SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-21982

Diametrics Medical, Inc.

Internal Revenue Service — Employer Identification No. 41-1663185

3050 Centre Pointe Drive, Suite 150, Roseville, Minnesota 55113
(651) 639-8035

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule 12b-2 of the Act).  Yes  x  No  o

As of November 3, 2004, 35,121,739 shares of Common Stock were outstanding.

Diametrics Medical, Inc.

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PART I – FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements (unaudited)

DIAMETRICS MEDICAL, INC.

See accompanying notes to consolidated financial statements.

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DIAMETRICS MEDICAL, INC.

See accompanying notes to consolidated financial statements.

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DIAMETRICS MEDICAL, INC.

Supplemental disclosure of noncash investing and financing activities:

-		As further described in note 2, effective May 28, 2004, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series G convertible preferred stock. A beneficial conversion feature embedded in the preferred stock was calculated at $1,067,650 and was recorded as a noncash charge to retained earnings and treated as a reconciling item on the Statements of Operations to adjust the reported net loss to “net loss available to common shareholders.” In connection with the Series G financing, the Company also issued new warrants to the investors in the Company’s Series E and Series F preferred stock to purchase an aggregate of 12,241,608 shares of common stock at $.05 per share and reduced the exercise price and ceiling exercise price of the warrants previously issued to the Company’s Series E and Series F preferred stock investors, respectively. The issuance of new warrants to the Series E and Series F investors and the change in the exercise price terms of the warrants previously issued to these investors was considered a dividend to the Series E and Series F preferred stockholders, requiring a noncash charge to retained earnings aggregating $1,050,690. This charge was also treated as a reconciling item on the Statement of Operations to adjust the reported net loss to “net loss available to common shareholders.”
-		As further described in note 3, effective January 16, 2004, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series F convertible preferred stock. A beneficial conversion feature embedded in the preferred stock was calculated at $665,994 and was recorded as a noncash charge to retained earnings and treated as a reconciling item on the Statements of Operations to adjust the reported net loss to “net loss available to common shareholders.”
-		The Company entered into capital lease obligations for equipment of $18,977 during the three months ended March 31, 2003.

See accompanying notes to consolidated financial statements.

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DIAMETRICS MEDICAL, INC.

(1) UNAUDITED FINANCIAL STATEMENTS

The interim consolidated financial statements of Diametrics Medical, Inc. (the “Company”) are unaudited and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information, pursuant to the rules and regulations of the Securities and Exchange Commission. Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. However, in the opinion of management, the financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the interim periods presented. Operating results for these interim periods are not necessarily indicative of results to be expected for the entire year, due to seasonal, operating and other factors.

Prior-year results of operations for the Company’s discontinued intermittent testing business have been reported as discontinued operations. This reclassification had no effect on the Company’s previously reported consolidated financial position, net loss or cash flows.

The Company has identified certain of its significant accounting policies that it considers particularly important to the portrayal of the Company’s results of operations and financial position and which may require the application of a higher level of judgment by the Company’s management, and as a result are subject to an inherent level of uncertainty. These are characterized as “critical accounting policies” and address the accounting for and classification of debt and equity instruments, revenue recognition and accounts receivable, inventories, foreign currency translation and transactions, impairment of long-lived assets and retirement plan funding, each more fully described under “Management’s Discussion and Analysis of Results of Operations and Financial Condition” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. No other changes to the Company’s critical accounting policies have been made during the quarter ended September 30, 2004.

These statements should be read in conjunction with the financial statements and related notes which are part of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

(2) SERIES G CONVERTIBLE PREFERRED STOCK FINANCING

On May 28, 2004, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series G convertible preferred stock at $100 per share. The financing was completed in a private placement with the Mercator Advisory Group and its related funds and BCC Acquisition II, LLC. The Mercator Advisory Group and its related funds were also the investors in the Company’s Series E and Series F convertible preferred stock issued in May 2003 and January 2004, respectively. Each share of the Series G preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock during the five consecutive trading days preceding the conversion date, with a maximum exercise price of $.14 per share and a minimum price of $.06 per share. The Company held a special meeting of its shareholders to request an increase in its authorized common stock from 100 million shares to 200 million shares on September 7, 2004. After the shareholders approved that increase, the minimum exercise price was decreased automatically to $.03 per share pursuant to the Certificate of Designations of Series G Convertible Preferred Stock, without further amendment.

As part of this financing, the Company issued three-year warrants (“Series G warrants”) to the purchasers of the Series G preferred stock. Those warrants entitle the holders to purchase an aggregate of 1,250,000 shares of the Company’s common stock at the lower of $.11 per share or the average of the lowest ten inter-day closing prices of the Company’s common stock during the ten trading days preceding the exercise

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date. The Company also issued three-year warrants to the Mercator Advisory Group and its related funds that invested in the Company’s Series E and Series F preferred stock to purchase an aggregate of 12,241,608 shares of common stock at $.05 per share.

Additionally, in connection with the Series G financing, the holders of the Company’s Convertible Senior Secured Fixed Rate Notes agreed to defer until December 31, 2004 the Company’s obligation to make interest payments previously due on June 30, 2004 (including interest payments originally due on December 31, 2003 and March 31, 2004, payment of which was deferred until June 30, 2004) and September 30, 2004. In exchange for the deferral of interest payments, the exercise price on the note holders’ common stock warrants was reduced from $.34 per share to $.09 per share. Finally, in connection with the Series G financing, the exercise price of the outstanding common stock warrants issued as part of the Series E preferred stock financing was reduced from $.35 per share to $.11 per share, and the ceiling price for the exercise of the common stock warrants issued as part of the Series F preferred stock financing was reduced from $.35 per share to $.11 per share.

The Series G financing effectively replaced the unfunded second tranche of the Series F preferred stock financing arranged in January 2004. As expected, the first $1.5 million tranche of financing generated in January 2004 under the Series F preferred stock agreement and other available funds had been substantially consumed by operations by the time the Series G financing was completed. This additional financing was necessary to help meet near-term funding requirements for support of the Company’s operations as the Company continued to pursue longer-term financing in order to sustain the development of its continuous monitoring business and explore additional applications of its technology.

Accounting for these transactions required a review of several criteria, including assessment of the treatment of the conversion feature associated with the Series G preferred stock, an assessment of the classification as debt or equity of the warrants issued in connection with the Series G preferred stock financing, an assessment of the impact of the changes in the exercise and ceiling exercise prices, as applicable, of the common stock warrants previously issued to the note holders and the Series E and Series F preferred stock investors and an assessment of the treatment of the fair value associated with the new warrants issued to the Series E and Series F preferred stock investors.

The application of the provisions of EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments” resulted in the calculation of an embedded beneficial conversion feature in the Series G preferred stock, which is required to be treated as a deemed dividend to preferred shareholders. The Company allocated the net investor proceeds of $1,445,000 from the issuance of the Series G convertible preferred stock to the preferred stock and Series G warrants based upon their relative fair values. The fair value allocated to the Series G warrants of $68,205 was recorded as equity. The fair value allocated to the preferred stock of $1,376,795 was used to calculate the value of the beneficial conversion feature of $1,067,650. The $1,067,650 was charged to retained earnings with the offsetting credit to additional paid-in-capital. The Company treated the beneficial conversion feature of $1,067,650 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the nine months ended September 30, 2004.

The Company classified the warrants issued in connection with the Series G preferred stock financing as equity rather than debt based upon an assessment of the Company’s contractual obligations for registration of the related common shares issuable upon exercise of the warrants as provided under EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” As further discussed in note 5, the reduction in the exercise price of the note holders’ warrants from $.34 to $.09 increased the fair value of those warrants by an estimated $70,517, which was recorded in the second quarter 2004 as a charge to interest expense with an offsetting credit to additional paid-in capital. The issuance of new warrants to the Series E and Series F investors and the reduction in the exercise price or ceiling exercise price, as applicable, of the warrants previously issued to these investors resulted in a deemed dividend on the Series E and Series F preferred stock, requiring a charge to retained earnings and an offsetting credit to additional paid-in capital aggregating $1,050,690. Similar to the beneficial conversion feature on the Series G preferred stock, this amount was charged to retained earnings, with an offsetting

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credit to additional paid-in-capital, and was treated as a reconciling item on the statement of operations to adjust the reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the nine months ended September 30, 2004.

(3) SERIES F CONVERTIBLE PREFERRED STOCK FINANCING

On January 16, 2004, the Company completed the sale in a private placement of 15,000 shares of Series F convertible preferred stock at a price of $100 per share, resulting in aggregate gross proceeds to the Company of $1.5 million. Each share of preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock for the five consecutive trading days preceding the conversion date, but at an exercise price of no more than $.25 per share and no less than $.20 per share. In accordance with the terms of the Series F preferred stock agreement, the floor conversion price was reduced to $.15 per share effective June 30, 2004, due to the Company’s inability to achieve a six-month cash flow projection through that date. Five-year warrants were also issued to purchase an aggregate of 6,000,000 shares of the Company’s common stock at the lower of $.35 per share or the average of the lowest ten inter-day closing prices of the Company’s common stock on the Over-the-Counter Bulletin Board during the 10 trading days immediately preceding the exercise date. As discussed in note 2, the ceiling exercise price on the Series F warrants was reduced from $.35 to $.11 per share in connection with the Series G preferred stock financing transaction completed in May 2004. Proceeds from the Series F interim financing were used to help meet the Company’s short-term funding requirements for support of its operations.

Accounting for this transaction falls primarily under EITF 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” and EITF 00-27, “Application of Issue 98-5 to Certain Convertible Instruments.” The Company allocated the net investor proceeds of $1,350,000 from the issuance of the Series F convertible preferred stock to the preferred stock and associated warrants based upon their estimated relative fair values. The resulting fair value allocations of $665,994 and $684,006 for the preferred stock and warrants, respectively, were recorded as equity in the first quarter 2004. The beneficial conversion feature embedded in the preferred stock was calculated at $665,994 and was limited to the fair value allocated to the preferred stock. The beneficial conversion feature of $665,994 was treated as a deemed dividend to preferred shareholders, and was charged to retained earnings, with the offsetting credit to additional paid-in-capital. Additionally, the Company treated the beneficial conversion feature of $665,994 as a reconciling item on the statement of operations to adjust its reported net loss to “net loss available to common shareholders,” which is used in the numerator in the loss per share calculation for the nine months ended September 30, 2004. The Company classified the warrants issued in connection with the Series F preferred stock financing as equity rather than debt based upon an assessment of the Company’s contractual obligations for registration of the related common shares issuable upon exercise of the warrants as provided under EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

(4) DISCONTINUED OPERATIONS

On September 29, 2003, the Company completed the sale of substantially all of the assets used in the Company’s intermittent testing business to International Technidyne Corporation (“ITC”), a wholly owned subsidiary of Thoratec Corporation, for approximately $5.2 million in cash and the assumption of certain liabilities, including trade payables of approximately $583,000. Of the $5.2 million cash payment, $758,000 was placed in escrow and restricted from the Company’s use for 180 days to cover excess trade payables assumed by ITC, any shortfall in collected receivables or any indemnification claims. The carrying value of assets sold to ITC approximated $3 million, and ITC assumed liabilities of the intermittent testing business totaling $669,000. As prescribed by SFAS No. 144, “Accounting for the Impairment of Long-lived Assets,” the Company began reporting the results of operations of the intermittent testing business as discontinued operations effective with the quarter ended September 30, 2003, for all periods presented. Upon completion of the sale transaction in September 2003, the Company recorded a gain on the sale of the intermittent testing business of $1.8 million. In late March 2004, sale proceeds remaining in escrow and deferred for

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recognition were released to the Company, amounting to approximately $713,000. After deducting transaction costs of $156,000, an additional gain on the sale of discontinued operations was recognized in the first quarter 2004 of approximately $557,000.

(5) CONVERTIBLE SENIOR SECURED FIXED RATE NOTES

Effective April 7, 2003, the Company completed the renegotiation of the terms of its $7.3 million Convertible Senior Secured Fixed Rate Notes due August 4, 2003, to extend repayment of the notes to August 4, 2005. In exchange for the extension of repayment, the Company agreed to reduce the conversion price for $6.9 million principal value of the notes from $8.40 to $3.51 per share, and to use 50% of the net proceeds in excess of $10 million received prior to August 4, 2005 from the issuance of any equity securities to pay down the principal value of the notes. In addition, the Company issued the note holders five-year warrants for 4,255,837 shares of its common stock at an exercise price of $.94 per share. This transaction requires accounting treatment prescribed under EITF 96-19, “Debtors Accounting for a Modification or Exchange of Debt Instruments.” As such, the modified notes and associated warrants were recorded in the second quarter 2003 as debt and equity, respectively, at their respective individual fair values of $5 million and $800,000. The $7.3 million carrying value of the original notes was retired, and the residual amount of $1.5 million was recorded in the second quarter 2003 in other income as a gain on modification of the notes. The Company will accrete the initial $5 million carrying value of the modified notes to their redemption value of $7.3 million over the remaining term of the notes using the effective interest method at an effective interest rate of approximately 17%. This will result in the recording of $2.3 million of additional interest expense over the remaining term of the notes, of which $252,895 and $728,921 was recorded in the three and nine months ended September 30, 2004, respectively, compared to $215,013 and $408,226 for the three and nine months ended September 30, 2003.

In January 2004, the note holders agreed to further amend the Note Purchase Agreement effective December 30, 2003 to defer the timing of interest payments due for the fourth quarter 2003 and the first quarter 2004, amounting to approximately $256,000, to June 30, 2004, and to reduce the exercise price of the warrants from $.94 per share to $.34 per share. In connection with the Series G preferred stock financing completed in May 2004, the note holders agreed to again amend the Note Purchase Agreement to defer until December 31, 2004 the Company’s obligation to make interest payments previously due on June 30, 2004 (including the deferred interest payments described above) and September 30, 2004, amounting to approximately $640,000. In exchange for the deferral of interest payments, the exercise price on the note holders’ common stock warrants was further reduced from $.34 per share to $.09 per share. The first and second quarter reductions in the exercise price of the warrants resulted in an increase in the fair value of the warrants of $90,674 and $70,517, respectively. These amounts were recorded as a charge to interest expense with an offsetting credit to additional paid-in capital in the respective quarter. The Company evaluated the appropriate accounting treatment for the modification of the terms of the convertible notes and associated warrants and determined that the provisions of SFAS No. 15, “Accounting for Debtors and Creditors for Troubled Debt Restructurings,” and EITF 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,” were not applicable.

(6) SUBSEQUENT EVENT

On October 14, 2004, the Company announced that it had initiated a restructuring of all its domestic and international operations. As a result of the restructuring, the Company has ceased manufacturing and support of its only current products, the Trend Care line of continuous blood and tissue monitoring systems. The Company is completing certain batches of production in process and is offering its customers the opportunity to purchase those products, when complete, as well as all products in inventory at the time the restructuring was announced. Virtually all employees were terminated in early November 2004.

The Company is pursuing additional financing to allow it to develop additional applications for its technology. If additional funds are not obtained, the Company will have no alternative but to cease all operations in the near future.

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It is unlikely that future product development activities would require many of the existing assets and the Company has therefore recorded a restructuring charge in the quarter ended September 30, 2004 to reduce property and equipment and inventory that it does not expect to sell to estimated realizable values. The Company also expects to implement some formal plan of discontinuing operations of its United Kingdom subsidiary which will impact the amounts of recorded liabilities in addition to the impairment of assets previously noted. No adjustments have been made to those liabilities pending final resolution of this matter.

The financial statements have otherwise been prepared on a going-concern basis which contemplates realization of assets, as adjusted, and satisfaction of liabilities and commitments in the normal course of business. The report of the Company’s independent auditors pertaining to the Company’s consolidated financial statements for the year ended December 31, 2003 contained an explanatory paragraph expressing substantial doubt about the Company’s ability to continue as a going concern as a result of recurring losses and negative cash flows. Failure to obtain additional funding during November 2004 would likely result in discontinuing business as a going-concern.

(7) LIQUIDITY

The Company incurred a consolidated net loss of $7,835,886 for the nine months ended September 30, 2004, preceded by a consolidated net loss of $8,479,145 (including net losses from continuing operations of $8,240,168) for the year ended December 31, 2003, and has incurred net losses since inception. The net loss for the 2004 year-to-date period is net of a $557,000 gain recognized upon the release in late March 2004 of escrowed proceeds from the Company’s sale of its intermittent testing business effective September 29, 2003.

The Company’s aggregate cash balance (including the impact of restricted cash) decreased by approximately $946,873 during the nine months ended September 30, 2004 to $88,472. Primarily impacting the reduction in cash during the first half of 2004 was a net loss from operations excluding noncash items of $7.8 million, partially offset by net proceeds of $2.7 million from the issuance during the first and second quarters of Series F and Series G convertible preferred stock, respectively, and the receipt of escrowed proceeds of approximately $.7 million from the sale of the Company’s intermittent testing business.

As discussed in “Discontinued Operations” under note 4 to the consolidated financial statements, on September 29, 2003, the Company completed the sale of substantially all of the assets used in the operation of the Company’s intermittent testing business to ITC. Gross proceeds received at closing amounted to $4,420,000, of which approximately $389,000 was used to pay accrued interest due on the Company’s Convertible Senior Secured Fixed Rate Notes. Proceeds from the sale also included approximately $758,000 placed in escrow by ITC and restricted from the Company’s use for 180 days to cover excess trade payables assumed by ITC, any shortfall in collected receivables or any indemnification claims. In late March 2004, sales proceeds remaining in escrow were released to the Company, amounting to $713,000. Effective upon the sale of the Company’s intermittent testing business, the holders of the Company’s Series E preferred stock elected to exercise their option to put back to the Company 50% of their original $1.5 million investment plus a return of 1% per month. As a result, in October 2003, the Company redeemed $750,000 in value of the Series E preferred stock, with cash payments of $790,250 including accrued interest. Additionally, the Company made payments of approximately $600,000 after the completion of the sale transaction for accrued retention bonuses earned by employees and accrued vacation pay for employees transferring to ITC or leaving the Company. Also, as part of changes made to reduce the cost structure of the Company’s continuing operations, the Company made payments after the closing of the sale for severance and related costs of approximately $659,000.

As more fully discussed under note 3 to the consolidated financial statements, on January 16, 2004, the Company completed the sale in a private placement of 15,000 shares of Series F convertible preferred stock at a price of $100 per share, resulting in aggregate gross proceeds to the Company of $1.5 million. Five-year warrants were also issued to purchase an aggregate of 6,000,000 shares of the Company’s common stock at the lower of $.35 per share or a defined average trading price preceding exercise, providing a potential source of future funding.

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Proceeds from this financing were used to help meet the Company’s short-term funding requirements for support of its operations, as the Company continued to pursue longer-term financing. In late April 2004, the Company received shareholder approval to increase its number of authorized shares of common stock by 40 million shares to 100 million shares, enhancing the Company’s ability to pursue additional equity financing.

In conjunction with the sale of Series F preferred stock in January 2004, holders of the Company’s Convertible Senior Secured Fixed Rate Notes agreed to amend the Note Purchase Agreement effective December 30, 2003 to defer the timing of interest payments due for the fourth quarter 2003 and the first quarter 2004, amounting to approximately $256,000, to June 30, 2004, and to reduce the exercise price on their outstanding warrants from $.94 per share to $.34 per share. The reduction in the exercise price resulted in an increase in the fair value of the warrants of $90,674, which was recorded as a noncash charge to other expense with an offsetting credit to additional paid-in-capital in the first quarter 2004. As noted below, the convertible notes and common stock warrants were further modified in May 2004.

On May 28, 2004, the Company completed a $1.5 million financing through the sale of 15,000 shares of Series G convertible preferred stock at $100 per share. The financing was completed in a private placement with the Mercator Advisory Group and its related funds and BCC Acquisition II, LLC. The Mercator Advisory Group and its related funds were also the investors in the Company’s Series E and Series F convertible preferred stock issued in May 2003 and January 2004, respectively. Each share of the Series G preferred stock is convertible at any time into common stock at 75% of the volume weighted average trading price of the lowest three inter-day trading prices of the common stock during the five consecutive trading days preceding the conversion date, with a maximum exercise price of $.14 per share and a minimum price of $.06 per share. The Company held a special meeting of its shareholders in September 2004 to request an increase in its authorized common stock from 100 million shares to 200 million shares. The shareholders approved that increase. The minimum exercise price was decreased automatically to $.03 per share pursuant to the Certificate of Designations of Series G Convertible Preferred Stock, without further amendment.

As part of this financing, the Company issued three-year warrants (“Series G warrants”) to the purchasers of the Series G preferred stock. Those warrants entitle the holders to purchase an aggregate of 1,250,000 shares of the Company’s common stock at the lower of $.11 per share or a defined average trading price preceding the exercise date. The Company also issued three-year warrants to the Mercator Advisory Group and its related funds that invested in the Company’s Series E and Series F preferred stock to purchase an aggregate of 12,241,608 shares of common stock at $.05 per share. The issuance of new warrants to the Series E and Series F investors was considered a dividend to those preferred stockholders, and required a noncash charge to retained earnings in the second quarter 2004 for the fair value of the warrants of $1,035,684.

Additionally, in connection with the Series G financing, the holders of the Company’s convertible notes agreed to defer until December 31, 2004 the Company’s obligation to make interest payments previously due on June 30, 2004 (including interest payments originally due on December 31, 2003 and March 31, 2004, payment of which was deferred until June 30, 2004) and September 30, 2004. In exchange for the deferral of interest payments, the exercise price on the note holders’ common stock warrants was reduced from $.34 per share to $.09 per share. Finally, in connection with the Series G financing, the exercise price of the outstanding common stock warrants issued as part of the Series E preferred stock financing was reduced from $.35 per share to $.11 per share, and the ceiling price for the exercise of the common stock warrants issued as part of the Series F preferred stock financing was reduced from $.35 per share to $.11 per share. The reduction in the exercise price of the note holders’ warrants resulted in an increase in the fair value of the warrants of $70,517, which was recorded as a noncash charge to interest expense with an offsetting credit to additional paid-in-capital in the second quarter 2004. The change in the exercise price terms of the Series E and Series F warrants was considered a dividend to the Series E and Series F preferred stockholders, and required a noncash charge to retained earnings in the second quarter 2004 for $15,006, representing the increase in the fair value of the warrants.

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The Series G interim financing effectively replaced the unfunded second tranche of the Series F preferred stock financing arranged in January 2004. As expected, the first $1.5 million tranche of financing generated in January 2004 under the Series F preferred stock agreement and other available funds had been substantially consumed by operations by the time the Series G financing was completed. This additional financing was necessary to help meet short-term funding requirements for support of the Company’s operations.

As part of an amendment to the exclusive distribution agreement with Philips signed in April 2003, the Company was provided an option to purchase from Philips certain unused inventory of TrendCare instruments previously sold to Philips. In late 2003, the Company provided a forecast to Philips for the purchase of approximately $0.6 million of TrendCare instruments over the course of 2004. The Company has satisfied approximately $41,000 of its instrument purchase commitment with Philips through June 30, 2004. The Company has advised Philips it will not meet the remaining amount of its purchase commitment.

The terms of the Company’s Convertible Senior Secured Fixed Rate Notes require a lump sum principal payment of $7.3 million in August 2005 to retire the notes, to the extent the note holders do not elect to exercise the conversion option prior to that date. The Company does not expect to be able to pay the full maturity value of the notes. As such, the Company expects to either renegotiate the terms of the notes to further extend repayment, or encourage conversion to common stock, or raise additional capital to allow retirement of the notes when due.

In January 2003, the Company received a Nasdaq Staff Determination indicating that the Company did not comply with the minimum stockholders’ equity requirement for continued listing on the Nasdaq National Market and that its securities were subject to delisting from that market. The Company subsequently applied and received approval to transfer the listing of its securities to the Nasdaq SmallCap Market effective February 26, 2003. The Company’s securities were later delisted from the SmallCap Market effective July 2, 2003, due to its failure to comply with the minimum common stock market value requirement for continued listing on that market. The Company’s common stock became immediately eligible to trade on the Over-the-Counter Bulletin Board effective with the open of business on July 2, 2003 under the symbol “DMED.” Trading of the Company’s common stock through the Over-the-Counter Bulletin Board may be more difficult because of lower trading volumes, transaction delays and reduced security analyst and news media coverage of the Company. These factors could contribute to lower prices and larger spreads in the bid and ask prices for the Company’s common stock. Trading of its common stock in an over-the-counter market may also attract a different type of investor in the Company’s common stock, which may limit the Company’s future equity funding options.

On June 9, 2004, KPMG LLP provided written notice to the Company that they declined to stand for reappointment and have resigned as auditors and principal accountants for the year ending December 31, 2004. KPMG LLP informed the Company that the client-auditor relationship would cease upon completion of the review by KPMG LLP of the Company’s consolidated financial statements as of and for the three and six-month periods ended June 30, 2004. KPMG LLP’s notice further indicated that in connection with the audits of the consolidated financial statements of the Company for the two years ended December 31, 2003, and the subsequent interim period through June 9, 2004, there were no disagreements with KPMG LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which disagreements if not resolved to their satisfaction would have caused them to make reference in connection with their opinion to the subject matter of the disagreement. The Company has appointed Virchow Krause & Company as its new auditors and principal accountants, effective early August 2004.

(8) NET LOSS PER COMMON SHARE

Basic earnings per share (“EPS”) is calculated by dividing net loss available to common shareholders by the weighted average common shares

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outstanding during the period. Diluted EPS reflects the potential dilution to basic EPS that could occur upon conversion or exercise of securities, options, or other such items, to common shares using the treasury stock method based upon the weighted average fair value of the Company’s common shares during the period. For each period presented, basic and diluted loss per share amounts are identical, as the effect of potential common shares is antidilutive. The following is a summary of outstanding securities which have been excluded from the calculation of diluted EPS because the effect on net loss per common share would have been antidilutive:

(1)		Based upon the lowest potential conversion rate of $.15 per share.
(2)		Based upon the lowest potential conversion rate as of September 30, 2004 of $.03 per share.

(9) COMPREHENSIVE LOSS

(10) INVENTORIES

(11) STOCK-BASED COMPENSATION

As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company applies the intrinsic-value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for the issuance of stock incentives to employees and directors. As a result, no compensation expense related to employees’ and directors’ stock incentives has been recognized in the financial statements as all options granted under stock incentive plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation costs for the Company’s stock incentive plans been determined based on the fair value of the awards on the date of grant, consistent with the provisions of SFAS No. 123, the Company’s net loss per share would have increased to the pro forma amounts indicated below:

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No stock options were granted under the Company’s stock option plans during the three and nine months ended September 30, 2004. The per share weighted average fair value of stock options granted during the three and nine months ended September 30, 2003 was $.72, determined using the Black Scholes option-pricing model with the following assumptions: an expected life of five years and no dividends, an annualized volatility of 97.5% and a risk-free interest rate of 2.3%.

(12) PRODUCT WARRANTY

The Company, in general, warrants its new hardware products to be free from defects in material and workmanship under normal use and service for a period of eighteen months after date of shipment in the case of distributors, and one year after date of sale in the case of end-user customers. The Company warrants its disposable products to be free from defects in material and workmanship under normal use until its stated expiration date. Under the terms of these warranties, the Company is obligated to repair or replace the products it deems to be defective due to material or workmanship. Beginning in the fourth quarter 2003, the Company established provisions for the estimated cost of maintaining product warranties for the hardware and disposable products of its continuing operations based on an estimated average per unit repair or replacement cost applied to the estimated number of units under warranty. The estimated average per unit repair or replacement cost reflects historical warranty incidence over the preceding twelve-month period. Evaluation of the reserve also includes consideration of other factors, including sales levels and types of warranty claims received. While warranty claims have not been material to the Company’s consolidated financial statements, the warranty reserve will be evaluated on an ongoing basis to ensure its adequacy.

(13) RELATED PARTY TRANSACTIONS

In August 1998, the Company issued Convertible Senior Secured Fixed Rate Notes, with proceeds aggregating $7,300,000, which were used to retire other debt of the Company. The investor group was led by BCC Acquisition II LLC. Effective April 7, 2003, the Company and the note holders completed a modification of the terms of the notes, including a two-year extension of repayment of the notes to August 4, 2005 and a reduction in the conversion price for $6,900,000 of the notes from $8.40 to $3.51 per share. Additionally, the note holders received five-year warrants for 4,255,837 shares of the Company’s common stock, at an exercise price of $.94 per share, subsequently reduced to $.34 per share and further reduced to $.09 per share as part of amendments to the Note Purchase Agreement completed in January 2004 and May 2004, respectively.

(14) DEFINED BENEFIT RETIREMENT PLAN FUNDING

The Company’s U.K. subsidiary sponsors a contributory defined benefit retirement plan (“Retirement Plan”) covering all eligible employees. The Company’s funding policy is to contribute into a trust fund at an annual rate that is intended to remain at a level percentage of total pensionable payroll. Annual contribution amounts are determined by a qualified actuary and are intended to adequately fund the Company’s

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projected pension liability payable upon employees’ retirement, given actuarial assumed rates of average market and trust fund investment performance. The Company modified the Retirement Plan effective August 31, 2003 to close the plan to future accrual of benefits. Company contributions made subsequent to August 31, 2003 will be allocated fully to reduce the Retirement Plan’s liabilities for participant benefits earned through August 31, 2003, thus helping to secure participant’s benefits earned through that date, and reducing the Company’s exposure to a potential future significant funding obligation. Subsequent to the August 31, 2003 modification of the Retirement Plan, the actuarial determined minimum funding requirement was established at 7,000 British pounds per month (or approximately $12,700 U.S. dollars based upon January 2004 exchange rates between the British pound sterling and the U.S. dollar). As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, the Company was funding the Retirement Plan at this minimum level during 2004. The Company has discontinued funding the Plan and is exploring options to satisfy Plan obligations.

(15) NEW ACCOUNTING PRONOUNCEMENTS

EITF Issue No. 03-01, “Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” addresses both qualitative and quantitative disclosures required for marketable equity and debt securities accounted for under Financial Accounting Standards Board (“FASB”) Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The disclosure requirements are effective for fiscal years ending after December 15, 2003. Additionally, the FASB’s Emerging Issues Task Force issued an EITF Consensus in April 2004 that will require companies carrying debt and equity securities at amounts higher than the securities’ fair values to use more detailed criteria to evaluate whether to record a loss and to disclose additional information about unrealized losses. The other-than-temporary impairment accounting guidance under the Consensus is effective for reporting periods beginning after June 15, 2004 and the disclosure requirements for annual reporting periods ending after June 15, 2004. EITF Issue No. 03-01 and its follow-on Consensus guidance is not expected to have a material impact on the Company’s financial statements.

In December 2003, the FASB issued revisions to Statement of Financial Accounting Standards (“SFAS”) No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” These revisions require changes to existing disclosures as well as new disclosures related to pension and other postretirement benefits, including disclosures about plan assets, investment strategy, plan obligations and cash flows. The Company will be required to adopt the new disclosure requirements of SFAS No. 132 effective with its financial statements for the year ending December 31, 2004. Certain interim period disclosure requirements relating to the components of net periodic benefit cost and contribution information are effective beginning in the first quarter 2004 and included in note 14.

In March 2004, the Emerging Issues Task Force issued EITF 03-06, “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings per Share.” This issue addresses a number of questions regarding the computation of earnings per share (“EPS”) by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company, when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating EPS. It clarifies what constitutes a participating security and how to apply the two-class method of computing EPS once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. The Company is evaluating the impact of the issue; however, it does not expect the issue to impact the calculation of basic or diluted EPS in 2004, as the Company expects to incur a net loss for the year ending December 31, 2004, causing all potentially dilutive securities to be anti-dilutive.

(16) CONTRACT TERMINATION COSTS

Effective May 31, 2004, the Company terminated the lease on one of its facilities located in the United Kingdom and incurred an early termination penalty of 30,000 British pounds sterling. Additionally, the Company vacated a small facility under lease in Malvern, Pennsylvania effective June 30, 2004. The Company is responsible for monthly payments under the noncancellable lease agreement for the Pennsylvania facility through March 2007 and is pursuing a third-party sublease of the property. The Company reviewed the provisions of SFAS No. 146,

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“Accounting for Costs Associated with Exit or Disposal Activities” to assess its expected liability associated with vacating the Pennsylvania facility and terminating the lease on its U.K. facility. In accordance with SFAS No. 146, the Company reduced the value of its remaining contractual commitment on the Pennsylvania lease by the estimated sublease income that could reasonably be obtained for the property, based upon feedback from the Company’s real estate broker. As a result, the Company incurred a charge to operating expenses and established a liability for $42,390 as of June 30, 2004 relating to the Pennsylvania facility. The early termination penalty on the U.K. facility remaining unpaid as of June 30, 2004 of approximately $45,000 was likewise recorded as a charge to operating expenses and established as a liability as of June 30, 2004.

Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

The Company’s discussion and analysis of results of operations and financial condition include forward-looking statements, which may include statements regarding the Company’s expectations about future financial performance; the continuation of historical trends; the sufficiency of its cash balances and cash generated from operating activities for future liquidity and capital resource needs; the expected impact of changes in accounting policies on the Company’s results of operations, financial condition or cash flows; anticipated problems and its plans for future operations; and the economy in general or the future of the medical device industry, all of which are subject to various risks and uncertainties. Actual results may differ materially from the Company’s expectations depending on a variety of important factors, including, but not limited to such factors as the Company’s ability to successfully implement its new business plan; the Company’s ability to raise an adequate level of capital to fund its operations; market demand and pressures on the pricing for its products; changing market conditions, competition and growth rates within the medical device industry; changes in accounting policies; risks associated with operations outside of the U.S.; changing economic conditions such as general economic slowdown, decreased consumer confidence and the impact of war on the economy; and other risks and uncertainties, including those described in Exhibit 99.1 to the Company’s Form 10-K filed with the U.S. Securities and Exchange Commission, with respect to the Company’s fiscal year ended December 31, 2003. When used in this Form 10-Q, and in future filings by the Company with the Securities and Exchange Commission, in the Company’s press releases, presentations to securities analysts or investors, in oral statements made by or with the approval of an executive officer of the Company, the words or phrases “believes,” “may,” “will,” “expects,” “should,” “continue,” “anticipates,” “intends,” “will likely result,” “estimates,” “projects,” or similar expressions and variations thereof are intended to identify such forward-looking statements.

OVERVIEW

The Company experienced significant changes over the past year. The Company’s primary line of business from its inception in 1990 through September 2003 was the development, manufacture and distribution of intermittent blood testing products. That line of business, which comprised 66% and 57% of consolidated revenues for the years ended December 31, 2003 and 2002, respectively, was sold in late September 2003. In late 1996, the Company acquired a continuous blood and tissue monitoring business. This business, now known as Diametrics Medical, Ltd, has operated as a wholly owned subsidiary of the Company, with manufacturing, research and development and marketing operations located in High Wycombe, England.

The Company’s continuous monitoring systems are based on fiber optic sensor technology which measures color changes optically via light transmitted through plastic fibers embedded with fluorescent dyes sensitive to chemicals in blood and tissue. Products include the TrendCare Continuous Blood Gas Monitoring Systems and the Neurotrend Cerebral Tissue Monitoring System. The TrendCare systems provide immediate and continuous information on blood gases and temperature in adult, pediatric and neonatal patients via a fiber optic sensor placed through an arterial catheter. Neurotrend continuously monitors oxygen, carbon dioxide, acidity and temperature through sensors placed directly

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in brain tissue, providing critical information regarding blood supply and oxygen levels in the brain that can guide clinicians and surgeons in treating patients with head trauma or those requiring surgery in the brain. The Company has distributed its Neurotrend cerebral tissue monitoring system through Codman under an exclusive worldwide distribution agreement.

The Company ended an exclusive distribution arrangement with Philips Medical Systems in late 2002 and started developing its own sales force and distribution network. Operations have never produced a significant portion of the funds required to continue developing the business and external fund raising efforts have become more difficult. The Company’s Board of Directors therefore concluded that it was not practicable to continue both lines of business, and in early 2003, started the process which led to the sale of the intermittent testing business.

Management subsequently focused on reinvigorating the continuous monitoring business. Many of the systems installed during recent years are relatively inactive. The entire sales and sales support organization in Europe, the United States and various international markets has worked during 2004 to increase utilization, and therefore sensor sales, where appropriate. Management had directed most of its sales and sales support resources to European markets, where sales opportunities for its continuous monitoring products appear most promising. New account efforts were focused on the neonatal market based on the more immediately recognized benefits in caring for critically ill newborns. Distributor relationships were carefully managed to focus on approximately ten countries where opportunities appeared greatest. Finally, the Company has actively explored new applications for its technology.

The Company has had the only continuous blood and tissue monitoring systems on the market, although various companies have previously tried to develop similar products. Continuous monitoring has not yet become the standard of care, so much of the Company’s sales and marketing efforts were directed toward education of physicians and clinicians involved in caring for critically ill patients. The systems sold by the Company consisted of a monitor, a patient data module, and a calibrator, which can support several monitors. After systems were installed, revenue was derived from the disposable sensors required for each use of the system. The Company has not penetrated a significant portion of either the neonatal market or the critically ill pediatric and adult market.

The sale of the intermittent testing business generated gross cash proceeds of $5.2 million, including escrowed proceeds released in late March 2004. A significant portion of the proceeds were required to satisfy commitments for severance payments, accrued vacation obligations and various other employee related commitments as well as accrued interest payments and the mandatory redemption of half of the Company’s Series E preferred stock. As a result of those commitments and the fact that significant management and administrative expenses continue, the Company was required to draw down the first $1.5 million tranche of financing under a $3 million Series F convertible preferred stock agreement completed in January 2004. Additionally, in late May 2004, the Company completed a $1.5 million private placement under a Series G convertible preferred stock agreement. This financing effectively replaced the unfunded second $1.5 million tranche of the Series F preferred stock financing arranged in January 2004. As expected, the $1.5 million of financing generated in January 2004 under the Series F preferred stock agreement and other available funds had been substantially consumed by operations by the time the Series G financing was completed. This additional financing was necessary to meet near-term funding requirements for support of the Company’s operations.

RESULTS OF OPERATIONS

Revenue. The Company’s total revenue from continuing operations was $697,443 and $1,992,738 for the three and nine months ended September 30, 2004, compared to $809,595 and $2,219,068 for the same periods in the prior year, a decrease of 14% and 10% for the three and nine month periods, respectively.

The decline in revenue during the third quarter and nine months ended September 30, 2004 was due primarily to a reduction in disposable sensor revenues. This reduction resulted primarily from the timing of disposable sensor purchases by two major customers in the prior year,

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with a concentration of those purchases in that year’s first quarter. Products sold internationally, consisting primarily of sales in Europe, comprised approximately 68% and 76% of total product revenue from continuing operations for the three and nine months ended September 30, 2004, respectively, compared to 82% and 78% for the respective periods in 2003. Remaining product revenue in each period was generated in the United States.

Cost of Revenue. Cost of revenue totaled $852,349 and $2,145,249, or 122% and 108% of total revenue for the three and nine months ended September 30, 2004, compared to $551,746 and $1,798,047, or 68% and 81% of total revenue for the same periods last year. The increase in cost of revenue as a percentage of total revenue was impacted primarily by reduced sensor production volumes and lower resulting absorption into inventory of overhead costs in the 2004 periods. Also contributing to the increase was the impact of lower average selling prices extended on large volume orders. Partially offsetting the impact of these changes was an increase in average selling prices for sensors, due to selling direct rather than through exclusive distributors.

Operating Expenses. Total operating expenses for the three and nine months ended September 30, 2004 totaled $3,359,949 and $6,906,103, a 36% and 4% increase relative to the respective periods last year. The increases in expense were impacted largely by restructuring and other non-recurring charges. The reduction in on-going expense reflects the Company reducing expenditures as operations declined.

Research and development expenditures totaled $415,952 and $1,321,495 for the three and nine months ended September 30, 2004, a 24% and 21% decline relative to the respective periods last year. Expenditures for the three and nine months ended September 30, 2004 were reduced by the recognition of $50,430 and $322,430 of funding from Codman under a development program to optimize neurotrend sensor characteristics. Funding from Codman included the Company’s costs under the development program for labor, materials, overhead and a profit margin.

Selling, general and administrative expenses totaled $925,785 and $3,566,396 for the three and nine months ended September 30, 2004, compared to $1,264, 860 and $4,324, 425 for the same periods in 2003. The 27% and 18% net reduction in expenses for the quarterly and year-to-date periods in 2004 was the result of a reduction in general and administrative expenses of $250,503 and $501,922, respectively, and a similar decrease in sales and marketing expenses of $88,572 and $256,107, respectively. The reductions were primarily due to cost cutting in line with the decline of business operations.

Restructuring and other non-recurring charges represent impairment charges for non-saleable inventory and the write-down to estimated net realizable value of property and equipment associated with operations discontinued in October 2004. See note 6 to the consolidated financial statements for further information.

Other Income (Expense). The three and nine months ended September 30, 2004 include $349,234 and $1,334,324 of net other expense, respectively, compared to $428,194 of net other expense and $592,307 of net other income for the comparable periods in 2003. Most of this category represents interest expense.

The significant changes between periods in net other income and expense occurred primarily as a result of the accounting treatment for the modification of the Company’s Convertible Senior Secured Fixed Rate Notes in April 2003, which resulted in the recognition of a $1.5 million gain during the second quarter 2003. Further, the modification of the notes required the accretion of the initial $5 million carrying value of the modified notes to their redemption value of $7.3 million using the effective interest method over the remaining term of the notes, resulting in $2.3 million of additional interest expense over this period. Accordingly, the accretion of the note balance resulted in an additional charge to interest expense of $252,895 and $728,922 for the three and nine months ended September 30, 2004, compared to $215,013 and $408,226 for the comparable periods in 2003. Additionally, as a result of amendments in January 2004 and May 2004 to the Note Purchase Agreement

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which reduced the exercise price of the warrants issued in connection with the April 2003 notes modification from $.94 to $.34 per share, and from $.34 to $.09 per share, respectively, the Company recorded charges to interest expense during the nine months ended September 30, 2004 for $161,191 representing the increase in the fair value of the warrants stemming from the reductions in the exercise price. The remaining increase in net other expense occurred as a result of an increase in realized foreign currency transaction losses.

Discontinued Operations. On September 29, 2003, the Company completed the sale of substantially all of the assets used in the Company’s intermittent testing business to ITC for approximately $5.2 million in cash and the assumption of certain liabilities, including trade payables of approximately $583,000. Of the $5.2 million cash payment, $758,000 was placed in escrow and restricted from the Company’s use for 180 days to cover excess trade payables assumed by ITC, any shortfall in collected receivables or any indemnification claims. As prescribed by SFAS No. 144, “Accounting for the Impairment of Long-lived Assets,” the Company began reporting the results of operations of the intermittent testing business as discontinued operations effective with the quarter ended September 30, 2003, for all periods presented. Upon completion of the sale transaction in September 2003, the Company recorded a gain on the sale of the intermittent testing business of $1.8 million. In late March 2004, sale proceeds remaining in escrow and deferred for recognition were released to the Company, amounting to approximately $713,000. After deducting transaction costs of $156,000, an additional gain on the sale of discontinued operations was recognized in the first quarter 2004 of approximately $557,000.

The operations of the Company’s intermittent testing business, reflected in discontinued operations, reported a net loss of $949,717 and $2,071,036 for the three and nine months ended September 30, 2003, respectively.

Net Loss / Net Loss Available to Common Shareholders. The Company’s reported consolidated net loss amounts for the three and nine months ended September 30, 2004 of $3,864,089 and $7,835,886 were further adjusted by charges of $0 and $2,784,334, respectively, for calculated beneficial conversion features on preferred stock and deemed preferred stock dividends to arrive at “net loss available to common shareholders” of $3,864,089 and $10,620,220, respectively. These amounts are used in the numerator in the loss per share calculation for each period. Such charges occurred as a result of the required accounting treatment of the Company’s issuance of $1.5 million of Series F convertible preferred stock and associated warrants in January 2004, followed by the issuance of $1.5 million of Series G convertible preferred stock and associated warrants in May 2004, as further discussed in notes 2 and 3 to the consolidated financial statements. Similarly, the Company’s reported consolidated net loss amounts for the three and nine months ended September 30, 2003 of $1,749,548 and $5,866,173 were further adjusted by a $958,962 charge for a beneficial conversion feature to arrive at “net loss available to common shareholders” of

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$1,749,548 and $6,825,135, respectively. The charge in 2003 occurred as a result of the required accounting treatment of the Company’s issuance of $1.5 million of Series E convertible preferred stock and associated warrants in May 2003.

LIQUIDITY AND CAPITAL RESOURCES

On October 14, 2004, the Company announced that it had initiated a restructuring of all its domestic and international operations. As a result of the restructuring, the Company has ceased manufacturing and support of its only current products, the Trend Care line of continuous blood and tissue monitoring systems. The Company is completing certain batches of production in process and is offering its customers the opportunity to purchase those products, when complete, as well as all products in inventory at the time the restructuring was announced. Virtually all employees were terminated in early November 2004.

The Company has depleted virtually all of its available cash and is pursuing additional financing to allow it to develop additional applications for its technology. If additional funds are not obtained, the Company will have no alternative but to cease all operations in the near future.

It is unlikely that future product development activities would require many of the existing assets and the Company has therefore recorded a restructuring charge in the quarter ended September 30, 2004 to reduce property and equipment and inventory that it does not expect to sell to estimated realizable values. The Company also expects to implement some formal plan of discontinuing operations of its United Kingdom subsidiary which will impact the amounts of recorded liabilities in addition to the impairment of assets previously noted. No adjustments have been made to those liabilities pending final resolution of this matter.

The financial statements have otherwise been prepared on a going-concern basis which contemplates realization of assets, as adjusted, and satisfaction of liabilities and commitments in the normal course of business. Failure to obtain additional funding during November 2004 would likely result in discontinuing business as a going-concern. In either event, it is unlikely that the Company will be able to certify its compliance with Section 404 of the Sarbanes-Oxley Act of 2002 by December 31, 2004.

The Company’s aggregate cash balance (including the impact of restricted cash) decreased by approximately $947,000 during the nine months ended September 30, 2004 to $88,472. Primarily impacting the reduction in cash during the first half of 2004 was a net loss from operations excluding noncash items of $7.8 million, partially offset by net proceeds of $2.7 million from the issuance during the first and second quarters of Series F and Series G convertible preferred stock, respectively, and the receipt of escrowed proceeds of approximately $.7 million from the sale of the Company’s intermittent testing business.

Analysis of Changes in Cash Flows From Continuing Operations. Net cash used in continuing operating activities totaled $3,902,681 for the nine months ended September 30, 2004, compared to $3,164,076 for the same period in 2003. This was primarily the result of consolidated net losses from continuing operations each period adjusted by noncash items, amounting to $7.8 million and $5.6 million in 2004 and 2003, respectively.

Net cash provided by investing activities totaled $480,483 for the nine months ended September 30, 2004, compared to net cash provided in investing activities of $3,065,074 for the nine months ended September 30, 2003. Primarily impacting investing activities during the 2004 period was the receipt in March 2004 of escrowed proceeds approximating $720,000 from the Company’s sale of its intermittent testing business. Purchases of property and equipment partially offset the 2004 net increase in cash provided by investing activities and comprised the full use of cash during the same period in 2003.

Net cash provided by financing activities totaled $2,554,975 and $995,208 for the nine months ended September 30, 2004 and 2003, respectively. Financing activities in the current period were primarily impacted by the Company’s receipt in January 2004 and May 2004 of combined net proceeds of approximately $2.7 million in connection with the completion of its Series F and Series G convertible

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preferred stock financings. This was partially offset by principal payments on capital lease obligations. Financing activities in the prior year’s period stemmed primarily from the Company’s receipt in May 2003 of net proceeds of $1.2 million in connection with the completion of a Series E convertible preferred stock financing. This was partially offset by principal payments on borrowings and capital leases and payment of debt extension costs related to the modification of the Company’s convertible notes.

At September 30, 2004, the Company had U.S. tax net operating loss and research and development tax credit carryforwards for income tax purposes of approximately $132 million and $1.5 million, respectively. Pursuant to the Tax Reform Act of 1986, use of a portion of the Company’s net operating loss carryforwards are limited due to a “change in ownership.” If not used, these net operating loss carryforwards begin to expire in 2005 ($500,000) and at increasing amounts between 2006 and 2023 ($31.6 million between 2006 and 2009, and $98.2 million thereafter). The Company’s foreign subsidiary also has a net operating loss carryforward of approximately $57.5 million, which can be carried forward indefinitely, subject to review by the governmental taxing authority.

Analysis of Changes in Cash Flows From Discontinued Operations. Net cash provided by discontinued operations totaled $557,052 for the nine months ended September 30, 2004, while net cash used in discontinued operations totaled $749,316 for the same period in 2003. Activity in the current period represents the release to the Company in late March 2004 of $713,000 of proceeds remaining in escrow from the sale of the intermittent testing business, reduced by $156,000 of related transaction costs. The use of cash during the prior year’s period primarily reflects the net loss before noncash items generated by the intermittent testing business during the period, partially offset by improvements in working capital.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

The Company is exposed to market risk from foreign exchange rate fluctuations of the British pound sterling to the U.S. dollar as the financial position and operating results of the Company’s U.K. subsidiary, DML, are translated into U.S. dollars for consolidation. The Company’s exposure to foreign exchange rate fluctuations also arises from transferring funds to its U.K. subsidiary in British pounds sterling. From November 1999 through October 2002, most of the Company’s sales were made to the Company’s two global distribution partners, Philips and Codman, with sales denominated in U.S. dollars, thereby significantly mitigating the risk of exchange rate fluctuations on trade receivables. With the termination of the exclusive agreement with Philips, the Company established a direct sales force in the United States, the United Kingdom and Germany, as well as nonexclusive third-party distributors in various other countries. All sales made from the Company’s U.S. operations are denominated in U.S. dollars and, with the exception of sales to end-user customers in Germany (which are denominated in euros), all sales made from DML are denominated in British pounds sterling. The Company is currently reassessing its risk of exchange rate fluctuations on trade receivables due to changing distribution relationships and methods precipitated by the termination of the Company’s exclusive agreement with Philips.

The Company is also exposed to both market and interest rate risk in the actuarial valuation of its subsidiary’s defined benefit retirement plan. The Retirement Plan’s projected benefit obligation exceeded the fair value of plan assets by approximately $3 million at the December 31, 2002 valuation date, reflecting a $1.6 million and $2 million increase in the plan’s underfunded status relative to December 31, 2001 and 2000, respectively. This occurred due to an environment of weaker investment performance in the global markets over the prior two to three years (which negatively affected the value of Retirement Plan assets), and to a lesser extent, lower prevailing interest rates (which drove the use of a lower discount rate to calculate the projected benefit obligation, thereby increasing the amount of this obligation at December 31, 2002). While the underfunded status of the Company’s Retirement Plan has improved as of the most recent valuation date of December 31, 2003 to approximately $2.5 million, and is expected to continue to improve over time as a result of actuarial assumed improvements in future average market (and trust fund) performance, the inability of the trust fund investments to perform at or near these average projected rates of return over the employees’ remaining service lives could result in a significant future funding obligation of the Company. To help

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manage this exposure, the Company modified the Retirement Plan effective August 31, 2003 to close the plan to future accrual of benefits. The Retirement Plan continues to exist; however, the liabilities of the Retirement Plan were frozen effective August 31, 2003. The Company has discontinued funding the Plan and is exploring options to satisfy plan obligations.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures.

Under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective in timely alerting them to the material information relating to the Company (or its consolidated subsidiary) required to be included in the reports the Company files or submits under the Exchange Act.

(b) Changes in internal controls over financial reporting.

During the quarter ended September 30, 2004, there has been no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

     None

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

     None

Item 3. Defaults Upon Senior Securities

     None

Item 4. Submission of Matters to a Vote of Security Holders

A special meeting of the Company’s shareholders was held on September 30, 2004. At the meeting, the shareholders voted to approve an amendment to the Company’s Amended and Restated Articles of Incorporation to increase the number of shares of all classes of stock from 105,000,000 to 205,000,000, and to increase the number of authorized shares of Common Stock, par value $.01 per share, from 100,000,000 to 200,000,000. This amendment was approved as follows: 24,914,627 votes “For,” 689,675 votes “Against” and 42,318 votes “Abstained.” Additionally, the Company’s shareholders voted to approve an amendment to the Company’s Certificate of Designations of Series F Convertible Preferred Stock to clarify the relative priority of such stock in the event of a liquidation.

Item 5. Other Information

     None

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Item 6. Exhibits

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DIAMETRICS MEDICAL, INC.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

   Dated:  November 9, 2004

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