The following management's discussion and analysis should be read in conjunction with our financial statements and the notes thereto appearing elsewhere in this Form 10-K.

Overview

Beginning with this annual report, the Company is divided into four reporting segments to more clearly delineate our main operating activities Below is a summary of these segments:

· Contract Research: The Contract Research segment consists of the Radiation Monitoring Devices, Inc. ("RMD") business unit, which is among the largest small business participants in U.S. government-funded research.

· Optics: The Optics segment encompasses four business units (our original optics business ("Dynasil Fused Silica"), Optometrics, Hilger Crystal, and Evaporated Metal Films ("EMF")) that manufacture commercial products, including optical crystals for sensing in the security and medical imaging markets, as well as optical components, optical coatings and optical materials for scientific instrumentation and other applications.

· Instruments: The Instruments segment consists of Dynasil Products (formerly known as RMD Instruments), which manufactures precision instrumentation for medical and commercial applications.

· Biomedical: The Biomedical segment consists of a single business unit, Dynasil Biomedical Corporation ("Dynasil Biomedical"), a medical technology incubator, developing disruptive technologies for a wide spectrum of applications, including hematology, hypothermic core cooling and tissue sealants.

For information about our financial segments and geographical information about our operating revenues and assets, see Note 16 to the Consolidated Financial Statements included in this Report. A complete description of our strategy is included in Item 1 of this Form 10-K.

Our markets are characterized by rapidly changing technology and the needs of our customers change and evolve regularly. Accordingly, our success depends on our ability to develop services and products that address these changing needs and to provide the people and technology needed to deliver these services and products. To remain competitive, we must consistently provide superior service, technology and performance on a cost-effective basis to our customers. Our business performance also is influenced by a variety of other factors including, but not limited to, economic conditions, U.S. Government spending on research and development programs, the availability of Research & Experimentation tax credits, competition, regulatory requirements and insurance costs. Further information on certain risks to our Company is located in Item 1a of this Form 10-K.

Fiscal 2012 Financial Overview

On December 31, 2012, the Company announced it is in default of certain financial covenants set forth in the terms of its outstanding indebtedness with respect to its fiscal year ended September 30, 2012. The Company continues to be current with all principal and interest payments due on all its outstanding indebtedness and management expects to continue discussions with its lenders to address the financial covenant situation. Under the default condition, our lenders have the ability to require immediate payment of all indebtedness under our loan agreements. While the lenders have not exercised this right, their ability to require immediate payment has caused all of our outstanding indebtedness to be accelerated to current classification on our consolidated financial statements. Given the uncertainty created by the defaults under the Company's outstanding indebtedness, the Company's independent registered public accounting firm has included a "going concern" qualification in its audit opinion for the year ended September 30, 2012.

The Company has recently taken and will continue to take actions to improve its liquidity, including the implementation of a number of initiatives designed to conserve cash, optimize profitability and right-size the cost structure of its various businesses.

The Company has retained Argus Management Corporation and Mirus Capital as financial advisors to assist it in evaluating strategic and restructuring alternatives, including the potential sale of product lines and/or a Company division. While the Company is actively considering such strategic alternatives, there can be no assurances that any such transaction will occur, or, if a transaction is completed, it will be on terms favorable to the Company.

In fiscal year 2012, we achieved nominal revenue growth but incurred higher expenses than in fiscal 2011. Revenues grew 2.0% from $47.0 million to $47.9 million, offset by a combination of higher-than-expected research and development costs and increased Selling, General & Administrative (SG&A) expenses. During the year we made significant investments within the Instruments segment on upgrades to the segment's two main product lines, specifically, the new hand-held lead paint analyzer, the LPXpro™, and the new wireless medical probe used in cancer surgery, the Navigator 2.0™ gamma counter. Though development of these products has been completed, they have not yet received the required regulatory approvals and additional changes, therefore, may become necessary. As a result of the higher-than-expected costs and delays in product launches, the Company determined that there was a decline in the fair value of business operation, and we recorded a non-cash goodwill impairment charge of $2.3 million for the period ended September 30, 2012 relating to our Instruments segment. Additionally, the Company incurred a large non-recurring increase in SG&A expenses. The increase stemmed from the Company's internal review of the cash application, billing and internal controls at RMD. The Company conducted this review at the direction of the Audit Committee of the Board of Directors. The Company incurred approximately $466,000 in SG&A expenses associated with the review. As a result of the review, which has been satisfactorily completed, the Company has adopted certain improved practices and internal controls. We do not anticipate additional expenses for this matter.

As a result of the foregoing, our loss from operations for fiscal 2012 was $3.7 million, compared with income from operations of $2.3 million in fiscal 2011. The net loss for fiscal 2012 was $4.3 million, or $0.29 per share, compared with net income of $1.35 million, or $0.08 per share, in 2011.

During the year, we pursued several growth initiatives, including:

· dual mode nuclear detector technology (which generated its first revenue in 2012);

· biomedical technologies within the Dynasil Biomedical business unit, concentrating on hematology, hypothermic core cooling and tissue sealants;

· patent portfolio, which we expanded during the year primarily within the Contract Research segment.

The Company is actively exploring commercialization opportunities in thin film digital x-rays, sensors for nondestructive testing and radiation dosimeters based on technologies developed at RMD. No determination has been made as to the Company's entry into these market segments.

Results of Operations

Results of Operations for the Fiscal Year Ended September 30,

2012

                                  Contract
                                  Research          Optics        Instruments      Biomedical         Total
Revenue                           24,270,675       17,456,436        6,054,752         105,287       47,887,150
Gross Profit                       8,859,780        7,125,962        3,436,542          83,459       19,505,743
SG&A                               9,523,642        5,548,421        4,915,723         939,149       20,926,935
Impairment of goodwill                     -                -        2,284,499               -        2,284,499
Operating Income (Loss)             (663,862 )      1,577,541       (3,763,680 )      (855,690 )     (3,705,691 )
GM %                                    36.5 %           40.8 %           56.8 %          79.3 %           40.7 %

Depreciation and Amortization        237,623          796,847          575,246          60,003        1,669,719
Capital expenditures                 348,314          462,445          207,454               -        1,018,213

Intangibles, Net                     366,853          960,821        5,135,634         239,997        6,703,305
Goodwill                           4,938,625        1,300,463        4,015,072               -       10,254,160
Total Assets                      12,870,151       11,588,145       12,537,403         469,729       37,465,428

Results of Operations for the Fiscal Year Ended September 30,

2011

                                  Contract
                                  Research          Optics        Instruments      Biomedical         Total
Revenue                           24,874,088       15,839,205        6,238,373               -       46,951,666
Gross Profit                      10,339,990        6,391,291        3,018,950               -       19,750,231
SG&A Costs                         9,149,838        5,178,590        2,639,944         495,201       17,463,573
Operating Income (Loss)            1,190,152        1,212,700          379,007        (495,201 )      2,286,658
GM %                                    41.6 %           40.4 %           48.4 %           0.0 %           42.1 %

Depreciation and Amortization        147,687          581,464          503,922               -        1,233,073
Capital expenditures                 284,098          915,978          343,186               -        1,543,262

Intangibles, Net                     456,367        1,096,773        5,613,366         300,000        7,466,506
Goodwill                           4,938,625        1,283,775        6,299,571               -       12,521,971
Total Assets                      10,447,842       14,683,407       15,363,526         371,808       40,866,583

Revenue

Revenues for the fiscal year ended September 30, 2012 were $47,887,150. This represents an increase of 2.0% over revenues for the fiscal year ended September 30, 2011 of $46,951,666. Contract Research revenues declined by 2.4% as a result of lower billable costs. The contract revenue backlog for contract research continues to be strong and is approximately $36 million and contains about 42% SBIR grants as of September 30, 2012. The Company is actively pursuing alternative funding avenues to further reduce the percentage of work through the SBIR program. This includes contract research for commercial businesses rather than governmental agencies.

Revenues in the Optics segment increased by 10.2% to $17.5 million in fiscal 2012. New customers and new product growth initiatives continue to be pursued throughout this segment.

Revenues in the Instruments segment declined by 2.9% to $6.1 million in fiscal year 2012. We believe that customers have delayed purchases of our existing products in anticipation of the availability of the newly refreshed products which are not yet approved by the necessary regulatory agencies.

The Biomedical segment achieved its first revenues of $105,287, primarily through a technology development contract with the Mayo Clinic.

Gross Profit

Gross profit for fiscal year 2012 declined by 1.2% to $19,505,743 from the prior year amount of $19,750,231. Gross profit as a percentage of sales declined to 40.7% from 42.1% at September 30, 2011 as a result of lower gross margin in the Contract Research segment and mix changes between the segments.

Gross profit dollars declined by 14.3% for the Contract Research segment. Gross profit as a percentage of sales declined to 36.5% from 41.6%, due to losses incurred to complete contracts and costs incurred in excess of provisional contract rates. This decline in gross profit for Contract Research was offset by improvements in other segments. The Optics segment's gross margin stayed relatively steady at 40.8% from 40.4%. The Instruments segment's gross margin improved to 56.8% from 48.4% as a result of additional revenues derived, in part, from re-activating the radioactive source in our installed base of lead paint analyzer ("LPA") products. The LPA units contain a tiny radioactive source which must be periodically refreshed. Instruments also sold three RadCam units during the year at high margin. A RadCam unit is a radiation detector married with a camera to provide a visual display of radioactive locations. Finally, the Biomedical segment had its first revenues, with small costs of goods sold.

Selling, General & Administrative ("SG&A") Expenses

SG&A expenses increased by $3.5 million to $20,926,935 or 43.7% of sales, for fiscal year 2012, from $17,463,573 or 37.2% of sales for fiscal year 2011. All segments experienced SG&A increases at various levels. All segments shared in higher costs at the corporate level. Corporate level costs are allocated to each operating business unit. The main higher cost at the corporate level related to the Company initiating an internal review of the billing and accounting practices and internal controls at its RMD division. The Company conducted this review at the direction of the Audit Committee of the Board of Directors. The Company incurred a total of approximately $466,000 of such expenses, all of which are reflected in the fiscal year ended September 30, 2012. This investigation has been satisfactorily completed and, as a result, the Company has adopted certain improved practices and internal controls, and does not anticipate additional expenses for this matter.

Contract Research SG&A increased to 39.2% of sales in fiscal 2012 from 36.8% of sales in the prior year. This segment has incurred the costs for the previously disclosed severance agreement with the former President of RMD in the amount of $325,000. Costs were also incurred to increase resources to better handle internal processes and internal control matters.

SG&A within the Optics segment increased $369,831, and the margin declined slightly to 31.8% of sales in fiscal 2012 from 32.7% in the prior year.

The Instruments segment incurred the greatest increase in SG&A costs, increasing $2,275,779 over prior year to 81.2% of sales in fiscal 2012 compared to 42.3% of sales in prior year. This segment has two main product lines: a hand-held lead paint analyzer and a medical gamma probe used primarily in breast cancer treatment. Both product lines were in need of revitalization with new features and functionality to maintain their positions in the marketplace. The Company spent $1.3 million on research and development on the products and significant monies on sales and marketing efforts in advance of the new product launches. Administrative staff was also increased in anticipation of future higher volume. As of this date, the updated products, the new hand-held lead paint analyzer, LPXpro™, and the new wireless medical probe, the Navigator 2.0™, are awaiting regulatory approval so that they can be sold in the marketplace. Recent sales of existing products have suffered as a result. Steps have been taken to reduce costs while awaiting the regulatory approvals. These include downsizing the administrative staff - including replacement of the general manager for the segment - and reducing the scheduled hours of the production staff. Regulatory approvals are expected imminently, but the timing is yet unknown. There can be no assurance when or if the regulatory approvals will be obtained and additional delays could lead to a further deterioration of product revenues. At September 30, 2012, the Company recorded an impairment of goodwill in the amount of $2,284,499 associated with the Instruments segment.

Finally, we have a full year of costs from the Biomedical segment in fiscal year 2012 as compared to only six months of costs in fiscal year 2011. SG&A costs were $939,149 compared to $495,201 in fiscal 2011. These costs were incurred to advance the development of the three main technologies: hematology, hypothermic core cooling and tissue sealants. While we believe these technologies are progressing favorably, they remain in the early stages of development and there can be no assurance that we will be able to successfully bring any of them to market. In order to advance further development activities, we are exploring the availability of outside financing, including through a sale, licensing or joint venture involving one or more technologies, though we may not be able to secure any such financing arrangement on favorable terms or at all.

Net Interest Expense

Net interest expense decreased slightly to $639,096 in fiscal 2012 from $641,815 in fiscal 2011. There were offsetting components to the change. First, the Company continued to make regular payments of principal to Sovereign Bank, N.A. ("Sovereign" or the "Bank") under the Loan and Security Agreement, dated July 7, 2010, as amended on April 1, 2011, April 12, 2012, and June 29, 2012 (the "Term Loan and the Acquisition Line of Credit"). With these periodic payments, debt was reduced by $1,860,678 during the year ended September 30, 2012. Offsetting this reduction in interest-bearing debt was new borrowings from Massachusetts Capital Resources Company on July 31, 2012 in the amount of $3.0 million. Proceeds of this borrowing were used to repurchase shares pursuant to the exercise of a contractual put right by a stockholder, in the amount of $1,857,546 with the remainder used for general working capital purposes. The new borrowings are subordinated to Sovereign's senior debt. The new borrowings carry an interest rate of 10%.

Income Tax Expense

Total income tax expense decreased from a tax provision of $293,000 in fiscal 2011 to a tax benefit of ($41,000) in fiscal 2012. There were offsetting components to the net decrease. First, income (loss) before the provision for income taxes decreased significantly resulting in a reduction of current tax due for federal and state purposes as compared to the prior year. This decrease was offset by a full valuation allowance on the U.S. net deferred tax assets recorded during fiscal 2012. Additionally, the current year tax benefit from research and experimentation credits is lower as the federal research and experimentation credit is not extended as of September 30, 2012.

Net Income

The Company had a net loss of $4,303,766 for the year ended September 30, 2012 compared to net income of $1,351,645 for the fiscal year ended September 30, 2011. Lower operating results from higher costs, goodwill impairment and the valuation allowance on tax assets due to the going concern opinion all contributed to the current year loss.

Liquidity and Capital Resources

Liquidity Overview

On December 31, 2012, the Company announced it is in default of the financial covenants set forth in the terms of its outstanding indebtedness at September 30, 2012. These covenants require the Company to maintain specified ratios of earnings before interest, taxes, depreciation and amortization (EBITDA) to fixed charges and to total/senior debt. The Company continues to be current with all principal and interest payments due on all its outstanding indebtedness and management expects to continue discussions with its lenders to address the financial covenant situation.

These financial covenant defaults give the lenders the right to accelerate the maturity of the indebtedness outstanding and foreclose on any security interest. Furthermore, Sovereign Bank, N.A, the Company's senior lender, may, at its option, impose a default interest rate with respect to the senior debt outstanding, which is 5% higher than the rate otherwise in effect. To date, the lenders have not taken any such actions. However, the Company cannot predict when or whether a resolution of this situation will be achieved.

As of September 30, 2012, the Company had total indebtedness outstanding of approximately $12.0 million, consisting of approximately $9.0 million of senior debt owed to Sovereign Bank and approximately $3.0 million of subordinated debt owed to Massachusetts Capital Resources Company. The Company's indebtedness is secured by substantially all the accounts and assets of the Company and is guaranteed by its subsidiaries.

The causes for the covenant violations are lower revenue and higher than expected expenses in the Company's Dynasil Products and RMD divisions during the fiscal quarter ended September 30, 2012, combined with the continued investment in Dynasil Biomedical Corp. and the Company's Dual Mode nuclear detection initiative. In addition, the Company incurred a significant, non-recurring charge of approximately $466,000 to its selling, general and administrative expenses during that quarter related to costs incurred as a result of a review, under the direction of the Audit Committee of the Board, of certain cash application processes and billing practices of the RMD division. This investigation has been completed and has resulted in modifications in the division's practices and internal controls. The Company does not anticipate additional expenses for this matter.

Because of the uncertainty of any resolution of the covenant violations and possibility of an acceleration of the indebtedness by the lenders, the Company has reclassified all of its outstanding indebtedness to current classification in the financial statements for the year ended September 30, 2012 filed herewith. As a result, the Company's independent registered public accountants, McGladrey LLP, has included a "going concern" qualification in its audit opinion with respect to such financial statements.

The Company has recently taken and will continue to take actions to improve its liquidity, including the implementation of a number of initiatives designed to conserve cash, optimize profitability and right-size the cost structure of its various businesses. The Company has retained Argus Management Corporation and Mirus Capital as financial advisors to assist it in evaluating strategic and restructuring alternatives, including the potential sale of product lines and/or a Company division. While the Company is actively considering such strategic alternatives, there can be no assurances that any such transaction will occur, or, if a transaction is completed, it will be on terms favorable to the Company.

Net cash as of September 30, 2012 was $3,414,880 which was a decrease of $1,064,960 as compared to $4,479,840 at September 30, 2011. The Company does not currently have cash available to satisfy its obligations under its indebtedness if it were to be accelerated or payment demanded. If the Company is not able to resolve its current defaults under its outstanding indebtedness and improve its liquidity through the actions described above, it may not have sufficient liquidity to meet its anticipated cash needs for the next twelve months.

Net cash provided by operating activities

Net cash provided by operating activities was $693,054 for fiscal year 2012 versus $3,892,646 for fiscal year 2011. Fiscal year 2012 net loss was $4,303,766. There were non-cash expenses contained in the net loss which included stock compensation expense of $935,396, depreciation and amortization expense of $1,669,719 and the impairment of goodwill was $2,284,499. These major non-cash items totaled $4,889,614. Net changes in assets totaled $1,695,234. This included $986,133 in an increase in accounts receivable, net of unbilled accounts receivable. Days Sales Outstanding ("DSO") increased to 63.3 days at September 30, 2012 from a record low of 46.1 days at September 30, 2011. Contract Research, the largest business segment, experienced an increase in DSO from prior year results of 35.8 days to 67.0 days at September 30, 2012. Expected improvements have yet to materialize and we continue efforts to streamline processes and improve collections. We do not believe that these internal procedural matters will ultimately affect the collectability of these receivables and accordingly, we have not made any increase in allowance for doubtful accounts for these receivables. DSO for the Optics segment was 50.9 days at September 30, 2012 compared with 49.5 days for the period in the prior year. The Instruments segment's DSO was 80.4 days at September 30, 2012 compared with a prior year DSO of 91.1 days. This segment has a portion of its revenues through distributors who usually have extended terms beyond net 30 days. Finally, the Biomedical segment has little revenue and a measure of DSO is not meaningful. Increases in assets were partially offset by net changes in liabilities of $1,503,514 for accounts payable, accrued expenses and deferred revenue.

Cash flows used in investing activities

Cash flows used in investing activities were $1,018,213 for fiscal 2012 compared with $1,843,262 for fiscal 2011. All expenditures in 2012 were made to purchase machinery and equipment and to invest in leasehold improvements. Fiscal year 2011 included $300,000 to acquire biomedical technologies by the newly created Dynasil Biomedical Corp. In fiscal 2012, the Contract Research segment used $348,314, primarily for leasehold improvements. The Optics segment used $462,445, primarily for replacement machinery and equipment. The Instruments segment used $207,454, primarily for machinery and equipment used in research, development and engineering. Biomedical had no capital expenditures. There are currently plans for capital expenditures of $1,511,000 during fiscal year 2013, depending on the availability of cash and/or financing. Due to the uncertainty with respect to the Company's long-term financing arrangements, the Company is not able to determine whether financing will be available to fund these capital expenditures.

Cash flows from financing activities

Cash flows from financing activities used $711,701 of cash in fiscal 2012 and used $1,803,411 of cash in fiscal 2011. Fiscal 2012 included new financing in the amount of $3,000,000 under a Note Purchase Agreement with Massachusetts Capital Resource Company ("MCRC"). The Company used $1,857,546 of the financing proceeds to repurchase shares of common stock pursuant to a put right exercised by Dr. Gerald Entine, a former owner of RMD and RMD Instruments, which required the repurchase of a total of 928,773 shares of Dynasil common stock held by Dr. Entine and certain affiliates (collectively "Entine") for an aggregate purchase price of $1,857,546. This put right originated from the Company's acquisition of RMD and RMD Instruments in July 2008 and is set forth in the Asset Purchase Agreement dated July 1, 2008 by and among the Company, RMD Instruments Corp., RMD Instruments, LLC and Entine. Transaction costs for the new financing used $56,600 in cash.

Finally, current year cash of $1,860,678 was used for regularly scheduled payments to Sovereign/Santander Bank under the five year term debt and acquisition line of credit.

Summary of Terms of Outstanding Indebtedness

Management expects to continue discussions with its lenders to address the financial covenant defaults as of September 30, 2012 as described above. The following is summary of the terms of the existing loan agreement in place with the Company's senior lender, Sovereign Bank, and the terms of subordinated debt owed to Massachusetts Capital Resources Company.

Sovereign Bank Loan Agreement

On June 29, 2012, the Company entered into a letter agreement (the "Waiver Letter") with Sovereign as well as Amendment No. 3 (the "Amendment") to the Loan and Security Agreement, dated July 7, 2010, as amended on April 1, 2011 and April 12, 2012 (the "Original Loan Agreement"). Under the Waiver Letter, the Lender agreed to waive non-compliance by the Company with certain financial covenants under the Original Loan Agreement as of June 30, 2012, subject to the Company's compliance with the terms of the Amendment, including the requirement that the Company would raise, on or before September 30, 2012, at least $2,000,000 in gross proceeds from the sale of its capital stock and/or the incurrence of new indebtedness which is subordinated to the indebtedness in favor of the Lender, on terms and conditions acceptable to the Lender in its sole discretion (the "Required Capital Raise") and applying the proceeds as described below, all of which the Company has successfully completed.

The Amendment also made certain other changes to the Original Loan Agreement, . . .