1
EXHIBIT 99.3
-8-
2
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
Quest Medical, Inc.
We have audited the accompanying statements of assets and liabilities of the
CVS Operations of Quest Medical, Inc. as of December 31, 1997 and 1996, and the
related statements of operations, changes in net assets and cash flows for the
years then ended. These statements are the responsibility of the company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe our audits provide a reasonable basis for
our opinion.
In our opinion, the statements referred to above present fairly, in all
material respects, the assets and liabilities of the CVS Operations of Quest
Medical, Inc. as of December 31, 1997 and 1996, and the results of its
operations and its cash flows for the years then ended, in conformity with
generally accepted accounting principles.
ERNST & YOUNG LLP
Dallas, Texas
February 25, 1998
-9-
3
QUEST MEDICAL, INC.
CVS OPERATIONS
ASSETS AND LIABILITIES
December 31, 1997 and 1996
- -----------------------------------------------------------------------------------------------------------------
ASSETS DECEMBER 31,
---------------------------------------
1997 1996
- -----------------------------------------------------------------------------------------------------------------
Current assets:
Receivables:
Trade accounts, less allowance for doubtful
accounts of $30,610 in 1997 and $14,337 in 1996 $ 2,180,491 $ 2,411,113
Net investment in sales-type leases 300,787 176,875
---------------------------------------
Total receivables 2,481,278 2,587,988
---------------------------------------
Inventories:
Raw materials 1,940,371 2,750,135
Work-in-process 601,270 708,513
Finished goods 2,667,035 1,895,749
---------------------------------------
Total inventories 5,208,676 5,354,397
---------------------------------------
Prepaid expenses and other current assets 131,735 218,680
---------------------------------------
Total current assets 7,821,689 8,161,065
---------------------------------------
Property, plant and equipment:
Leasehold improvements 63,629 44,272
Furniture and fixtures 3,369,484 3,221,839
Machinery and equipment 4,684,108 4,555,592
Cardioplegia equipment rented to customers 450,211 --
---------------------------------------
8,567,432 7,821,703
Less accumulated depreciation and
amortization 4,933,577 3,942,627
---------------------------------------
Net property, plant and equipment 3,633,855 3,879,078
---------------------------------------
Purchased technology from acquisitions, net of
accumulated amortization of $314,659 in 1997 and
$264,108 in 1996 383,341 433,892
Cost in excess of net assets acquired, net of accumulated
amortization of $227,749 in 1997 and $185,016 in 1996 785,457 828,190
Patents and patent applications, net of accumulated
amortization of $1,501,090 in 1997 and $1,311,556 in 1996 874,308 1,063,843
Other assets 8,631 8,631
=======================================
$ 13,507,282 $ 14,374,697
=======================================
See accompanying notes to financial statements.
-10-
4
QUEST MEDICAL, INC.
CVS OPERATIONS
ASSETS AND LIABILITIES
December 31, 1997 and 1996
- -----------------------------------------------------------------------------------------------------------------
LIABILITIES AND NET ASSETS DECEMBER 31,
---------------------------------------
1997 1996
- -----------------------------------------------------------------------------------------------------------------
Current liabilities:
Accounts payable $ 410,483 $ 1,515,316
Accrued vacations 112,870 112,870
Accrued sales commissions 23,947 63,866
Other accrued expenses 128,664 112,470
---------------------------------------
Total current liabilities 675,964 1,804,522
---------------------------------------
Net assets of CVS Operations 12,831,318 12,570,175
=======================================
$ 13,507,282 $ 14,374,697
=======================================
See accompanying notes to financial statements.
-11-
5
QUEST MEDICAL, INC.
CVS OPERATIONS
STATEMENTS OF OPERATIONS
- -----------------------------------------------------------------------------------------------------------------
DECEMBER 31,
---------------------------------------
1997 1996
- -----------------------------------------------------------------------------------------------------------------
Net revenue $ 14,306,127 $ 14,670,664
Cost of revenue 7,805,473 7,690,005
---------------------------------------
Gross profit 6,500,654 6,980,659
---------------------------------------
Operating expenses:
General and administrative 1,976,297 2,117,568
Research and development 1,302,987 2,026,673
Marketing 2,888,170 3,251,533
---------------------------------------
6,167,454 7,395,774
---------------------------------------
Earnings (loss) from operations 333,200 (415,115)
---------------------------------------
Interest expense (442,599) (348,523)
---------------------------------------
Loss from operations before income tax benefit (109,399) (763,838)
Income tax benefit (15,909) (236,967)
---------------------------------------
Net loss $ (93,490) $ (526,671)
=======================================
See accompanying notes to financial statements.
-12-
6
QUEST MEDICAL, INC.
CVS OPERATIONS
STATEMENTS OF CASH FLOWS
- -----------------------------------------------------------------------------------------------------------------
DECEMBER 31,
---------------------------------------
1997 1996
- -----------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net loss $ (93,490) $ (526,671)
Adjustments to reconcile net loss from operations
to net cash provided (used) by operating activities:
Depreciation and amortization 1,273,788 1,065,453
Increase in inventory reserve 230,700 --
Changes in assets and liabilities:
Receivables 106,710 (716,117)
Inventories (84,979) (872,253)
Prepaid expenses and other assets 86,945 175,534
Accounts payable (1,104,833) 642,830
Accrued expenses (23,725) 85,793
---------------------------------------
Net cash provided (used) by operating activities 391,096 (145,431)
Cash flows from investing activities:
Additions to property, plant and equipment (745,729) (1,580,468)
---------------------------------------
Net cash used by investing activities (745,729) (1,580,468)
---------------------------------------
Net cash transfers from parent $ (354,633) $ (1,725,899)
=======================================
See accompanying notes to financial statements.
-13-
7
QUEST MEDICAL, INC.
CVS OPERATIONS
STATEMENTS OF CHANGES IN NET ASSETS
- -----------------------------------------------------------------------------------------------------------------
DECEMBER 31,
---------------------------------------
1997 1996
- -----------------------------------------------------------------------------------------------------------------
Net assets of CVS Operations, beginning of year $ 12,570,175 $ 11,370,947
Net loss (93,490) (526,671)
Cash transfers from parent, net 354,633 1,725,899
=======================================
Net assets of CVS Operations, end of year $ 12,831,318 $ 12,570,175
=======================================
See accompanying notes to financial statements.
-14-
8
CVS OPERATIONS
QUEST MEDICAL, INC.
NOTES TO FINANCIAL STATEMENTS
NOTE 1 BUSINESS OF CVS
The CVS Operations (also referred to herein as "CVS") of Quest Medical, Inc.
(the "Parent") design, develop, manufacture and market a variety of healthcare
products used primarily in cardiovascular surgery and intravenous fluid
delivery applications. CVS revenues are derived primarily from sales throughout
the United States and to a lesser extent from sales internationally.
The research and development, manufacture, sale and distribution of medical
devices are subject to extensive regulation by various public agencies,
principally the Food and Drug Administration and corresponding state, local and
foreign agencies. Product approvals and clearances can be delayed or withdrawn
for failure to comply with regulatory requirements or upon the occurrence of
unforeseen problems following initial marketing.
In addition, CVS products are purchased primarily by hospitals and other users
which then bill various third-party payers including Medicare, Medicaid,
private insurance companies and managed care organizations. These third-party
payers reimburse fixed amounts for services based on a specific diagnosis. The
impact of changes in third-party payer reimbursement policies and any
amendments to existing reimbursement rules and regulations which restrict or
terminate the eligibility of CVS products could have an adverse impact on the
CVS Operations' financial condition and results of operations.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The financial statements include the accounts of the CVS Operations of Quest
Medical, Inc. These financial statements reflect the revenues and expenses of
the CVS Operations, including direct and indirect expenses of the operations
that are paid by the Parent and charged directly to the CVS Operations.
Allocation of the general overhead from the Parent includes charges for
regulatory, general corporate management, accounting and payroll services,
human resources, management information systems and facilities expenses based
on revenues of the CVS Operations to total revenues for the Parent. Management
of the Parent believes that the expenses charged to the CVS Operations on this
basis are not materially different from the costs that would have been incurred
had the CVS Operations borne such expenses on a direct basis.
The taxable income or loss of the CVS Operations is included in the
consolidated tax return of the Parent. No current or deferred tax assets or
liabilities have been allocated to the CVS Operations by the Parent.
-15-
9
CVS OPERATIONS
QUEST MEDICAL, INC.
NOTES TO FINANCIAL STATEMENTS
Interest expense on the Parent's corporate facility has been allocated to the
CVS Operations based on space utilization. Interest expense on the Parent's
general credit facilities was allocated to the CVS Operations based on the
ratio of the net assets of the CVS Operations to the total net assets of the
Parent.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
NET ASSETS
The Parent utilizes a centralized cash management system. Cash advanced from
the Parent to the CVS Operations has been reflected as an increase in net
assets in the accompanying statements.
REVENUE RECOGNITION
CVS recognizes revenue from product sales when the goods are shipped to its
customers.
LEASES
CVS leases the MPS myocardial protection system to customers under
noncancellable leases with terms of up to five years. The present value of the
minimum rentals to be received under such leases is recorded as net sales. The
difference between the gross rentals to be received and the present value of
the rentals is recorded as unearned finance income and is amortized into income
on the interest method over the lease term. The cost of the leased equipment is
charged to cost of sales at the time the sale is recorded. At December 31, 1997
and 1996, the balance in the net investment in sales-type leases was $300,787
and $176,875, respectively.
INVENTORIES
Inventories are recorded at the lower of standard cost or market. Standard cost
approximates actual cost determined on the first-in, first-out (FIFO) basis.
PROPERTY, PLANT, AND EQUIPMENT
Property, plant and equipment is stated at cost. Additions and improvements
extending asset lives are capitalized while maintenance and repairs are
expensed as incurred. Depreciation is provided using the straight-line method
over the estimated useful lives of the various assets ranging from 3 to 10
years.
INTANGIBLE ASSETS
The excess of costs over the net assets of acquired businesses (goodwill) is
amortized on a straight-line basis over the estimated useful life of 25 years.
-16-
10
CVS OPERATIONS
QUEST MEDICAL, INC.
NOTES TO FINANCIAL STATEMENTS
The cost of purchased technology related to acquisitions is based on appraised
values at the date of acquisition and is amortized on a straight-line basis
over the estimated useful life (15 years) of such technology.
The cost of purchased patents is amortized on a straight-line basis over the
estimated useful life (4 to 17 years) of such patents. Costs of patents which
are the result of internal development are charged to current operations.
The Parent assesses the recoverability of the CVS intangible assets primarily
based on its current and anticipated future undiscounted cash flows. At
December 31, 1997, the Parent does not believe there has been any impairment of
the CVS intangible assets.
RESEARCH AND DEVELOPMENT
Product development costs including start-up, research and development,
advertising and promotional costs are charged to CVS Operations in the year in
which such costs are incurred.
ADVERTISING
Advertising expense is charged to operations in the year in which such costs
are incurred. Total advertising expense included in marketing was $17,454 and
$20,299 at December 1997 and 1996, respectively.
RECLASSIFICATION
Certain prior period amounts have been reclassified to conform to current year
presentation.
NOTE 3 COMMITMENTS AND CONTINGENCIES
The CVS Operations has no material commitments under noncancelable operating
leases. Total rent expense under operating leases included in CVS Operations
for the years ended December 31, 1997 and 1996 was $14,784 and $14,983,
respectively.
NOTE 4 FINANCIAL INSTRUMENTS, RISK CONCENTRATION AND MAJOR CUSTOMERS
In the United States, the CVS accounts receivable are due primarily from
hospitals and O.E.M. suppliers located throughout the county. Internationally,
the Parent's accounts receivable are due primarily from distributors. The CVS
Operations generally does not require collateral for trade receivables. The CVS
Operations maintains an allowance for doubtful accounts based upon expected
collectibility. Any losses from bad debts have historically been within
management's expectations.
Net sales to a major CVS customer for each of the three years ended December
31, as a percentage of total net revenues from CVS Operations was as follows:
1997--14 percent and 1996--16 percent. Foreign sales for the years ended
December 31, 1997
-17-
11
CVS OPERATIONS
QUEST MEDICAL, INC.
NOTES TO FINANCIAL STATEMENTS
and 1996 were approximately 12 percent and 13 percent, respectively, of total
net revenues.
NOTE 5 EMPLOYEE BENEFIT PLANS
The Parent has a defined contribution retirement savings plan (the "Plan")
available to substantially all employees. The Plan permits employees to elect
salary deferral contributions of up to 15 percent of their compensation and
requires the Parent to make matching contributions equal to 50 percent of the
participants' contributions, to a maximum of 6 percent of the participants'
compensation. The Board of Directors may change the percentage of matching
contribution at its discretion. The expense of the Parent's contribution
charged to CVS Operations was $77,438 in 1997 and $94,973 in 1996. This charge
was based on the ratio of CVS revenues to total revenues of the Parent.
Management of the Parent believes that the expense charged to the CVS
Operations is not materially different from the cost that would have been
incurred had the CVS Operations borne such expense on a direct basis.
6. INCOME TAXES
A reconciliation of the income tax benefit to the benefit calculated at the
U.S. statutory rate follows:
1997 1996
----------------------------------------------------------------------------------
Income tax benefit at Federal statutory rate $ (37,196) $ (259,637)
Tax effect of research and development credit -- --
Nondeductible amortization of goodwill 11,940 15,258
Nondeductible meals and entertainment 17,936 19,146
Other (8,589) (11,734)
--------------------------------
Income tax benefit $ (15,909) $ (236,967)
================================
-18-