company believes that, pursuant to specific FDA
regulations, the safety and efficacy data submitted to the FDA by one entity
supporting such entity's PMA application cannot be used by another entity in its
PMA application. Generally, this means that another entity desiring to submit a
PMA application for a laser similar to the MicroLight 830(TM) cannot rely on the
Company's clinical trial results to support such entity's PMA application, but
must conduct its own trials and gather its own data. Although no assurances can
be given, this provision could increase the length of time for a competitor of
the Company to obtain FDA approval to commercially sell a similar product in the
United States for human application.

PATENTS AND PROPRIETARY RIGHTS

The Company actively pursues a policy of seeking patent protection both
in the U.S. and abroad for its proprietary technology. The Company owns several
U.S. issued patents and various foreign counterparts. The Company also has one
patent application pending in the U.S. The Company also relies on trade secrets
and un-patented know-how in connection with the use of the MicroLight 830(TM),
but the Company may be vulnerable to competitors who attempt to copy the laser
technology used in such product or to gain access to the Company's trade secrets
and know-how. Although the Company has conducted a search to discover any
patents which the MicroLight 830(TM) or its use may infringe, the Company is not
aware of any patents which may be infringed by this product.

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Litigation, which could result in substantial cost to and diversion of
effort by the Company, may be necessary to enforce any patent issued to the
Company, to protect trade secrets or know-how owned by the Company or to
determine the scope and validity of the proprietary rights of others. Adverse
findings in any proceeding could subject the Company to significant liabilities
to third parties, require the Company to seek licenses from third parties and
adversely affect the Company's ability to sell its product.

GOVERNMENT REGULATION

All medical devices are subject to FDA regulation under the Medical
Device Amendments of the Food, Drug and Cosmetic Act, as amended ("FDCA").
Pursuant to the FDCA, a medical device is ultimately classified as either a
Class I, Class II or Class III device. Class I devices are subject only to
general controls which are applicable to all devices. Such controls include
regulations regarding FDA inspections of facilities, Quality Systems Regulations
(formerly known as Good Manufacturing Practices), labeling, maintenance of
records and filings with the FDA. Class II devices must meet general performance
standards established by the FDA. Class III devices are subjected to a more
stringent PMA process by the FDA before they can be commercially marketed and
must adhere to such standards once on the market. Such PMA can involve extensive
testing to prove safety and efficacy of the devices. Most of the Company's
products are Class II devices. FDA marketing clearance of these devices is
obtained under Section 510 (k) of the FDCA, which provides for FDA clearance for
products that can be shown to be substantially equivalent to devices in commerce
prior to May 1976 (the month and year of enactment of the FDCA) or which have
subsequently been granted market clearance. Most of the Company's remaining
products are Class I devices (i.e., treatment tables and fitness and exercise
equipment.)

Currently, all of the Company's products and manufacturing facilities
are subject to pervasive and continuing regulation by the FDA. All phases of the
manufacturing and distribution process are governed by FDA regulation. Products
must be produced in registered establishments and be manufactured in accordance
with Quality Systems Regulations, as such term is defined under the Code of
Federal Regulations. In addition, all such devices must be periodically listed
with the FDA. Labeling and promotional activities are subject to scrutiny by the
FDA and, in certain instances, by the Federal Trade Commission. The export of
devices is also subject to regulation in certain instances. The FDA conducts
inspections periodically to ensure compliance with these regulations.

The FDA's mandatory Medical Device Reporting ("MDR") regulation
obligates the Company to provide information to the FDA on injuries alleged to
have been associated with the use of a product or in connection with certain
product failures which could cause serious injury or death. If as a result of
FDA inspections, MDR reports or other information, the FDA believes that the
Company is not in compliance with regulations, the FDA can institute proceedings
to detain or seize products, enjoin future violations, or assess civil or
criminal penalties against the Company, its officers or employees. Although the
Company and its products have not been the subject of such FDA enforcement
action, any such action by the FDA could result in a disruption of the Company's
operations for an undetermined time.

In addition to the foregoing, foreign countries in which the Company's
products may be sold, as well as state governments and other federal and local
agencies within the U.S., may impose additional regulatory requirements on the
Company, and such actions could have a material adverse effect on the Company's
ability to do business.

There can be no assurance that the FDA will grant PMA clearance for the
MicroLight 830(TM) for the treatment of CTS on a timely basis, if at all. Until
it obtains FDA market clearance, the Company is unable to sell the product in
commercial quantities for human application in the U.S. market.

The Company is not required to notify or obtain approval from the FDA
regarding any of its devices sold for veterinarian applications. However, the
Company is required to obtain, prior to commencing any sales activities, a
radiological health registration number and to file an Initial Report for all
models of its devices. With no objection from the FDA to the introduction of the
LASERMEDICS VMD 830(TM) into commerce, the Company continues to market this
product in the veterinary market, although much of the Company's efforts is
focused on the marketing and distribution of its many other products.

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THIRD-PARTY REIMBURSEMENT AND HEALTHCARE REFORM

Healthcare providers, such as hospitals and physicians, that purchase
medical products for use on patients generally rely on third party payors,
principally Medicare, Medicaid and private health insurance plans, to reimburse
all or part of the costs and fees associated with the products used, procedures
performed or services provided. The Company's products are purchased by
hospitals, corporations, clinics and private physicians. These customers then
bill various third-party payors for the healthcare services provided to their
patients with use of the Company's products. These payors include Medicare,
Medicaid and private insurance payors. Generally, government agencies reimburse
hospitals and other healthcare providers for patient medical care at a fixed
rate according to diagnosis-related groups (DRGs) as mandated by Congress.
Reimbursements are dependent on many factors which may include the payor's
determination that a service or procedure was not experimental and was used for
an approved indication. The Company records revenue for these transactions based
upon historical experience and known policies of the third-party payors
regarding approved expenditures and other factors.

During the third quarter of 1997, the Company commenced an extensive
analysis of its accounts with particular emphasis on accounts receivable for the
Company's operations, which include third-party billings. In conjunction with
the analysis, the Company intensified its collection efforts. Billings to
third-party payors, by their nature, demand longer-than-average time to bill and
much longer-than-average time to collect. Upon further scrutiny in the fourth
quarter and on the basis of the analysis, management revised its estimates of
collectibility of the Company's accounts receivable for operations, which
include third-party billings and increased its reserve for doubtful accounts by
approximately $2,000,000. The Company has also changed certain procedures in the
collection process in order to improve the future collectibility of the accounts
receivable. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."

The Company believes that the nature of the non-intrusive utilization
of its products in patient care and the advantages of their relative cost and
ease of use may be positive factors in reducing health care costs. However, the
Company cannot predict the ultimate effect of the current governmental focus on
healthcare reform on the sale of its products. Although the market for some of
the Company's products could be adversely affected by changes in governmental
and private third-party payors' policies, the Company believes that healthcare
legislation may have some beneficial effect on its business by increasing the
availability of healthcare, emphasizing less invasive surgery and increasing the
need for efficiency by healthcare personnel.

RESEARCH AND DEVELOPMENT

GENERAL. The Company is continually conducting, researching and
developing new products by utilizing a team approach involving the engineering,
manufacturing and marketing resources. These research and development efforts
are designed primarily to apply state-of-the-art technology and the Company's
expertise to the treatment of wide-ranging medical conditions. Although the
Company has developed a number of its products, such as the original
Fluidotherapy device, Medipads and others, most of its research and development
efforts are directed towards product improvement and enhancement of previously
developed or acquired products. Such enhancement may involve updating and
redesigning existing products to improve features, performance and reliability.

The Company is also involved in the development and application of
various new products many of which are in early stages of development and will
require additional development work, FDA approval, clinical or other testing or
market research and development efforts prior to commercial introduction. In
this regard, the Company is continuing its clinical research and investigation
using the MicroLight 830(TM) under its IDE. Expenses incurred in connection with
research and development in 1997 and 1996 amounted to approximately $395,000 and
$314,000, respectively.

The Company also estimates that it will incur expenditures
approximating $500,000 for research and development, in the event it obtains FDA
approval for human application of the MicroLight 830(TM), for which no assurance
can be given. Such research and development effort will primarily emphasize
additional photobiostimulation applications for the MicroLight 830(TM), such as
pain suppression, wound healing and sports injuries, in various medical
disciplines including general medicine, dentistry, veterinary medicine, physical
therapy, orthopedic surgery, dermatology and re-constructive and cosmetic
surgery.

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CLINICAL TRIALS FOR THE MICROLIGHT 830(TM). The MicroLight 830(TM), a
Class III medical device, has been defined by the FDA as a "non-significant
risk" device. The Company is allowed to conduct clinical trials under an
approved IDE using the MicroLight 830(TM). In August 1997, the FDA accepted the
Company's Pre-IDE Clinical Investigation Plan for a multi-center, double-blind,
randomized, clinical study to evaluate the efficacy of the MicroLight 830(TM) in
the treatment of CTS. These clinical trials are subject to IDE regulations,
including record keeping, adverse event reporting and other clinical study
requirements. Pursuant to IDE regulations the Company's clinical researchers are
required to be reviewed and approved by an Institutional Review Board (IRB) to
treat human patients for research purposes. The objective of these clinical
trials is to evaluate the therapeutic effects of low-level laser energy in pain
management, soft tissue trauma (including RSI) and dental applications. The
Company is sponsoring independent research studies on the effects of the
MicroLight 830(TM) at various clinical sites in the U.S.

No assurance can be given that (i) the results of the various research
studies that are being or have been conducted using the MicroLight 830(TM), will
demonstrate to the FDA's satisfaction the safety and effectiveness of the
MicroLight 830(TM) in treating CTS, (ii) the FDA will agree that the design of
the studies is satisfactory, (iii) the FDA will not require additional clinical
studies, or (iv) the Company can obtain the necessary FDA marketing clearance
for the MicroLight 830(TM) on a timely basis, if at all. The FDA's rejection of
the clinical design or the data generated could lead to rejection of the
application for commercial marketing of the MicroLight 830(TM) and/or the need
to conduct additional clinical trials.

PRODUCT LIABILITY AND INSURANCE

The Company's business includes the risk of product liability claims.
Although the Company has not experienced any product liability claims to date,
any such claims could have an adverse impact on the Company. The Company
currently maintains product liability insurance covering up to $3,000,000 in
liability claims, but does not intend to seek additional coverage until after
such time, if ever, as it obtains marketing approval from the FDA for human
application of the MicroLight 830(TM).

EMPLOYEES

As of March 16, 1998, the Company had approximately 376 full-time and 5
part-time employees. None of the Company's employees are represented by a union,
and management believes that its relations with its employees are good. The
Company believes that the success of its business will depend, in part, on its
ability to attract and retain qualified personnel.

ITEM 2. PROPERTIES

The Company owns three buildings of which two are located in Sugar
Land, Texas, and the other in Belton, Texas. The addresses of these owned
facilities are 120 Industrial Boulevard, Sugar Land, Texas 77478, 140 Industrial
Boulevard, Sugar Land, Texas 77478 and 2121 Industrial Park Road, Belton, Texas
76513. The Company's principal executive and administrative offices are located
at the 120 Industrial Boulevard, Sugar Land, facility consisting of
approximately 25,000 square feet. Electronics manufacturing and warehouse
operations for the Company's pain management products and certain administrative
functions are located at the 140 Industrial Boulevard, Sugar Land, facility
consisting of approximately 50,000 square feet. The manufacturing and warehouse
facilities for much of the Company's physical therapy and fitness products are
located at the Belton facility consisting of approximately 59,000 square feet.

The Company also leases three regional warehouse and distribution
facilities in Akron, Ohio, St. Paul, Minnesota and Atlanta, Georgia, of
approximately 15,000, 5000 and 5,550 square feet, respectively. The Company also
leases approximately 4,900 and 4,500 square feet of office space in Plymouth,
Michigan, and Happauge, New York, respectively, as principal operations center
for its HCLS training unit and customer service operations for the recently
acquired Cybex products, respectively.

The Company believes that its facilities, whether leased or owned, are
adequate to meet its current needs and should continue to be adequate for the
foreseeable future.

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ITEM 3. LEGAL PROCEEDINGS

There are no material legal proceedings to which the Company is party
or of which any of its property is the subject other than ordinary, routine
claims incidental to the Company's business.

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

None.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock currently trades in and is quoted on The
Nasdaq SmallCap Market under the symbol "HENL." The following table sets forth
the range of high and low bid prices on the Company's Common Stock for calendar
years 1997 and 1996 on The Nasdaq SmallCap Market:

CALENDAR PERIOD HIGH LOW
------ ------
1997:
First Quarter ........................................ $6.500 $4.125
Second Quarter ....................................... 7.750 4.375
Third Quarter ........................................ 7.500 4.937
Fourth Quarter ....................................... 9.000 5.187

1996:
First Quarter ........................................ $8.750 $4.250
Second Quarter ....................................... 8.875 6.000
Third Quarter ........................................ 8.125 4.750
Fourth Quarter ....................................... 6.875 5.750

The Company has authorized 20,000,000 shares of common stock, par value
$.01 per share. As of March 16, 1998, there were 5,383,205 shares issued and
outstanding and 303 shareholders of record, although the Company believes that
there are other persons who are beneficial owners of the Company's securities
held in "street" names. All shares of Common Stock currently outstanding are
validly issued, fully paid and non-assessable.

The Company has neither declared nor paid any dividends on common stock
since its inception and presently anticipates that no dividends will be declared
in the foreseeable future. Any future dividends will be subject to the
discretion of the Company's Board of Directors and will depend upon, among other
things, future earnings, the operating and financial condition of the Company,
its capital requirements, debt obligation agreements, general business
conditions and other pertinent facts. Therefore, there can be no assurance that
any dividends on the Common Stock will be paid in the future.

RECENT SALES OF UNREGISTERED SECURITIES

The following sales of unregistered securities occurred during the year
ended December 31, 1997, in private transactions in which the Company, unless
otherwise indicated, relied on the exemption from registration available under
Section 4(2) of the Securities Act of 1993, as amended (the "Securities Act"):

In January 1997, the Company acquired substantially all of the
inventory, distribution systems and customers associated with the Homecare
division of Gatti Medical Supply, Inc. In connection with the acquisition, the
Company issued to the sellers a total of 51,117 shares of the Company's common
stock.

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In connection with a non-compete agreement entered in September 1997
with a former employee, the Company issued to the former employee 10,000 shares
of the Company's common stock.

In December 1997, the Company acquired all of the issued and
outstanding common stock of NCI, Inc., a Michigan corporation. In connection
with the acquisition, the Company issued to the seller 188,847 shares of the
Company's common stock.

In October 1997, the Company offered to exchange Amended and Restated
Class J Warrants with the holders of the then outstanding Class J Warrants in a
transaction exempt from registration under Section 3(a)(9) of the Securities
Act. Of the 104,941 Class J Warrants then outstanding, the holders of an
aggregate of 65,341 agreed to exchange their original Class J Warrants for
Amended and Restated Class J Warrants. In December 1997, the Company undertook
to redeem the Amended and Restated Class J Warrants pursuant to the terms
thereof. Upon receipt of the Notice of Redemption, certain holders of the
Company's Amended and Restated Class J Warrants exercised their rights under the
Warrants and purchased shares of the Company's common stock. In connection with
this transaction, the Company issued an aggregate of 61,341 shares of its common
stock and redeemed 4,000 Amended and Restated Class J Warrants.

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

GENERAL

The Company's principal business strategies are to (i) expand
distribution channels and explore new markets, (ii) consolidated the
highly-fragmented physical therapy and rehabilitation industry by pursuing
strategic acquisitions that complement existing product lines and increase
market share, (iii) maximize the utilization of existing manufacturing
facilities for increased productivity, (iv) improve profitability, (v) reduce
long-term indebtedness, and (vi) obtain market clearance from the FDA for the
MicroLight 830(TM).

Prior to April 30, 1996, the Company was primarily engaged in the
development and application for marketing clearance of the MicroLight 830(TM).
Beginning with the acquisition of Maxxim's Henley Division, the Company has
pursued a strategy of consolidating the highly-fragmented physical therapy and
rehabilitation industry. Since that time, the Company has grown significantly as
a result of additional acquisitions. See "Business -- Acquisitions." All
acquisitions were accounted for under the purchase method of accounting for
business combinations and accordingly, the results of operations for such
acquisitions are included in the Company's financial statements only from the
applicable date of acquisition. As a result, the Company believes that its
historical results of operations for the periods presented may not be directly
comparable. The Company believes the historical results of operations do not
fully reflect the operating efficiencies and improvements that are expected to
be achieved by integrating the acquired businesses and product lines.

The Company intends to continue its evaluation of acquisitions, and a
period of rapid growth could place a significant strain on the Company's
management, operations and other resources. There can be no assurance that the
Company will continue to be able to identify attractive or willing acquisition
candidates, or that the Company will be able to acquires such candidates on
economically acceptable terms. The Company's ability to grow through
acquisitions and manage such growth will require the Company to continue to
invest in its operational, financial and management information systems and to
attract, retain, motivate and effectively manage its employees. The inability of
the Company's management to manage growth effectively would have a material
adverse effect on the financial condition, results of operations and business of
the Company. As the Company pursues its acquisition strategy in the future, its
financial position and results of operations may fluctuate significantly from
period to period.

The following discussion should be read in conjunction with the
consolidated financial statements and the related notes thereto and other
detailed information appearing elsewhere herein.

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RESULTS OF OPERATIONS

FISCAL 1997 COMPARED TO 1996

The Company achieved record sales in fiscal 1997, with total revenue of
approximately $24,257,000 reflecting an increase of approximately $11,771,000 or
94% over the amount reported for fiscal year 1996. The increase was primarily
due to increased sales from the acquired operations. Net loss for fiscal 1997
amounted to approximately $2,124,000 compared to a net loss of approximately
$879,000 in fiscal 1996. The increase in net loss resulted primarily from the
effect of the one-time adjustment to the allowance for doubtful accounts.

The Company's gross profit for fiscal 1997 was approximately
$12,530,000 compared to approximately $6,770,000 for fiscal 1996. Gross margin
as a percentage of sales in 1997 decreased to 52% from 54% in 1996. The decrease
in the 1997 gross margin percentage compared with 1996 was primarily the result
of lower margin products representing a larger portion of sales in 1997. The
increase as a percentage of revenue of lower margin products was primarily
attributable to the Company's acquisition of several distribution oriented
businesses which traditionally have lower profit margins than the manufacturing
operations of the Company.

Sales, general and administrative expense increased by approximately
$4,478,000, from approximately $4,740,000 in 1996 to approximately $9,218,000 in
1997, an increase of approximately 94%, while remaining constant at
approximately 38% of net sales for both periods presented. This increase was due
primarily to increased sales, general and administrative costs related to the
acquired operations.

Research and development expense increased by approximately $193,000,
from approximately $314,000 in 1996 to approximately $507,000 in 1997, an
increase of approximately 62%. The increase is primarily due to additional costs
regarding the onset of clinical trials during 1997 pertaining to the Company's
MicroLight 830(TM) product. As a percentage of sales, research and development
costs actually decreased from 3% in 1996 to 2% in 1997. This was primarily due
to an increased revenue base in 1997 due to the acquired operations.

Provision for doubtful accounts increased by approximately $1,750,000,
from approximately $1,421,000 in 1996 to approximately $3,171,000 in 1997, an
increase of approximately 123%. This increase was due to the effect of the
Company's fourth quarter revision of its estimates of collectibility of the
accounts receivable, which increased the provision for doubtful accounts by
approximately $2,000,000. Approximately $1,500,000 of this provision related to
receivables outstanding for more than a year at December 31, 1997. Factors
contributing to the need for this increased provision included application of
insufficient resources to the collection of accounts receivable and logistical
problems and delays caused in connection with the implementation of a new
accounting system. The Company now has a credit and collections department that
consists of four full-time employees who verify and approve credit, review
accounts receivable agings on a timely basis and follow-up on collections of
accounts. Additionally, the Company sold all of its Homecare operations in
August of 1998 (including the related receivables). The Homecare operations were
the only part of the Company's operations that included third-party billing and
it was these types of receivables that were the impetus for the significant
increase in provision for doubtful accounts.

Depreciation and amortization expense increased by approximately
$432,000, from approximately $284,000 in 1996 to approximately $716,000 in 1997,
an increase of approximately 152%. This increase was primarily a result of
increased depreciation and amortization related to the acquired operations.

Interest expense for 1997 amounted to approximately $1,148,000 compared
to approximately $815,000 in 1996. The increase in interest expense was
primarily due to the interest-bearing notes issued to finance the Company's
acquisitions.

As of December 31, 1997, the Company had net operating loss
carryforwards for income tax purposes of approximately $6,324,000 available to
offset future taxable income. The carryforwards will begin to expire in 2005. A
valuation allowance was provided to fully reserve the net deferred tax asset due
to realization uncertainties regarding future operating results.

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FISCAL 1996 COMPARED TO 1995

Total revenue for fiscal year 1996 amounted to approximately
$12,486,000 reflecting an increase of approximately $11,959,000 over the amount
reported for fiscal year 1995. The increase is primarily due to increased sales
from the acquired operations acquired from Maxxim Medical, Inc. Net loss
decreased about 38% from approximately $1,420,000 in fiscal 1995 to
approximately $879,000 in fiscal 1996. The decrease in net loss is due to
achievement of more profitable operations during the second six-month period of
fiscal 1996.

The Company's gross profit for fiscal 1996 was approximately $6,770,000
compared to approximately $183,000 for fiscal 1995. Product gross margin as a
percentage of sales in 1996 increased to 54% from 35% in 1995. The increase in
the 1996 gross margin percentage compared with 1995 resulted primarily from
sales of many high margin products acquired from Henley.

Operating expenses in 1996 increased approximately $5,196,000 over the
amount of approximately $1,530,000 reported for 1995. However, as a percent of
sales, operating expenses in 1996 decreased to 54% compared to 290% a year
earlier. The increase in operating expenses is due to increased relative costs
of operating the acquired businesses. However, the decreased operating expenses
as a percent of sales reflects the effects of larger overall sales from the
acquired products and certain cost containment measures undertaken following the
Henley acquisition. The Company will continue to face the challenge of managing
expense growth as it seeks to expand distribution channels and explore new
markets while moving towards the consolidation of the highly-fragmented physical
therapy and rehabilitation industry.

Interest expense for 1996 amounted to approximately $815,000 compared
to approximately $84,000 in 1995. The increase in interest expense was primarily
due to the interest-bearing notes issued to finance the Company's acquisition of
the Henley Division, which was partially offset by the effects of the conversion
of certain interest-bearing notes into shares of the Company's common stock.

For the year ended December 31, 1996, the amount of other income and
expense, net included certain non-recurring employee relocation and severance
costs which were not incurred in 1995.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 1997, the Company had cash and cash equivalents in the
amount of $123,620 as compared to $507,892 at December 31, 1996. The decrease in
cash and cash equivalents resulted primarily from expenses incurred in pursuing
the Company's overall growth strategy.

At December 31, 1997, the Company's investment in inventories was
significant relative to its sales for the year then ended, primarily due to the
product line acquired from Cybex in late 1997. The Company believes its
inventory turnover will increase in 1998; however, the actual results will be
impacted by, among other things, the nature, timing and integration of
businesses acquired.

In March 1998, the Company sold 1,825 shares of its Series A
Convertible Preferred Stock (the "Preferred Stock") at $1000 per share in a
private offering, resulting in net proceeds of approximately $1.8 million. The
Preferred Stock is convertible into the Company's common stock at the lesser of
(i) 75% of the average closing bid price for the Company's common stock as
reported on The Nasdaq SmallCap Market for the 5 trading days prior to
conversion, or (ii) $6.50 per share. In connection with the transaction, the
Company also issued to the investors a 5-year warrant to purchase up to 146,000
shares of the Company's common stock at exercise prices ranging from $7.125 per
share to $9.619 per share. The Company has agreed to file a registration
statement covering the resale of the shares of Common Stock issuable upon the
conversion of the Preferred Stock and exercise of the warrants sold to the
investors described above. Based on the requirements of the Consensus of the
Emerging Issues Task Force (D-60) regarding the accounting for preferred stock
with a floating conversion rate, the Company will incur a dividend expense in
the future for the conversion of the Preferred Stock. Such dividend expense is
calculated as the discount over fair market value as of the date the Preferred
Stock was sold to the investors. This discount amount of $608,333 will be
treated as a dividend to the holders of the Preferred Stock and will be ratably
charged to operations over a period of 120 days from the date of issuance, the
first date upon which the Preferred Stock is convertible.

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The Company's current sources of liquidity consist primarily of (i)
funds from operations, (ii) proceeds from the sale of the Preferred Stock, (iii)
funds held at the end of fiscal year 1997 and (iv) the amounts, if any,
available under the Amended Loan Agreement with Comerica. The Amended Loan
Agreement with Comerica provides for (i) a one-year revolving loan ("Line of
Credit"), which permits borrowings up to $8,000,000 through January 1999 and
(ii) three term loans in the amounts of $1,430,000 ("Term Note A"), $1,616,000
("Term Note B") and $1,260,000 ("Term Note C"). Term Note A, Term Note B and
Term Note C are payable in monthly installments of $23,833, $8,978 and $7,000,
respectively, plus interest through September 2002, May 2011 and February 2013,
respectively. The Line of Credit also includes a $250,000 letter of credit
facility. Interest on the Line of Credit and the three term loans is payable
monthly and is calculated at a rate equal to the Prime Rate plus one-half of one
percent per annum. Term Note B is callable by Comerica beginning on the fifth
anniversary of the Amended Loan Agreement. All of the borrowings from Comerica
are secured by substantially all of the assets of the Company. As of December
31, 1997, the Company had approximately $894,000 available for borrowing under
the Line of Credit. The total amount available for borrowing under the Line of
Credit is the lesser of (i) $8,000,000 and (ii) a variable borrowing base
calculated based on the amount and type of outstanding accounts receivable and
the value of certain items of inventory. At December 31, 1997, the Company had
working capital of approximately $2,637,000 and its current ratio was 1.2 to 1
as compared to $5,592,000 and 2.2 to 1 at December 31, 1996. This decrease in
the current ratio is primarily due to the increase in the amount of outstanding
line of credit, consistent with the Company's growth strategy. At December 31,
1997, the Company had no material capital expenditure commitment.

In connection with an agreement entered into in April 1996 with Maxxim
Medical, Inc. ("Maxxim"), the Company issued to Maxxim a convertible
subordinated promissory note in the principal amount of $7 million (the "Note").
The Note is due and payable on March 1, 2003 with interest payable semi-annually
on November 1 and May 1 of each calendar year and calculated at a rate equal to
2% per annum and increasing annually 2% per annum. The Company may redeem all or
any portion of the outstanding principal amount of the Note at redemption prices
ranging from 104% to 110% of the principal amount being redeemed, depending on
when the redemption occurs as set forth in the Note. In addition, the Note is
subject to mandatory redemption in annual installments of $1.4 million
commencing on March 1, 1999 at premiums starting at 7% and decreasing 1% each
year. The Company is also required to redeem 40% of the Note upon the completion
of a public offering. The Note is convertible into common stock at an initial
conversion price of $2 per share, provided that upon the occurrence of any
default under the Note, the conversion price will be automatically adjusted to
an amount equal to the lesser of the conversion price then in effect or 80% of
the average market price for the Company's common stock for the 30 trading days
immediately preceding the event of default. The conversion price is also subject
to adjustment upon the occurrence of certain events (including certain issuances
of common stock for less than the conversion price) to provide anti-dilution
protection.

In February and March 1998, the Company entered into agreements with
Maxxim pursuant to which Maxxim converted an aggregate of $4,000,000 of the Note
into an aggregate of 2,000,000 shares of the Company's common stock, par value
$.01 per share. The conversions were based on the current conversion price of
$2.00 per share under the Note. The agreements also provide that the entire $4
million of the Note so converted reduces the principal amount of the Note and
such sum shall be applied to the Company's full redemption obligation due in the
year 2003 and partially to the Company's redemption obligation due in the year
2002 as provided in the Note. The Company has agreed to file a registration
statement covering the resale of the shares of Common Stock issued to Maxxim as
a result of the conversions described above.

The Company is currently assessing the potential impact of the present
computer technology issue generally referred to as the "Year 2000 Problem." The
Year 2000 Problem, which is common to most corporations, relates to the
inability of information systems, primarily computer software programs, to
properly recognize and process date sensitive information related to the Year
2000 and beyond. The Company is currently evaluating the expected costs to be
incurred in connection with the Year 2000 Problem, and expects that such costs
will not be material.

Management believes that the funds generated from operations, along
with the Company's current working capital position and bank credit will be
sufficient to satisfy the Company's capital requirements for the Company's
existing operations for the foreseeable future. However, the Company will need
to obtain significant additional capital to finance its acquisition strategy,
including the Enraf-Nonius acquisition. See "Business -- Acquisitions." If the
Company's operating cash flows are inadequate or if the Company is unable to
raise sufficient financing, there can be no assurance that the Company will be
able to successfully fund its current operations or implement its acquisition

15
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strategy. The Company believes that its success in obtaining the necessary
financing will depend upon, among other factors, successfully operating the
recently acquired businesses. Sources of additional financing may include
additional bank debt or the public or private sale of equity or debt securities.
There can be no assurance that the Company will be successful in arranging such
financing at all or on terms commercially acceptable to the Company.

ITEM 7. FINANCIAL STATEMENTS

The information required hereunder is included in this report as set
forth in the "Index to Financial Statements."

INDEX TO FINANCIAL STATEMENTS

PAGE
Reports of Independent Public Accountants ............................ 17-18
Consolidated Balance Sheet ........................................... 19
Consolidated Statements of Operations ................................ 20
Consolidated Statements of Stockholders' Equity ...................... 21
Consolidated Statements of Cash Flows ................................ 22
Notes to Consolidated Financial Statements ........................... 23-37

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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors of
Henley Healthcare, Inc.

We have audited the accompanying consolidated balance sheet of Henley
Healthcare, Inc., a Texas corporation, and subsidiaries as of December 31, 1997,
and the related consolidated statements of operations, stockholders' equity and
cash flows for the year 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 audit. The consolidated
financial statements for the year ended December 31, 1996, were audited by other
accountants. Although the audit opinion of the other accountants covers the
income statement for the year ended December 31, 1996, such opinion does not
cover the resultant restatement of the Company's earnings per share pursuant to
the adoption of Statement of Financial Accounting Standards No. 128.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Henley Healthcare, Inc., and
subsidiaries as of December, 31, 1997, and the results of their operations and
their cash flows for the year then ended in conformity with generally accepted
accounting principles.

We have also audited the calculation of the 1996 loss per share, as restated, as
described in Note 1, "Loss per share." In our opinion, the recalculation of loss
per share pursuant to Statement of Financial Accounting Standards No. 128 is
appropriate and has been properly applied in accordance with generally accepted
accounting standards.

ARTHUR ANDERSEN LLP

Houston, Texas
March 13, 1998

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INDEPENDENT AUDITOR'S REPORT

To the Board of Directors
Henley Healthcare, Inc.

We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of Henley Healthcare, Inc. and Subsidiary
(formerly Lasermedics, Inc.) for the year ended December 31, 1996 (prior to the
effects on such financial statements of the adoption of Statement of Financial
Accounting Standards No. 128, "Earnings per Share" and the resultant restatement
of the Company's earnings per share for the year ended December 31, 1996 as
discussed in Note 1). 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 audit.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the results of operations and cash flows of Henley
Healthcare, Inc. and Subsidiary for the year ended December, 31, 1996 (prior to
the effects on such financial statements of the adoption of Statement of
Financial Accounting Standards No. 128, "Earnings per Share" and the resultant
restatement of the Company's earnings per share for the year ended December 31,
1996 as discussed in Note 1) in conformity with generally accepted accounting
principles.

GOLDSTEIN GOLUB KESSLER LLP

New York, New York
February 23, 1997

18
<PAGE>
HENLEY HEALTHCARE, INC.

CONSOLIDATED BALANCE SHEET

DECEMBER 31, 1997
------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents ................................. $ 123,620
Accounts receivable, net of allowance for doubtful ........ 6,675,800
accounts of $2,165,124
Inventory ................................................. 8,147,357
Prepaid expenses .......................................... 228,165
Other current assets ...................................... 71,960
------------
TOTAL CURRENT ASSETS ....................... 15,246,902

PROPERTY, PLANT AND EQUIPMENT, net ........................... 3,994,231
GOODWILL AND OTHER INTANGIBLES, net .......................... 5,670,004
OTHER ASSETS, net ............................................ 1,244,580
------------
TOTAL ASSETS ........................................... $ 26,155,717
============
LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
Line of credit ............................................ $ 7,105,868
Current maturities of long-term debt ...................... 433,763
Accounts payable .......................................... 3,970,270
Accrued expenses and other current liabilities ............ 1,099,572
------------
TOTAL CURRENT LIABILITIES .............................. 12,609,473

INTEREST PAYABLE ............................................. 536,667
LONG-TERM DEBT, net of current maturities .................... 9,466,179
------------
TOTAL LIABILITIES ...................................... 22,612,319

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
Preferred stock - $.10 par value; 2,500,000
shares authorized; none issued and outstanding ......... --
Common stock - $.01 par value; 20,000,000
shares authorized; 3,473,897 shares issued ............. 34,738
Additional paid-in-capital ................................ 14,117,079
Accumulated deficit ....................................... (10,382,240)
------------
3,769,577
Treasury stock, at cost, 279,000 common shares ............ (226,179)
------------
TOTAL STOCKHOLDERS' EQUITY ............................. 3,543,398

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ............. $ 26,155,717
============

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

19
<PAGE>
HENLEY HEALTHCARE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 1997 1996
------------ ------------
NET SALES ...................................... $ 24,257,014 $ 12,485,961
COST OF SALES .................................. 11,726,802 5,752,266
------------ ------------
GROSS PROFIT ................................... 12,530,212 6,733,695

OPERATING EXPENSES:
Selling, general and administrative ......... 9,217,765 4,740,058
Research and development .................... 506,629 313,599
Provision for doubtful accounts ............. 3,171,163 1,420,518
Depreciation and amortization ............... 716,264 283,746
------------ ------------
INCOME (LOSS) FROM OPERATIONS .................. (1,081,609) (24,226)

INTEREST EXPENSE ............................... (1,147,842) (814,636)
OTHER INCOME (EXPENSE), net .................... 105,018 (40,475)
============ ============
NET LOSS ....................................... $ (2,124,433) $ (879,337)
============ ============
NET LOSS PER COMMON SHARE - basic and diluted .. $ (0.71) $ (0.44)
============ ============
WEIGHTED AVERAGE SHARES OUTSTANDING 3,000,119 1,995,388
============ ============

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

20
<PAGE>
HENLEY HEALTHCARE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1997
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL
--------------------------- PAID-IN ACCUMULATED
SHARES PAR VALUE CAPITAL DEFICIT
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1995 ............. 1,761,225 $ 17,612 $ 7,232,691 $ (7,378,470)

Issuance of common stock for services
in February 1996 ....................... -- -- 6,379 --
Subscriptions for common stock at $3.00
per share in January through June 1996 . 644,670 6,447 1,927,577 --
Issuance of common stock for services .... 33,333 333 99,667 --
Issuance of common stock on conversion
on Bridge Notes ........................ 176,773 1,768 528,552 --
Issuance of common stock on the
exercise of warrants ................... 75,000 750 6,750 --
Issuance of common stock for equipment .. 4,000 40 11,960 --
Issuance of common stock for acquisitions 121,170 1,211 748,789 --
Issuance of common stock related to
employment agreement ................... 205,268 2,053 97,947 --
Net loss ................................. -- -- -- (879,337)
------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1996 ............. 3,021,439 30,214 10,660,312 (8,257,807)

Issuance of common stock for acquisitions 361,117 3,611 2,907,229 --
Issuance of common stock for non-compete
agreement .............................. 10,000 100 53,025 --
Exercise of common stock options ......... 20,000 200 159,800 --
Exercise of common stock warrants ........ 61,341 613 336,713 --
Net loss ................................. -- -- -- (2,124,433)
------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1997 ............. 3,473,897 $ 34,738 $ 14,117,079 $(10,382,240)
============ ============ ============ ============
<CAPTION>
TREASURY STOCK
---------------------------- STOCKHOLDERS'
ACQUISITION EQUITY
SHARES COST (DEFICIT)
------------ ------------ ------------
<S> <C> <C> <C>
BALANCE AT DECEMBER 31, 1995 ............. (281,000) $ (227,800) $ (355,967)

Issuance of common stock for services
in February 1996 ....................... 2,000 1,621 8,000
Subscriptions for common stock at $3.00
per share in January through June 1996 . -- -- 1,934,024
Issuance of common stock for services .... -- -- 100,000
Issuance of common stock on conversion
on Bridge Notes ........................ -- -- 530,320
Issuance of common stock on the
exercise of warrants ................... -- -- 7,500
Issuance of common stock for equipment .. -- -- 12,000
Issuance of common stock for acquisitions -- -- 750,000
Issuance of common stock related to
employment agreement ................... -- -- 100,000
Net loss ................................. -- -- (879,337)
------------ ------------ ------------
BALANCE AT DECEMBER 31, 1996 ............. (279,000) (226,179) 2,206,540

Issuance of common stock for acquisitions -- -- 2,910,840
Issuance of common stock for non-compete
agreement .............................. -- -- 53,125
Exercise of common stock options ......... -- -- 160,000
Exercise of common stock warrants ........ -- -- 337,326
Net loss ................................. -- -- (2,124,433)
------------ ------------ ------------
BALANCE AT DECEMBER 31, 1997 ............. (279,000) $ (226,179) $ 3,543,398
============ ============ ============
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.

21
<PAGE>
HENLEY HEALTHCARE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997 1996
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ................................................................. $ (2,124,433) $ (879,337)
Adjustments to reconcile net loss
to net cash provided by (used in) operating activities:
Depreciation and amortization expense ............................... 716,264 283,746
Amortization of discount on notes payable ........................... -- 151,667
Interest expense imputed on notes payable ........................... 284,667 294,820
Provision for doubtful accounts ..................................... 3,171,163 1,420,518
Shares issued for public relations agreement ........................ -- 8,000
Shares issued for equipment ......................................... -- 12,000
Shares issued for services/with employment agreement ................ -- 200,000
Shares issued for compensation ...................................... 160,000 --
Shares issued for non-compete agreement ............................. 53,125 --
Changes in operating assets and liabilities:
Increase in accounts receivable ................................... (4,258,785) (2,623,498)
(Increase) decrease in inventory .................................. (398,533) 1,381,689
(Increase) decrease in prepaid expenses and other current assets .. 88,115 (149,693)
Increase in other assets .......................................... (290,209) (16,447)
Increase in accounts payable and accrued liabilities ................ 2,464,591 500,785
------------ ------------
Total adjustments ................................................. 1,990,398 1,463,587
------------ ------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES ................... (134,035) 584,250
------------ ------------

CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, net of cash acquired of $68,600 and $46,270, respectively .. (4,862,371) (6,603,046)
Capital expenditures ..................................................... (356,533) (140,570)
------------ ------------
NET CASH USED IN INVESTING ACTIVITIES ................................. (5,218,904) (6,743,616)
------------ ------------

CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock ............................... -- 1,941,524
Proceeds from exercise of common stock warrants .......................... 337,326 --
Proceeds from line of credit ............................................. 13,891,049 2,187,071
Payments on line of credit ............................................... (8,972,251) --
Proceeds from long-term debt ............................................. 1,430,000 2,509,000
Principal payments on long-term debt ..................................... (1,717,457) (173,701)
------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ............................. 4,968,667 6,463,894
------------ ------------
Net increase (decrease) in cash and cash equivalents ....................... (384,272) 304,528
Cash and cash equivalents at beginning of period ........................... 507,892 203,364
------------ ------------
Cash and cash equivalents at end of period ................................. $ 123,620 $ 507,892
============ ============
Supplemental disclosures of cash flow information: Cash paid during the year
for:
Interest ................................................................. $ 796,643 $ 325,136
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.

22
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. PRINCIPAL BUSINESS ACTIVITY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

NATURE OF OPERATIONS

Henley Healthcare, Inc. (formerly Lasermedics, Inc.) and Subsidiaries
(collectively, the "Company") is a manufacturer, provider and marketer of
diversified products and services in the physical therapy and rehabilitation
industry. Substantially all of the Company's customers are located throughout
the United States. The Company, organized in November 1990, was in the
development stage through April 30, 1996, and for the years ended December 31,
1997 and 1996, is considered an operating company.

The Company achieved substantial growth over the last 18 months through
acquisition of businesses and product lines. Consequently, the Company continues
to face the challenge of successfully integrating the operations of the acquired
businesses and implementing the acquired product lines into its overall
marketing strategy. The Company's future success is dependent on many factors
which include, among others, competition, technological changes, generating
sufficient sales volume to achieve and maintain profitability and obtaining
sufficient financing to fund its stated business objectives. The Company will
continue to seek to expand the market for its products. However, markets for the
Company's current and future products are highly competitive and subject to
continuing technological change and development. Future sales growth will depend
to some extent upon the ability of the Company to successfully market its
current and future products in this competitive environment. Additionally, some
of the Company's products are regulated by the FDA, and the Company is required
to secure clearance from the FDA prior to marketing certain new products. Lack
of clearance or delays in securing such clearance could have a negative impact
on sales of such new products.

Following is a summary of the Company's significant accounting policies:

BASIS OF PRESENTATION

The consolidated financial statements include the accounts of Henley Healthcare,
Inc. and its wholly-owned subsidiaries. Inter-company transactions and balances
have been eliminated in consolidation.

REVENUE RECOGNITION

Revenue is recognized when title passes to the buyer, typically when the product
is shipped or services have been rendered. Service revenues and costs of service
revenues are not presented separately in the financial statements because they
are not material. The Company sells a wide range of products to a diversified
base of customers around the world. The Company has agreements with third-party
payors that provide payment at varying rates. Net revenue is reported at the
estimated net realizable amount from customers and third-party payors.

CASH EQUIVALENTS

The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents. The Company maintains
cash in bank deposit accounts which, at times, exceed federally insured limits.
The Company has not experienced any losses on these accounts.

INVENTORY

Inventory is stated at the lower of cost, determined by the first-in, first-out
(FIFO) valuation method, or market. Cost includes the acquisition of raw
materials and components, direct labor and overhead.

23
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

PROPERTY, PLANT AND EQUIPMENT

The amount of property, plant and equipment is stated at cost less accumulated
depreciation. Depreciation and amortization of property, plant and equipment is
provided using the straight-line method over the estimated useful lives of the
assets. Maintenance, repairs and minor replacements are charged to expense as
incurred; significant renewals and betterments are capitalized.

RECLASSIFICATION

Certain reclassifications have been made to prior year data in the consolidated
financial statements to conform to the current year's presentation.

INCOME TAXES

The Company employs the liability method of accounting for income taxes pursuant
to Statement of Financial Accounting Standards ("SFAS") No. 109, under which
method recorded deferred income taxes reflect the tax consequences on future
years of temporary differences (differences between the tax basis of assets and
liabilities and their financial amounts at year-end). The Company provides a
valuation allowance that reduces deferred tax assets to their estimated net
realizable value based on an evaluation of the likelihood of the realization of
those tax benefits.

LOSS PER SHARE

The Company adopted SFAS No. 128, "Earnings per Share," in the fourth quarter of
1997, and has retroactively revised the presentation of net loss per share in
historical financial statements to present both basic and diluted net loss per
share as required by SFAS No. 128. Basic net loss per common share is based on
the weighted average number of shares outstanding during the period, while
diluted net loss per common share considers the dilutive effect of stock options
and warrants reflected under the treasury stock method. The Company's net loss
per share presented in the accompanying financial statements, calculated under
SFAS No. 128, is the same as net loss per share calculated under the provisions
of APB Opinion No. 15. Both basic net loss per share and diluted net loss per
share are the same since the Company's outstanding stock options and warrants
have not been included in the calculation because their effect would have been
anti-dilutive.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires the use of estimates and assumptions by
management affecting the reported amounts of assets and liabilities and revenue
and expenses and the disclosure of contingent assets and liabilities. Actual
results could differ from those estimates.

STOCK OPTIONS

The Company measures compensation cost using APB Opinion No. 25 ("APB 25") as
permitted by SFAS No. 123, "Accounting for Stock-Based Compensation." Pursuant
to APB 25, the Company records deferred compensation expense for stock-based
compensation arrangements based on the excess of the market value of the common
stock on the measurement date over the exercise price of the common stock
option/warrant granted. The deferred compensation is amortized over the vesting
period of each unit of stock-based compensation. No compensation expense is
recorded if the exercise price of the stock-based compensation grant is equal to
the market price of the Company's common stock on the date of grant.

RESEARCH AND DEVELOPMENT

Expenditures relating to research and development are expensed as incurred.

24
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

GOODWILL AND INTANGIBLES

Goodwill represents the excess of the aggregate purchase price paid by the
Company over the fair market value of the tangible and identifiable intangible
net assets acquired, arising from business acquisitions accounted for under the
purchase method. Goodwill and intangibles are amortized on a straight-line basis
over their estimated useful lives of 15 years for goodwill and for periods
ranging from 2 to 7 years for identifiable intangibles. Accumulated amortization
at December 31, 1997 was $374,092.

OTHER ASSETS

Other assets consists principally of acquired trade name rights, which are being
amortized over the shorter of the life of the rights or 7 years. Accumulated
amortization at December 31, 1997 was $38,000.

LICENSE AGREEMENTS

The Company has executed licensing agreements under which it has secured the
rights provided under certain patents and trade names. License fees and
royalties, payable under the terms of these agreements, are expensed as
incurred.

IMPAIRMENT OF LONG-LIVED ASSETS

The Company has adopted SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which requires
that long-lived assets and certain identifiable intangibles (including goodwill)
held and used by a company be reviewed for possible impairment whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. The Company periodically assesses the realizability of its
long-lived assets pursuant to the provisions of SFAS No. 121. Based on the
Company's analysis of the undiscounted future cash flows for its long-term
assets, no impairments have been recognized under SFAS No. 121.

2. INVENTORY:

Inventory at December 31, 1997, included the following:

Raw material ......................................... $3,599,132
Work-in-process ...................................... 28,875
Finished goods ....................................... 4,519,350
----------
$8,147,357
==========

Substantially all of the Company's inventory is pledged as collateral for the
Company's long-term debt.

25
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. PROPERTY, PLANT AND EQUIPMENT:

At December 31, 1997, property, plant and equipment consisted of the following:

Estimated
Useful Life
------------
Land ....................................... $ 190,000
Buildings .................................. 1,932,311 25 years
Machinery and equipment .................... 2,231,435 3 to 7 years

Office furniture and fixtures .............. 238,016 5 years
Automobile ................................. 6,000 5 years
-----------
4,597,762
Less accumulated depreciation .............. (603,531)
-----------
Property, plant and equipment, net ......... $ 3,994,231

Substantially all of the Company's property, plant and equipment is pledged as
collateral for the Company's long-term debt.

4. GOODWILL AND OTHER INTANGIBLES:

At December 31, 1997, goodwill and other intangibles consisted of the following:

Estimated
Useful Life
-------------
Goodwill .................................... $ 4,947,297 15 years
Proprietary training programs ............... 700,000 5 to 10 years
Patents ..................................... 203,674 7 years
Covenant not to compete ..................... 193,125 2 years
-----------
6,044,096
Less accumulated amortization ............... (374,092)
-----------
Goodwill and other intangibles, net ......... $ 5,670,004

5. ACQUISITIONS:

BUSINESSES

On April 30, 1996, the Company entered into an agreement with Maxxim, whereby
the Company purchased certain assets of (and assumed certain liabilities
associated with) the Henley Division of Maxxim for an estimated purchase price
of approximately $13.5 million including related acquisition costs of
approximately $650,000. The assets acquired consist of real property; tangible
personal property including machinery, equipment, furniture and fixtures;
general intangibles; contracts; business licenses; accounts receivable;
inventory; and prepaid expenses. The purchase price was paid by the issuance of
the Company's convertible subordinated promissory note in the principal amount
of $7,000,000 (the "Note") with the balance of the purchase price paid in cash.

26
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company obtained the cash portion of the purchase price pursuant to
financing arrangements entered into with Comerica Bank - Texas, a Texas banking
corporation ("Comerica"), which financing is secured by substantially all of the
assets of the Company including the Henley assets acquired from Maxxim.

On November 12, 1996, the Company purchased substantially all of the assets of
(and assumed certain liabilities associated with) MJH Medical Equipment, Inc.
("MJH") for an estimated purchase price of approximately $435,000 including
related acquisition costs of approximately $45,000. The assets acquired consist
of tangible personal property including equipment, furniture and fixtures;
contracts; business licenses; accounts receivable; inventory; and prepaid
expenses. The purchase price was paid by the issuance of the Company's
promissory note in the principal amount of approximately $120,000 and 39,063
shares of common stock, with the balance of the purchase price paid in cash.

On November 27, 1996, the Company, through a wholly-owned subsidiary, acquired
all of the outstanding shares of common stock of Health Career Learning Systems,
Inc., a Michigan corporation, for an estimated purchase price of approximately
$680,000 including related acquisition costs of approximately $80,000. The
purchase price was paid by the issuance of 82,107 shares of common stock with
the balance of the purchase price paid in cash.

These 1996 acquisitions have been accounted for as purchases for accounting
purposes, and the results of operations of the acquisitions have been included
in the consolidated statement of operations from the dates of acquisition. The
estimated purchase price in excess of the estimated fair value of the net assets
acquired, aggregated approximately $2,261,000 for all of the acquisitions.
Assuming these acquisitions had occurred on January 1, 1996, pro forma net
sales, net loss and net loss per common share for the year ended December 31,
1996, would amount to $20,120,000, $(1,462,000) and $(.73), respectively. These
amounts reflect adjustments for interest on the Note and the financing
arrangements with Comerica, amortization of goodwill, compensation related to an
employment agreement and depreciation on re-valued property, plant and
equipment.

In January 1997, the Company entered into an agreement pursuant to which it
acquired all of the issued and outstanding common stock of Texas T.E.N.S., Inc.,
a privately-owned Texas corporation ("TENS"), for an estimated purchase price of
approximately $850,000 plus related acquisition costs of approximately $65,000.
The purchase price was paid by the Company's issuance of a subordinated
promissory note in the principal amount of $400,000 (the "TENS Note") with the
balance of the purchase price paid in cash. In August 1997, the principal
balance on the TENS Note plus all accrued and unpaid interest due on the Note
was paid.

In May 1997, the Company entered into an agreement pursuant to which it acquired
all of the issued and outstanding shares of common stock of Med-Quip, Inc.
("Medquip"), a privately-owned Georgia corporation, for an estimated purchase
price of approximately $1,418,000 plus related acquisition costs of
approximately $56,000. The purchase price was paid by the issuance of an
aggregate of 300,000 shares of the Company's common stock and the payment of
approximately $40,000 in cash.

In October 1997, the Company entered into an agreement with the sole owner of
Summer Medical ("SM"), an unincorporated sole proprietorship, pursuant to which
the Company acquired all of the owner's interests in SM and assumed certain
business-related liabilities associated with SM. Under the agreement, the
Company issued to the owner 10,000 shares of common stock and agreed to issue an
additional 20,000 shares by the second anniversary of the agreement. The
estimated fair market value of the additional 20,000 shares is being recorded as
compensation expense over the term until the second anniversary.

In December 1997, the Company acquired all of the issued and outstanding common
stock of NCI, Inc., a Michigan corporation ("NCI"), for an estimated purchase
price of $1,190,000 plus estimated acquisition costs of $5,000. The purchase
price was paid by the issuance to the seller of 188,847 shares of the Company's
common stock.

These 1997 acquisitions of businesses have been accounted for as purchases for
accounting purposes, and the results of operations of the acquired companies
have been included in the consolidated statement of operations from the

27
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

respective dates of acquisition to December 31, 1997. Pro forma financial
information is not provided because the amounts are not materially different
from 1997 and 1996 results. The estimated purchase price in excess of the
estimated fair value ("FV") of the net assets acquired aggregates approximately
$3,047,000 for the acquisitions as shown below:
<TABLE>
<CAPTION>
TENS MEDQUIP SM NCI Total
----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Purchase price .......... $ 850,000 $ 1,417,500 $ 56,625 $ 1,189,736 $ 3,513,861
Acquisition costs ....... 65,000 56,000 15,000 5,000 141,000
----------- ----------- ----------- ----------- -----------
915,000 1,473,500 71,625 1,194,736 3,654,861
----------- ----------- ----------- ----------- -----------
FV of assets acquired ... 613,095 637,216 72,019 700,000 2,022,330
FV of liabilities assumed 114,355 504,619 101,908 -0- 720,882
----------- ----------- ----------- ----------- -----------
Net assets (liabilities)
acquired ................ 498,740 132,597 (29,889) 700,000 1,301,448
----------- ----------- ----------- ----------- -----------
Excess of cost over fair
value of net assets
acquired (goodwill) ..... $ 416,260 $ 1,340,903 $ 101,514 $ 494,736 $ 2,353,413
----------- ----------- ----------- ----------- -----------
</TABLE>
Other Acquisitions:

In January 1997, the Company also purchased substantially all of the inventory,
distribution systems and customers associated with the Homecare division of
Gatti Medical Supply, Inc., a privately-owned Pennsylvania corporation, for a
purchase price of approximately $302,000 plus related acquisition costs of
approximately $28,000. The Company paid the purchase price by issuing to the
sellers a total of 51,117 shares of common stock. The Company also agreed to
issue up to an aggregate of 50,117 additional shares of common stock subject to
the achievement of specific terms and conditions in the agreement. Such
additional shares will be recorded as compensation expense based on the market
value of the shares, if and when they are probable of being issued.

In March 1997, the Company entered into new agreements with CB Svendsen a/s
("CBS"), the Danish company with whom the Company has worked on the development
and marketing of the MicroLight 830TM since June 1991. Pursuant to the new
agreements, the Company paid $100,000 to CBS and obtained unto perpetuity the
sole and exclusive world-wide distribution rights to all low level laser devices
manufactured by or for CBS. In connection with these agreements, the Company is
required to pay a 3 percent royalty on revenue generated by the Company on sales
of the applicable products. Also pursuant to the agreements, the Company
obtained unto perpetuity the exclusive world-wide manufacturing rights to all
low level laser devices manufactured by or for CBS subject to the payment to CBS
by June 15, 1998, of $175,000.

In September 1997, the Company entered into an agreement with Cybex
International, Inc., a New York corporation ("Cybex"), whereby it purchased
certain assets of (and assumed certain liabilities associated with) the
isokinetic rehabilitation product line (the "Product Line") of Cybex for an
estimated purchase price of approximately $3.2 million plus related acquisition
costs of approximately $1.0 million. The assets acquired consist of tangible
personal property including machinery, equipment, furniture and fixtures;
specific intangibles; contracts; intellectual property; business licenses;
inventory; and prepaid expenses. The purchase price was allocated as follows:
approximately $2,700,000 to inventory, $500,000 to property, plant and
equipment, and $1,000,000 to patents and trade names.

28
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. LONG-TERM DEBT:

The following table summarizes the Company's long-term debt at December 31,
1997, which is described below:

Note payable - Maxxim ....................... (a) $7,000,000
Term Note A - Comerica ...................... (b) 1,382,334
Term Note B - Comerica ...................... (b) 1,445,422
Note payable - MJH .......................... (c) 72,186
----------
9,899,942
Less: Current maturities .................... 433,763
----------
$9,466,179
==========

(a) The Note which the Company issued to Maxxim in connection with the
acquisition of its Henley Division in April 1996, is payable subject to
mandatory redemption requirements of $1.4 million annually beginning on March 1,
1999 with a final payment due March 1, 2003. These mandatory redemptions are
subject to premiums starting at 7% and decreasing 1% each year. The installment
premiums are recognized as interest expense on a straight-line basis over the
term of the note. In addition, the Company is required to redeem 40 percent of
the note upon completion of a public offering. The Company also may redeem any
or all of the outstanding principal amount of the Note at its option at
redemption prices ranging from 104% to 110% of the principal amount being
redeemed, depending on when the redemption occurs as set forth in the Note.
Interest is payable semi-annually on November 1 and May 1 of each calendar year
at a rate of 2% per annum and increasing 2% annually on May 1. However, the
Company accrues interest related to the note on a straight-line basis at an
average rate of 7.4% per annum. Accordingly, $530,667 of accrued interest has
been classified as long term in the accompanying balance sheet.

(b) In connection with the acquisition of the Henley Division from Maxxim, the
financing arrangements ("Loan Agreement") with Comerica provided for (i) a
two-year revolving loan arrangement which permitted borrowings up to $4,000,000
through April 1998, pursuant to a monthly borrowing base calculation derived
from the Company's accounts receivable and inventory and (ii) two term loans in
the amount of $893,000 ("Term Note A") and $1,616,000 ("Term Note B"),
respectively. Term Note A and Term Note B are payable in monthly installments
plus interest. The revolving loan also includes a $250,000 letter of credit
facility. Interest on the revolving loan and the two term loans is payable
monthly at a rate equal to the Prime Rate (8.50% at December 31, 1997) plus
one-half of one percent per annum. Term Note B is callable by Comerica beginning
on its fifth anniversary. In June 1997, the Company entered into an Amended and
Restated Loan Agreement with Comerica which, among other things, permitted
borrowings up to $5,000,000 on the revolving loan arrangement.

In connection with the acquisition of the Product Line from Cybex in September
1997, the Company obtained the cash purchase price pursuant to an amendment to
the Amended and Restated Loan Agreement (the "Amended Loan Agreement") entered
into with Comerica. The Amended Loan Agreement provides for a revolving loan
which permits borrowings up to $8,000,000 pursuant to a borrowing base
calculation derived from the Company's accounts receivable and inventory. The
revolving loan had an outstanding balance of $7,105,868 at December 31, 1997,
and is subject to interest at the Prime Rate (8.50% at December 31, 1997) plus
one-half of one percent per annum, payable monthly. In connection with the
Amended Loan Agreement, the Company paid off its Term Note A with Comerica in
the amount of $893,000 and issued a substitute Term Note A in the amount of
$1,430,000. The revolving loan's maturity date is February 1, 1999, while the
$1,430,000 Term Note A is due on September 30, 2002. All of the borrowings from
Comerica are secured by substantially all of the assets of the Company. The
Amended Loan Agreement also contains a number of affirmative covenants, negative
covenants and financial covenants with which the Company must comply including a
minimum tangible net worth, leverage ratio, working capital ratio, fixed charge
ratio and interest coverage ratio. The Company, among other provisions, is also
limited in the amount of its capital expenditures, research and development
expenditures and dividends and all future acquisitions and major corporate
transactions require approval of Comerica, as do offerings of securities by the
Company.

29
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(c) In connection with the acquisition of MJH Equipment, Inc. in November 1996,
the Company issued a note payable to the seller, in the amount of approximately
$120,000. The note is payable in monthly principal installments of $3,336 plus
interest at a bank's prime lending rate plus 2% per annum through November 1999.

The estimated fair value of the Maxxim Note amounted to $7,000,000 pursuant to a
valuation by an investment banking firm. Based on borrowing rates currently
available to the Company for loans with similar terms and average maturities the
fair value of the Company's other long-term debt approximates the carrying
amount.

Aggregate maturities of long-term debt are as follows:

For the year ending December 31,
1998 .................... $ 433,763
1999 .................... 1,825,883
2000 .................... 1,793,729
2001 .................... 1,793,729
2002 .................... 1,746,083
2003 and thereafter .................... 2,306,755
----------
$9,899,942

7. RELATED PARTY TRANSACTIONS:

In May 1996, the Company entered into an agreement with Mezzanine Financial
Relations, Inc., ("Mezzanine") a financial relations company, which agreement
the parties amended in November 1996, whereby Mezzanine agreed to provide
financial consulting services with regard to potential mergers and acquisitions
in consideration for a monthly fee of $10,000. The agreement terminated on
January 31, 1997. The Executive Vice President, Chief Financial Officer and a
director of the Company is a shareholder of Mezzanine and its Chairman of the
Board.

8. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES:

The following are included in accrued expenses and other current liabilities at
December 31, 1997:

Property taxes ............................................ $ 169,716
Sales taxes ............................................... 61,761
Payroll and commissions ................................... 344,140
Interest payable .......................................... 148,420
Accrued acquisition costs ................................. 19,771
Accrued professional and other fees ....................... 88,749
Other ..................................................... 267,015
----------
$1,099,572

30
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9. INCOME TAXES:

The following is an analysis of the Company's deferred tax assets at December
31, 1997:

Deferred tax assets:
Accrued expenses and other ................................. $ 34,000
Allowance for doubtful accounts ............................ 699,000
Deferred compensation ...................................... 494,000
Net operating loss carryforwards ........................... 2,150,000
-----------
3,377,000

Deferred tax liability:
Depreciation and amortization .............................. (49,000)

Net deferred tax asset before valuation allowance .......... 3,328,000
Valuation allowance .......................................... (3,328,000)
-----------
Net deferred tax asset ....................................... $ -0-

The components of the Company's income tax provisions for the years ended
December 31, 1997 and 1996, were as follows:

1997 1996
--------- ---------
Current .................................. $(666,000) $(132,000)
Deferred ................................. 666,000 132,000
--------- ---------
Provision for income taxes ............... $ -0- $ -0-

Differences between the Company's effective income tax rate and the statutory
federal rate for the years ended December 31, 1997 and 1996 are as follows:

1997 1996
--------- ---------
Provision at the statutory rate .............. $(722,000) $(132,000)
Permanent differences and other .............. 71,000 56,000
Increase in valuation allowance .............. 651,000 76,000
--------- ---------
Total tax provision .......................... $ -0- $ -0-

As of December 31, 1997, the Company had net operating loss carryforwards for
income tax purposes of approximately $6,324,000 available to offset future
taxable income. The carryforwards will begin to expire in 2005. Between January
1993 and December 1997, the Company completed an initial public offering, had
warrants exercised, completed private offerings of securities and made
acquisitions of established businesses or product lines. Under the Internal
Revenue Code Section 382 these activities effected an ownership change and thus
severely limit on an annual basis, the Company's ability to utilize its net
operating loss carryforwards. A valuation allowance was provided to fully
reserve the net deferred tax asset due to realization uncertainties regarding
future operating results.

31
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. STOCKHOLDERS' EQUITY:

In connection with an agreement the Company entered into with a public relations
firm, the Company issued to the firm, in February 1996, 2,000 shares of its
treasury common stock as compensation for services. The Company recognized
$8,000 in related compensation expense at December 31, 1996, based on the market
price of the common stock on the date of the agreement. During the year ended
December 31, 1996, the Company issued 33,333 shares of common stock to a
director of the Company for his services in connection with the Company's
pre-market approval application submission to the FDA. The Company recognized
approximately $100,000 in related expense based on the market price of the
common stock on the date of the related agreement.

In connection with the Gatti acquisition in January 1997, the Company issued
51,117 shares of its common stock as consideration for the acquisition. In May
1997, the Company issued 300,000 shares of its common stock as consideration for
the acquisition of Med-Quip; and in October 1997, the Company issued 10,000
shares of its common stock for the acquisition of Summer Medical.

In connection with the Amended Loan Agreement with Comerica relating to the
acquisition of the Product Line from Cybex, the Company entered into an
amendment to a Subordination Agreement (the "Subordination Amendment") by and
among Maxxim, Comerica and the Company. Pursuant to the Subordination Amendment,
the maximum amount of the Company's debt with Comerica that can be issued senior
to the Note was increased from $10,000,000 to $12,000,000. In exchange for
Maxxim's execution of the Subordination Amendment, the Company entered into a
note modification agreement with Maxxim in which the Conversion Price (as
defined in the Note) was reduced from $3.00 to $2.00. The modification of the
Note increased the number of shares of the Company's common stock, par value
$.01 per share ("Common Stock"), beneficially owned by Maxxim from 2,333,333
(approximately 43%) to 3,500,000 (approximately 53%). (See Note 16 below). The
Note is convertible into Common Stock at any time at Maxxim's option. The
conversion price is also subject to adjustment upon the occurrence of certain
events (including certain issuances of common stock for less than the conversion
price) to provide anti-dilution protection. Such conversion could, depending on
the fair market value of the Company's common stock at the time of conversion,
result in substantial dilution to holders of the Company's common stock. The
Company's common stock issuable upon conversion of the Note is subject to the
terms of a registration rights agreement entered into by the Company and Maxxim
whereby Maxxim (and certain subsequent holders) shall retain certain demand and
piggyback registration rights with respect to those shares of common stock.

The Company issued to a former employee, in October 1997, 10,000 shares of its
common stock as partial consideration for a non-compete agreement. The Company
has capitalized $53,125 in related costs based on the market price of the common
stock on the date of the agreement.

Also, in October 1997, the Company issued to a former employee, 20,000 shares of
its common stock pursuant to the exercise of stock options and in connection
with the settlement of a contract dispute. In connection with the settlement,
the Company has recognized $160,000 in related compensation expense based on the
market price of the common stock on the date of the settlement.

In December 1997, the Company acquired all of the issued and outstanding common
stock of NCI, Inc., a Michigan corporation. As consideration for the
acquisition, the Company issued to the seller 188,847 shares of the Company's
common stock.

32
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

11. STOCK OPTIONS AND WARRANTS:

Pursuant to the provisions of the 1996 Non-Employee Director Stock Option Plan
(the "Director Stock Plan") and the 1996 Incentive Stock Plan (the "Incentive
Plan"), certain of the Company's directors were granted stock options during
fiscal 1997 as discussed below. At December 31, 1997, there were 95,000 and
1,180,000 shares available for issuance under the Director Stock Plan and the
Incentive Plan, respectively. A summary of the Company's options and warrants as
of December 31, 1997 and 1996, and changes during the years then ended is
presented below:
<TABLE>
<CAPTION>
1997 1996
---------------------------- ----------------------------
Weighted Avg. Weighted Avg.
Shares Exercise Price Shares Exercise Price
---------- -------------- ---------- --------------
<S> <C> <C> <C> <C>
Outstanding at beginning of year ..... 1,811,502 $ 5.24 962,726 $ 3.81
Canceled/expired ..................... (91,385) 5.53 (50,000) 0.10
Granted .............................. 60,000 5.83 973,776 6.02
Exercised ............................ (91,341) 4.57 (75,000) 0.10
---------- -------------- ---------- --------------
Outstanding at end of year ........... 1,688,776 $ 5.24 1,811,502 $ 5.24

Options and warrants exercisable at
year-end ........................ 1,688,776 $ 5.24 1,811,502 $ 5.24
Weighted-average fair value of options
and warrants granted during the year $ 4.31 $ 1.26
</TABLE>
The following table summarizes the information about stock options and warrants
outstanding at December 31, 1997:
<TABLE>
<CAPTION>
Options and Warrants Outstanding and Exercisable
----------------------------------------------------------------------
Weighted Average
Range of Number Outstanding Remaining Weighted Average
Exercise Prices at December 31, 1997 Contractual Life Exercise Price
- ------------------ -------------------------- --- ------------------- -- -------------------
<S> <C> <C> <C>
$1.00-$3.00 205,000 2.0 $ 3.00
$4.00-$5.50 515,000 4.4 $ 4.49
$6.00-$7.88 968,776 3.4 $ 6.11
-----------------------
1,688,776 3.7 $ 5.24
=======================
</TABLE>
The Company has elected, in accordance with the provisions of Statement of
Financial Accounting Standards No. 123 ("SFAS No. 123") to apply APB Opinion No.
25 and related interpretations in accounting for stock options granted to
employees, and accordingly, has presented the disclosure-only information as
required by SFAS No. 123. If the Company had elected to recognize compensation
cost based on the fair value of the options granted at the grant date as
prescribed by SFAS No. 123, the Company's net loss and net loss per common share
for the years ended December 31, 1997 and 1996, would approximate the pro forma
amounts shown in the table below.

Year ended December 31, 1997 1996
------------- -------------
Net loss - as reported ....................... $ (2,124,433) $ (879,337)
Net loss - pro forma ......................... $ (2,286,913) $ (1,023,837)
Net loss per common share - as reported ...... $ (0.71) $ (0.44)
Net loss per common share - pro forma ........ $ (0.76) $ (0.51)

For the year ended December 31, 1997, the pro forma values were calculated using
the Black-Scholes option pricing model and included the following weighted
average assumptions: zero dividends, expected stock price volatility of 80.7

33
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

percent, risk-free interest rate of 6.4 percent and an expected life of 7.3
years. For the year ended December 31, 1996, the fair value of each option grant
on the date of grant was valued by an investment banking firm taking into
account as of the grant date the exercise price and expected life of the option,
the current price of the underlying stock and its expected volatility, expected
dividends on the stock and the risk-free interest rate for the expected term of
the option as prescribed by SFAS No. 123.

In connection with their re-election to the Board of Directors in June 1997,
four non-employee directors were each granted a stock option under the Director
Plan to purchase 10,000 shares of the Company's common stock at a price of $4.81
per share. Also, in November 1997, two employee directors were each granted
options under the Incentive Stock Plan to purchase 10,000 shares of the
Company's common stock at a price of $7.88 per share, such options to become
vested over a three year period contingent upon the continued employment of the
directors.

In December 1997, certain holders of the Company's Amended and Restated J
Warrants exercised their rights under the Warrants and purchased an aggregate of
61,341 shares of the Company's common stock at a price of $5.50 per share. In
connection with the exercise of these Warrants, the Company received cash
proceeds of approximately $337,000. Holders of an aggregate of 43,600 Warrants
elected not to exercise their rights and their Warrants expired or were
redeemed.

12. COMMITMENTS AND CONTINGENCIES:

EMPLOYMENT AND CONSULTING AGREEMENTS

The Company has entered into various employment and consulting agreements with
various key personnel, directors and certain shareholders aggregating $802,000
which expire at various dates through November 1999. Certain of these agreements
provide for incentive bonuses and or commissions, as defined in the agreements.
In connection with the SM acquisition, the Company entered into an employment
agreement with the seller that provides for the issuance of 20,000 shares of the
Company's common stock over a two-year period if the employee meets certain
criteria as specified in the agreement. The Company will recognize a charge to
operations upon the issuance of such shares based on the fair market value of
the shares as of the issuance date.

EXCLUSIVE RIGHTS AGREEMENT

Also pursuant to the agreements, the Company obtained unto perpetuity the
exclusive world-wide manufacturing rights to all low level laser devices
manufactured by or for CBS subject to the payment to CBS by June 15, 1998, of
$175,000.

LEASES

The Company is obligated under various non-cancelable operating leases
(including certain related-party leases aggregating approximately $14,150 per
month) for warehouse and office space expiring through June 2001, which are
subject to increase for real estate taxes and operating expense escalation. Rent
expense charged to operations under these operating leases amounted to
approximately $243,000 and $45,000 for the years ended December 31, 1997 and
1996, respectively.

34
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Minimum future rental payments are as follows:

Fiscal Years
- ----------------
1998 ........................ $182,383
1999 ........................ 174,234
2000 ........................ 140,009
2001 ........................ 26,652
--------
$523,278

LITIGATION AND CLAIMS

The Company is subject to legal proceedings and claims arising in the ordinary
course of its business. In the opinion of management, the ultimate outcome of
all legal actions and claims will not have a material adverse effect upon the
consolidated financial position and results of operations of the Company.

13. EMPLOYEE BENEFIT PLANS:

The Company's 401(k) savings plan (the "Plan") adopted in fiscal 1996, covers
all qualified employees. The Plan permits participants to contribute up to 15%
of their base compensation (as defined) each year. The Company will match at
least 25% of the participant's contribution up to a maximum of 6% of gross pay.
The Company's matching percentage may be adjusted as Company profitability
dictates. Two officers of the Company serve as trustees of the Plan. Matching
contributions to the Plan for the years ended December 31, 1997 and 1996,
amounted to approximately $44,141 and $25,000, respectively.

14. SUPPLEMENTAL CASH FLOW INFORMATION:

Non-cash investing and financing transactions during the years ended December
31, 1997 and 1996, were as follows:

1997 1996
---------- ----------
Common shares issued in connection
with acquisitions .............................. $2,910,840 $ 750,000
Common shares issued in connection
with conversion of bridge notes ................ -- 530,320
Common shares issued for
equipment ...................................... -- 12,000
Common shares issued for employment
agreement and/non-compete ...................... 53,125 208,000
Accrued amounts relating to acquisitions ......... -- 92,253
Compensation related to common stock
options in legal settlement .................... 160,000 --

35
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

15. NON-RECURRING FOURTH QUARTER ADJUSTMENT:

During the fourth quarter of 1997 the Company revised its estimates of
collectibility of its accounts receivable, and accordingly, increased its
reserve for uncollectible accounts by approximately $2,000,000. During the third
quarter of 1997, the Company commenced an extensive analysis of its accounts
with particular emphasis on its accounts receivable which relate to the
Company's operations, which include third-party billings. In conjunction with
the analysis, the Company intensified its collection efforts. Billings to
third-party payors, by their nature, demand longer-than-average time to bill and
much longer-than-average time to collect. Upon further scrutiny in the fourth
quarter and on the basis of the analysis, management revised its estimates of
collectibility of the Company's accounts receivable for operations, including
third-party billings. Factors contributing to the need for this increased
provision included application of insufficient resources to the collection of
accounts receivable and logistical problems and delays caused in connection with
the implementation of a new accounting system. The Company has also changed
certain procedures in the collection process in order to improve the future
collectibility of the accounts receivable.

The effects of this revision on the Company's results of operations is to
increase net loss by approximately $2,000,000, the amount of the increase in the
provision for doubtful accounts. Approximately $1,500,000 of this provision
related to receivables outstanding for more than a year at December 31, 1997.

16. SUBSEQUENT EVENTS - UNAUDITED:

ACQUISITIONS

On January 6, 1998, the Company, through a wholly-owned subsidiary, acquired all
of the outstanding shares of common stock of Garvey Company, a Minnesota
corporation, as a wholly-owned subsidiary for an estimated purchase price of
approximately $880,000 plus related acquisition costs of approximately $40,000.
The purchase price was paid by the issuance of 120,308 shares of common stock,
with a market price of approximately $7.315 per share.

On February 9, 1998, the Company purchased substantially all of the assets and
assumed certain liabilities associated with AMC Acquisition Corp., a Texas
corporation, for an estimated purchase price of approximately $450,000 plus
related acquisition costs of approximately $30,000. The purchase price was paid
by the issuance of 68,000 shares of common stock, with a market price of
approximately $6.618 per share.

On February 12, 1998, the Company entered into an agreement with Maxxim whereby
it acquired from Maxxim an office/warehouse building located at 140 Industrial
Boulevard, Sugar Land, Texas, for an estimated purchase price of approximately
$1.2 million. The purchase price was paid in cash which the Company obtained
pursuant to a second amendment of its Amended Loan Agreement (the "Second
Amendment") with Comerica. In connection with the Second Amendment with
Comerica, the Company obtained a Term Note C in the principal amount of
$1,260,000 with a maturity date of February 12, 2013. Term Note C bears interest
at the Prime Rate plus one-half of one percent per annum, is payable in monthly
principal installments of $7,000 plus all accrued interest thereon and subject
to the terms and conditions of the Amended Loan Agreement with Comerica. All of
the borrowings from Comerica are secured by substantially all of the assets of
the Company.

EQUITY TRANSACTIONS

On February 20, 1998, and March 13, 1998, the Company entered into agreements
with Maxxim pursuant to which Maxxim converted an aggregate of $4,000,000 of the
Note into an aggregate of 2,000,000 shares of the Company's common stock, par
value $.01 per share. The conversions were based on the current conversion price
of $2.00 per share under the Note. The agreements also provide that the entire
$4 million conversion shall be applied to the Company's full redemption
obligation due in the year 2003 and partially to the Company's redemption
obligation due in the year 2002 as provided in the Note. The Company has agreed
to file a registration statement covering the resale of the shares of Common
Stock issued to Maxxim as a result of the conversions described above.

36
<PAGE>
HENLEY HEALTHCARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

On March 13, 1998, the Company entered into an agreement with some private
institutional investors pursuant to which the Company issued to the investors
$1,825,000 of its Series A Convertible Preferred Stock (the "Preferred Stock")
for cash. Beginning 120 days from the date of issuance, the Preferred Stock is
convertible at the holder's option into Henley's Common Stock at the lesser of
(i) 75% of the average closing bid price for Henley's Common Stock as reported
by Nasdaq for the 5 trading days prior to conversion or $6.50. The value of the
discount ($608,000) is deemed to be a preferred stock dividend that is
recognized ratably from the date of issuance through the date the preferred
stock is first convertible. In connection with the agreement, the Company also
issued to the investors a 5-year warrant to purchase 146,000 shares of the
Company's Common Stock at exercise prices ranging from $7.125 to $9.619. The
Company has agreed to file a registration statement covering the resale of the
shares of Common Stock issuable upon the conversion of the Preferred Stock and
exercise of the warrants sold to the investors described above.

PRO FORMA FINANCIAL INFORMATION

The following summarized pro forma (unaudited) information assumes these
acquisition and equity transactions were completed at December 31, 1997:

Current assets ........................................ $16,126,497
Goodwill .............................................. 6,458,840
Total assets .......................................... 27,912,682
Line of credit ........................................ 5,450,868
Long-term debt ........................................ 5,513,816
Stockholders' equity .................................. 10,847,064

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

On October 20, 1997, the Company informed Goldstein Golub Kessler LLP ("GGK"),
its former principal accountants, of the decision of its Board of Directors to
appoint Arthur Andersen LLP as its principal accountants in place of GGK whom
the Board voted to dismiss. The Board's decision in no way reflects any
dissatisfaction with the services of GGK, but is based on the Company's desire
to engage the services of a bigger firm consistent with its growth strategy.

In connection with the audits of the two most recent fiscal years ended
December 31, 1996 and the subsequent interim periods through October 20, 1997,
the Company had no disagreements with GGK on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope or procedure,
which disagreements, if not resolved to the satisfaction of GGK, would have
caused them to make reference to the subject matter of the disagreements in
connection with their opinion.

The accountant's reports of GGK on the financial statements of the Company as
of and for the fiscal year ended December 31, 1996 did not contain any adverse
opinion or disclaimer of opinion, nor was it qualified or modified as to
uncertainty, audit scope or accounting principles. The accountant's report of
GGK on the financial statements of the Company as of and for the fiscal year
ended December 31, 1995 did not contain any adverse opinion or disclaimer of
opinion, nor was it qualified or modified as to audit scope or accounting
principles, but contained an explanatory paragraph as to uncertainty about the
Company's ability to continue as a going concern relating to substantial
cumulative losses incurred as a development stage company from inception through
that date.

37
<PAGE>
PART III

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

EXECUTIVE OFFICERS AND DIRECTORS

The following table provides information concerning each executive officer and
director of the Company as of the date hereof:

<TABLE>
<CAPTION>
NAME AGE POSITION
<S> <C>
Michael M. Barbour 53 Director, Chief Executive Officer, Director
Dan D. Sudduth 56 Executive Vice President, Chief Financial Officer, Director
Chike J. Ogboenyiya 46 Vice President - Finance, Secretary
Theron L. Morrow 43 Vice President - Sales and Marketing
Chadwick F. Smith, MD 64 Medical Director, Director, Chairman of Board
Pedro A. Rubio, M.D., Ph.D. 53 Director
Kenneth W. Davidson 50 Director
Ernest J. Henley, Ph.D. 71 Director
</TABLE>
Michael M. Barbour has been President, Chief Executive Officer and Director of
the Company since May 1991. He has over 13 years experience in the field of
laser products. Prior to forming Lasermedics, he was President of Medical
Training Centers of America (formerly The Houston Laser Institute) from January
1987 to April 1991, which he founded in order to train and inform doctors in the
medical and surgical use of lasers. From April 1984 to January 1987, he was
President of Surgimedics, a Houston, Texas, manufacturer and distributor of
medical products. Mr. Barbour graduated from the University of Houston in 1967
with a B.B.A. in marketing.

Dan D. Sudduth joined the Company as Executive Vice President and Chief
Financial Officer in February 1997. He has been a Director of the Company since
January 1996. Mr. Sudduth was Chief Financial Officer for Mezzanine Telecom,
Inc., a Houston-based telecommunications company ("MTI"), from 1994 to January
1997 and currently serves as a Director of MTI. During 1995 and 1996, Mr.
Sudduth was President and Director of AMC Home Healthcare, Inc., a respiratory
therapy company in Houston, Chairman of Mezzanine Financial Relations, Inc., a
merchant banking firm in Houston, and Chief Financial Officer and Director of
Creative Communications International, Inc., a Houston telecommunications
company. From 1992 to 1994, Mr. Sudduth served as Chairman and Chief Executive
Officer of Heart Labs of America, Inc. From 1988 to 1992, he was President and
Chief Financial Officer of American Biomed, Inc. Mr. Sudduth received a B.B.A.
in 1964 from Lamar University.

Chike J. Ogboenyiya has been Vice President-Finance of the Company since
January 1994 and Secretary since August 1994. He has over 20 years of extensive
industry experience in accounting, corporate finance and business management.
From 1990 to 1993, he was president and owner of a small accounting firm which
offered business consulting and financial services to various clients. Prior to
that time, he was a Director and Chief Financial Officer for Kaulimax
International Corporation, a privately-held exporter of apparel located in
Houston, Texas, from 1984 to 1990. Mr. Ogboenyiya is a Certified Public
Accountant, graduated with an M.S. from the University of Houston in 1979, and
graduated cum laude from Texas Southern University in 1977 with a B.B.A. in
Accounting.

Theron L. Morrow has been Vice President-Sales and Marketing of the Company
since November 1997. He has over 12 years of experience in the medical devices
industry. From 1991 to 1996, Mr. Morrow was divisional Vice President of
Marketing for Maxxim Medical, Inc. Mr. Morrow holds a B.S. degree in sports
medical sciences from Texas Christian University.

Chadwick F. Smith, MD has been a Director of the Company since May 1991 and
Chairman of the Board of Directors since June 1993. He is also a Consultant to
the Company. See "Certain Relationships and Related Transactions." Dr. Smith is
a Clinical Professor of Orthopedic Surgery at the University of Southern
California School of Medicine, a position he has held since 1981. He has also
been a member of the Medical Staff of Orthopedic Hospital, Los Angeles,

38
<PAGE>
California, since 1966. Dr. Smith graduated with a B.A. from Southern Methodist
University in 1954, graduated from the University of Texas medical school in
1958, and has been a diplomate of the American Board of Orthopedic Surgery since
1968.

Pedro A. Rubio, MD., Ph.D. has been a Director of the Company since January
1996. He is currently a Clinical Associate Professor of Surgery at the
University of Texas Health Science Center in Houston. He was Director of
Education of the Laser Training Institute of Houston, from November 1993 until
January 1996. He served as World President of the International College of
Surgeons in Chicago in 1995, and was Chairman of the Department of Surgery at
the Columbia/HCA Medical Center Hospital in Houston from 1976 to 1994, when he
became Chairman Emeritus. Dr. Rubio holds the degrees of Bachelor of Science,
Master of Science in Surgical Technology, Doctor of Philosophy in Biomedical
Technology and Doctor of Medicine and Surgery. Dr. Rubio is a Diplomate of the
American Boards of Surgery, Laser Surgery, Abdominal Surgery, Forensic Medicine,
Quality Assurance and Utilization Review, Forensic Examiners and Pain
Management.

Kenneth W. Davidson has been a Director of the Company since April 1996. He
has also been President, Chief Executive Officer and Chairman of the Board of
Directors of Maxxim Medical, Inc. since November 1986, and a Director since
1982. Prior to that time, Mr. Davidson was the Corporate Director of Business
Development at Intermedics, Inc., which is principally a manufacturer of
implantable devices such as pacemakers. Mr. Davidson is also a Director of
Encore Orthopedics, Inc., a designer and manufacturer of implantable orthopedic
devices.

Ernest J. Henley, Ph.D., has been a Director of the Company since April 1996,
and is also a consultant to the Company. He has been a Director of Maxxim since
1976. See "Certain Relationships and Related Transactions." Dr. Henley's
principal employment for more than fifteen years has been as a Professor of
Chemical Engineering at the University of Houston.

All directors hold office until the next annual meeting of stockholders and
until their successors have been duly elected and qualified. All non-employee
directors of the Company are reimbursed for expenses incurred for attendance at
meetings of the Board of Directors and any Board committee and are eligible to
receive stock options pursuant to the 1996 Non-Employee Director Stock Option
Plan. See "Item 10. Executive Compensation."

Each officer of the Company serves at the discretion of the Board of
Directors, subject to the terms of his employment agreement, if any, and is
eligible to receive stock options pursuant to the 1996 Incentive Stock Plan. See
"Item 10. Executive Compensation" below, for a discussion of the Company's
employment agreement with Mr. Barbour. Each member of management devotes his
full time to the Company's affairs.

COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

Section 16(a) of the Exchange Act requires a company's directors and executive
officers, and persons who own more than 10% of the equity securities of the
Company to file initial reports of ownership and reports of changes in ownership
of the Common Stock with the Securities and Exchange Commission. Officers,
directors and greater than 10% shareholders are required to furnish the Company
with copies of all Section 16(a) reports they file.

Based solely on a review of the forms the Company has received or prepared,
the Company believes that during the year ended December 31, 1997, all filing
requirements applicable to the Company's directors, officers and greater than
10% shareholders were met except Dr. Chadwick F. Smith who failed to file a Form
4 on a timely basis in connection with the shares of Common Stock he pledged as
security for a loan from a financial institution.

SCIENTIFIC ADVISORY BOARD

The Company established a Scientific Advisory Board of distinguished
physicians and scientists with a wide range of experience in the medical field.
The Board meets formally or by teleconference at the Company's expense every six
months to discuss research data regarding the Company's products.

By selection, the medical and scientific advisors are geographically diverse
and have varied experience within the laser field, including hospital work,
teaching at universities, and working within different industries or types of
private

39
<PAGE>
practice. All of the advisors are in private practice, employed by hospitals,
universities or other organizations, none of which in the future is expected by
the Company to compete with the Company. These advisors are expected to devote
only a small portion of their time to the Company, and they are not expected to
participate actively in the Company's affairs. Certain of the institutions with
which the Scientific Advisors are affiliated may adopt new regulations or
policies that limit the ability of the advisors to consult with the Company;
however, the loss of the services of any of the Scientific Advisors is unlikely
to adversely affect the Company. The Scientific Advisory Board is comprised of
the following individuals:

JACK ANSTANDIG, MD. - Neurologist, Acupuncture and Pain Management Specialist;
Member, American Academy of Neurology, American Academy of Medical Acupuncture
and International Association.

CHADWICK F. SMITH, MD. - Clinical Professor of Orthopedic Surgery, University of
Southern California School of Medicine; Medical Director, International
Children's Program, Orthopedic Hospital, Los Angeles. Dr. Smith is also a
Director of the Company.

C. THOMAS VANGSNESS, MD. - Assistant Professor, Orthopedic Surgery and Chief of
Sports Medicine, University of Southern California. Dr. Vangsness owns 22,833
shares of the Company's common stock.

PEDRO A. RUBIO, MD., PH.D. - Past World President of the International College
of Surgeons (Chicago); Clinical Associate Professor of Surgery, University of
Texas Health Science Center, Houston; Diplomate, American Boards of Surgery,
Laser Surgery, Forensic Medicine, Quality Assurance and Pain Management. Dr.
Rubio is also a Director of the Company.

ITEM 10. EXECUTIVE COMPENSATION

SUMMARY OF COMPENSATION. The following table provides information concerning
compensation paid or accrued during the fiscal years ended December 31, 1997,
1996 and 1995 to the Company's President and Chief Executive Officer, Michael M.
Barbour and Chief Financial Officer, Dan D. Sudduth. During 1997, 1996 and 1995,
no other executive officers received compensation which exceeded $100,000:
<TABLE>
<CAPTION>
LONG TERM COMPENSATION
----------------------------------------------------------
ANNUAL COMPENSATION AWARDS PAYOUTS
---------------------------------- -------------------------------- -------- ------------
SECURITIES
UNDERLYING ALL
OTHER ANNUAL RESTRICTED STOCK OPTIONS/ LTIP OTHER
NAME AND POSITION YEAR SALARY BONUS COMPENSATION AWARDS SARS (#) PAYOUTS COMPENSATION
- ------------------ ---- -------- -------- ------------ ----------------- ------------ ------- ------------
<S> <C> <C> <C> <C>
Michael M. Barbour 1997 $160,000 40,000 -- -- 3,333 -- --
CEO .............. 1996 $171,657 -- -- -- -- -- --
1995 $110,000 -- $ 9,000 -- -- -- --

Dan D. Sudduth (1) 1997 $134,811 -- -- -- 3,333 -- --
CFO .............. 1996 -- -- -- -- -- -- --
1995 -- -- -- -- -- -- --
</TABLE>
(1) Mr. Sudduth was a consultant to the Company prior to February 1997 when
he became an employee.

40
<PAGE>
OPTION/SAR GRANTS. The following table provides certain information with
respect to common stock options granted during the fiscal year ended December
31, 1997 by the Company's Chief Executive Officer and Chief Financial Officer:
<TABLE>
<CAPTION>
NUMBER OF
SECURITIES PERCENT OF
UNDERLYING TOTAL OPTIONS EXERCISE
NAME AND OPTION/SARS /SARS GRANTED PRICE EXPIRATION
POSITION GRANTED TO EMPLOYEES ($/SHARE) DATE
<S> <C> <C> <C> <C> <C>
Michael M. Barbour 10,000 50% $7.88/share 11/07/00
CEO
Dan D. Sudduth 10,000 50% $7.88/share 11/07/00
CFO
</TABLE>
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR ENDED OPTION
VALUES. The following table provides certain information with respect to option
exercises during the fiscal year ended December 31, 1997 by the Company's Chief
Executive Officer and Chief Financial Officer:
<TABLE>
<CAPTION>
NUMBER OF VALUE OF
SECURITIES UNDERLYING UNEXERCISED
UNEXERCISED IN-THE-MONEY
SHARES OPTIONS/SARS OPTIONS/SARS AT
ACQUIRED ON VALUE AT FISCAL YEAR END (#) FISCAL YEAR END ($) (1)
NAME EXERCISE REALIZED DECEMBER 31, 1997 REALIZED
- ----------------------- -------------- ---------- ------------------------------ ------------------------------
EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
------------- --------------- ------------ ----------------
<S> <C> <C> <C>
Michael M. Barbour -- -- 225,000 3,333 $ 712,500 --
Dan D. Sudduth -- -- -- 3,333 -- --
</TABLE>
(1) Calculated by multiplying the number of shares underlying outstanding
in-the-money options by the difference between the last sales price of
the Common Stock on December 31, 1997 ($7.00 per share) and the
exercise prices, which range between $3.00 and $4.50 per share. Options
are in-the-money if the fair market value of the underlying Common
Stock exceeds the exercise price of the option.

COMPENSATION OF DIRECTORS

Effective January 15, 1996, the Board of Directors of the Company (the "BOD")
adopted the following plans which were approved by the Company's shareholders in
July 1996: (i) a 1996 Incentive Stock Plan under which the Company can issue up
to 1.2 million shares of the Company's common stock to eligible officers,
employees, and consultants of the Company and (ii) a 1996 Non-Employee Directors
Stock Option Plan (the "Outside Director Plan") under which the Company can
issue up 250,000 shares of common stock to its outside directors. On February
17, 1998, the Company filed a registration statement on Form S-8 covering all of
the shares issuable under both plans with the Securities and Exchange
Commission.

In connection with their re-election to the BOD in June 1997, Drs. Rubio,
Smith, and Henley and Mr. Davidson were each granted a stock option under the
Outside Director Plan to purchase 10,000 shares of the Company's common stock at
a price of $4.81 per share. Also, in connection with their membership in the BOD
in 1997, each of Messrs. Sudduth and Barbour was granted an option under the
1996 Incentive Stock Plan to purchase 10,000 shares of the Company's common
stock at a price of $7.88 per share. The options granted to Messrs. Barbour and
Sudduth vest over a three-year period.

The Outside Director Plan also provides that at the discretion of the BOD, the
Company may pay a cash fee to non-employee directors from time to time for
serving on and for attendance at meetings of, the BOD or any committee thereof
(as such fees are set by the BOD from time to time.) During the year ended
December 31, 1997, the Company paid the non-employee directors $500 per person
for attendance at each meeting of the Board of Directors.

41
<PAGE>
EMPLOYMENT CONTRACTS

In November 1996, the Company entered into an agreement with Michael M.
Barbour, effective as of May 1, 1996, employing him as its Chief Executive
Officer at a base annual salary of $160,000. The agreement also provides for an
annual bonus amount payable to Mr. Barbour based on specific formula as provided
in the agreement. The agreement terminates on December 31, 1998.

42
<PAGE>
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth certain information regarding the number and
percentage of shares of Common Stock beneficially owned as of March 16, 1998, by
any person (including any group of affiliated persons) known by the Company to
own 5% or more of the outstanding shares of the Company's Common Stock, each
named executive officer and director, and all executive officers and directors
of the Company as a group. Unless otherwise indicated, the Company has been
advised that all holders listed have the power to vote and dispose of the number
of shares set forth as beneficially owned by them.

<TABLE>
<CAPTION>
NAME AND ADDRESS AMOUNT AND NATURE OF
OF BENEFICIAL OWNER (1) BENEFICIAL OWNERSHIP (2) PERCENT OF CLASS
- ----------------------------------------------------------- ------------------------ ----------------
<S> <C> <C>
Ernest J. Henley, Ph.D .................................... 3,545,000(3) 51.17%
Kenneth W. Davidson ....................................... 3,520,000(3) 50.99%
10300 49th Street North
Clearwater, FL 33762
Maxxim Medical, Inc. ...................................... 3,500,000(4) 50.85%
10300 49th Street North
Clearwater, FL 33762
Chadwick F. Smith, MD ..................................... 430,666(5) 7.67%
1127 Wilshire Blvd ......................................
Los Angeles, California 90017
Michael M. Barbour ........................................ 421,748(6) 7.52%
Pedro A. Rubio, MD, Ph.D .................................. 129,128(7) 2.36%
Dan D. Sudduth ............................................ 70,000(8) 1.28%
All Executive Officers and Directors as a Group (8 persons) 4,667,042(9) 61.38%
</TABLE>
(1) Unless otherwise specified, the address of each beneficial owner is c/o
Henley Healthcare, Inc. 120 Industrial Boulevard, Sugar Land, Texas
77478.

(2) Except as otherwise indicated, all shares are beneficially owned, and
the sole investment and voting power is held, by the person named. This
table is based on information supplied by the officers, directors and
principal shareholders and reporting forms, if any, filed with the
Securities and Exchange Commission on behalf of such persons. A person
is deemed to beneficially own shares of common stock underlying
options, warrants or other convertible securities if the stock can be
acquired by such person within sixty days of the date hereof.

(3) Includes 1,500,000 shares issuable upon the conversion of the Company's
convertible subordinated promissory note, as amended, in the principal
amount of $3 million issued to Maxxim (the "Maxxim Note"), and
2,000,000 shares currently owned by Maxxim, as to which Dr. Henley and
Mr. Davidson, who are directors of both the Company and Maxxim, may be
deemed the beneficial owners by virtue of their affiliation with
Maxxim. See "Certain Relationships and Related Transactions." The
additional 45,000 and 20,000 shares listed for each of Dr. Henley and
Mr. Davidson, respectively, consist entirely of warrants and/or options
exercisable as of the date hereof.

(4) In addition to holding 2,000,000 shares of common stock, Maxxim is the
holder of the Maxxim Note, which is convertible into 1,500,000 shares
of Common Stock. See "Certain Relationships and Related Transactions."

(5) Includes 235,000 shares issuable upon exercise of currently exercisable
options.

(6) Includes 228,333 shares issuable upon exercise of currently exercisable
options.

(7) Includes 78,333 shares issuable upon exercise of currently exercisable
options.

(8) Includes 63,333 shares issuable upon exercise of currently exercisable
options or warrants.

(9) In addition to the 1,500,000 shares issuable upon conversion of the
Maxxim Note and the currently exercisable options and warrants listed
above, this amount includes (i) 500 shares and 50,000 currently
exercisable options owned by Chike J. Ogboenyiya, the Company's Vice
President-Finance and Secretary.

43
<PAGE>
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Effective May 1996, the Company entered into a consulting agreement with
Chadwick F. Smith, MD, one of its Directors. The agreement includes an annual
compensation of $90,000 and terminates on December 31, 1998.

In May 1996, the Company entered into an agreement with Mezzanine Financial
Relations, Inc., a financial relations company ("Mezzanine"), pursuant to which
Mezzanine agreed to provide financial consulting services with regard to
potential mergers and acquisitions in consideration for a monthly fee of
$10,000. Mr. Sudduth, Executive Vice President, Chief Financial Officer and a
Director of the Company, is a shareholder of Mezzanine and its Chairman of the
Board. The agreement terminated on January 31, 1997.

On April 30, 1996, the Company entered into an agreement with Maxxim, whereby
the Company purchased certain assets (and assumed certain liabilities)
associated with for an estimated purchase price of approximately $13.5 million.
The purchase price was paid by the issuance of the Company's convertible
subordinated promissory note in the principal amount of $7 million, with the
balance of the purchase price paid in cash provided through a financing with a
bank. Mr. Davidson and Dr. Henley are currently employed by Maxxim, with Mr.
Davidson serving in the capacities of Chairman of the Board, Chief Executive
Officer and President and Dr. Henley serving as a Director and consultant. Dr.
Henley's consulting agreement, which was entered into between Dr. Henley and
Maxxim in 1987, was acquired in the transaction with Maxxim. The agreement
included a monthly consulting fee in the amount of $5,833 and terminated on
October 31, 1997. The Company currently uses Dr. Henley's services on as-needed
basis for a monthly consulting fee of $1,750.

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

EXHIBITS

See "Index of Exhibits" below which lists the documents filed as exhibits
herewith.

REPORTS ON FORM 8-K

On October 15, 1997, the Company filed a Current Report on Form 8-K in which
it reported its agreement with Cybex pursuant to which it purchased certain
assets of (and assumed certain liabilities associated with) the isokinetic
rehabilitation product line of Cybex.

On October 24, 1997, the Company filed a Current Report on Form 8-K in which
it reported the dismissal of Goldstein Golub Kessler LLP ("GGK"), the Company's
former principal accountants, and the engagement of Arthur Andersen LLP as its
principal accountants to replace GGK.

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this Amendment to this Report to be signed on its behalf by the
undersigned, thereunto duly authorized on this 27th day of January, 1999.

HENLEY HEALTHCARE, INC.
(Registrant)

By: /S/ MICHAEL M. BARBOUR
MICHAEL M. BARBOUR,
(President and Chief Executive Officer)

44
<PAGE>
HENLEY HEALTHCARE, INC.
EXHIBITS TO FORM 10-KSB
FOR THE YEAR ENDED DECEMBER 31, 1997

INDEX OF EXHIBITS

Exhibits incorporated by reference to a prior filing are designated by
an asterisk (*); all exhibits not so designated are documents filed herewith:

EXHIBIT
NO. DESCRIPTION

3.1* Amended and Restated Articles of Incorporation (Exhibit 3.1 to the
Company's Periodic Report on Form 10-QSB for the quarter ended June 30,
1997 (File No. 0-28556)).

3.2* Amended and Restated By-Laws (Exhibit 3.2 to the Company's Annual
Report on Form 10-KSB for the year ended December 31, 1997 (File No.
0-28566)).

3.3* Statement of Designation of Series A Preferred Stock (Exhibit 3.3 to
the Company's Annual Report on Form 10-KSB for the year ended December
31, 1997 (File No. 0-28566)).

4.1* Specimen Stock Certificate. (This exhibit to the Company's Registration
Statement on Form S-18 (No. 33-49972) dated July 22, 1992).

4.2* Specimen Form of Warrant Certificate. (Exhibit 4.2 to the Company's
Annual Report on Form 10-KSB for the year ended December 31, 1995 (File
No. 0-28566)).

4.3* Form of Underwriter's Warrant. (Exhibit 4C to the Company's
Registration Statement on Form S-18 (No. 33-49972) dated July 22,
1992).

10.1* 1996 Amended and Restated Non-Employee Director Stock Option Plan.
(Exhibit C to the Company's Proxy Statement on Schedule 14A dated June
24, 1996 (File No. 0-28566)).

10.2* 1996 Incentive Stock Plan. (Exhibit B to the Company's Proxy Statement
on Schedule 14A dated June 24, 1996 (File No. 0-28566)).

10.3* Employment Agreement with Michael Barbour dated November 22, 1996.
(Exhibit 10.4 to the Company's Annual Report on Form 10-KSB for the
year ended December 31, 1996 (File No. 0-28566)).

10.4* Consulting Agreement with Chadwick F. Smith, MD dated November 22,
1996. (Exhibit 10.5 to the Company's Annual Report on Form 10-KSB for
the year ended December 31, 1996 (File No. 0-28566)).

10.5* Asset Purchase Agreement dated November 12, 1996 with MJH Medical
Equipment and Michael J. Houska. (Exhibit 10.6 to the Company's Annual
Report on Form 10-KSB for the year ended December 31, 1996 (File No.
0-28566)).

10.6* Employment Agreement with Michael J. Houska dated November 12, 1996.
(Exhibit 10.7 to the Company's Annual Report on Form 10-KSB for the
year ended December 31, 1996 (File No. 0-28566)).

10.7* Plan and Agreement of Merger with Health Career Learning Systems, Inc.
dated November 27, 1996. (Exhibit 10.8 to the Company's Annual Report
on Form 10-KSB for the year ended December 31, 1996 (File No.
0-28566)).

10.8* Stock Purchase Agreement with Paula L. Buhr dated January 24, 1996.
(Exhibit 10.9 to the Company's Annual Report on Form 10-KSB for the
year ended December 31, 1996 (File No. 0-28566)).

10.9* Asset Purchase Agreement with Gatti Medical Supply dated January 24,
1996. (Exhibit 10.10 to the Company's Annual Report on Form 10-KSB for
the year ended December 31, 1996 (File No. 0-28566)).
<PAGE>
INDEX OF EXHIBITS, CONTINUED

EXHIBIT
NO. DESCRIPTION

10.10* Master Agreement and Manufacturing Agreement with CB Svendsen, a/s
dated March 12, 1997. (Exhibit 10.11 to the Company's Annual Report on
Form 10-KSB for the year ended December 31, 1996 (File No. 0-28566)).

10.11* Asset Purchase Agreement with Cybex International, Inc. dated September
30, 1997 (Exhibit 10.11 to the Company's Annual Report on Form 10-KSB
for the year ended December 31, 1997 (File No. 0- 28566)).

10.12* Plan and Agreement of Merger with Garvey Company dated January 9, 1998
(Exhibit 10.12 to the Company's Annual Report on Form 10-KSB for the
year ended December 31, 1997 (File No. 0-28566)).

10.13* Asset Purchase Agreement with AMC Acquisition Corp., Dan D. Sudduth,
Britton D. Sudduth and Roger W. Dartt dated February 12, 1998 (Exhibit
10.13 to the Company's Annual Report on Form 10- KSB for the year ended
December 31, 1997 (File No. 0-28566)).

10.14* Asset Purchase Agreement with August Schild d/b/a Summer Medical dated
October 6, 1997 (Exhibit 10.14 to the Company's Annual Report on Form
10-KSB for the year ended December 31, 1997 (File No. 0-28566)).

16.1* Letter dated October 24, 1997, from GGK to the Commission regarding
disclosure in the Company's Form 8-K filed on that date (Exhibit 16.1
to the Company's Current Report on Form 8-K dated October 24, 1997).

21.1* Subsidiaries of Registrant (Exhibit 21.1 to the Company's Annual Report
on Form 10-KSB for the year ended December 31, 1997 (File No.
0-28566)).

23.1 Consent of Arthur Andersen LLP

23.2 Consent of Goldstein Golub Kessler LLP

27.1* Financial Data Schedule (Exhibit 27.1 to the Company's First Amendment
to its Annual Report on 27.1* Form 10-KSB/A for the year ended December
31, 1997 (File No. 0-28566)).

EXHIBIT 23.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the
incorporation of our report included in this Form 10-KSB/A-2, into the Company's
previously filed Registration Statements on Form S-8 (No. 33-76614 and No.
333-46383) and on Form S-3 (No. 333-50769 and No. 333-63915).

/s/ARTHUR ANDERSEN LLP
ARTHUR ANDERSEN LLP

Houston, Texas
January 27, 1999

EXHIBIT 23.2

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

We hereby consent to the incorporation of our report dated February 23,
1997, on the consolidated statements of operations, stockholders' equity and
cash flows for the year ended December 31, 1996, included in this Form
10-KSB/A-2, into the Company's previously filed Registration Statements on Form
S-8 (No. 33-76614 and No. 333-46383) and on Form S-3 (No. 333-50769 and No.
333-63915).

/s/GOLDSTEIN GOLUB KESSLER LLP
GOLDSTEIN GOLUB KESSLER LLP

New York, New York
January 27, 1999