(3) NET LOSS PER SHARE:

For the three and six months ended June 30, 2001 and 2000, net loss per share is computed using the weighted average common shares outstanding during the period.  Common share equivalents are not included in the net loss per share calculations, since they are anti-dilutive.  Warrants and options to purchase 4,111,138 and 3,894,990  shares of the Company’s common stock were outstanding as of June 30, 2001 and 2000, respectively, and could potentially dilute basic earnings per share in future periods if the Company generates net income.

(4) COMPREHENSIVE INCOME:

There was no accumulated other comprehensive income or loss for the three and six months ended June 30, 2001 and 2000, respectively.

(5) NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board approved Statements of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and No. 142, “Goodwill and Other Intangible Assets.”  The statements eliminate the pooling-of-interests method of accounting for business combinations and require that goodwill and certain intangible assets not be amortized.  Instead, these assets will be reviewed for impairment at least annually with any related losses recognized when incurred.  SFAS No. 141 is generally effective for business combinations completed after June 30, 2001.  SFAS No. 142 is effective January 1, 2002 for existing goodwill and intangible assets and July 1, 2001 for business combinations completed after June 30, 2001.  The Company does not expect these statements to materially affect its financial position or results of operations.

Overview

Vital Images develops, markets and supports 3D medical imaging software for use primarily in disease screening, clinical diagnosis and therapy planning.  The Company’s software applies proprietary computer graphics and image processing technologies to a wide variety of data supplied by computed tomography (“CT”) scanners, magnetic resonance (“MR”) imaging devices and ultrasound scanning equipment.  Vital Images’ products allow clinicians to create both two- and three-dimensional views of human anatomy and to non-invasively navigate within these images to better visualize and understand internal structures and pathologies.  The Company believes that its high-speed visualization technology and customized protocols cost-effectively brings 3D visualization and analysis into the routine, day-to-day practice of medicine.  The Company, which operates in a single business segment, markets its products to healthcare providers and to manufacturers of diagnostic imaging systems through a direct sales force in the United States and independent distributors in international markets.

Revenue

Revenue was $3,681,000 for the three months ended June 30, 2001, compared with $2,513,000 for the three months ended June 30, 2000, a 46% increase.  For the six months ended June 30, 2001, revenue was $7,013,000 compared with $4,784,000 in the comparable six-month period of the prior year, a 47% increase. These increases were primarily the result of volume and pricing increases in sales of Vitreaâ 2, the Company’s flagship medical visualization and analysis software, as well as increasing sales of the add-on VScore software for coronary artery calcium scoring.  Software and hardware revenue from the Vitrea 2 platform totaled $3,144,000, or 85% of total revenue, and $5,921,000, or 84% of total revenue, for the three and six months ended June 30, 2001, respectively, compared with $2,122,000, or 84% of total revenue, and $3,986,000, or 83% of total revenue, for the three and six months ended June 30, 2000.  There were also increases in maintenance and service revenue related to Vitrea 2 sales for both the three and six months ended June 30, 2001 compared with the same periods in the prior year. The increases principally reflect the Company’s increasing number of customers purchasing maintenance as well as installation and training services for the expanding customer base.

Gross Margin

The gross margin percentage decreased from 79% and 78% for the three and six months ended June 30, 2000, respectively, to 75% and 76% for the three and six months ended June 30, 2001, respectively, primarily as a result of hardware revenue becoming a higher percentage of the total revenue in 2001.  The Company receives only a nominal discount in purchasing the third-party hardware and peripheral components of the Vitrea 2 system, and the Company's gross margin on the resale of these system components approximates its discount.  The Company anticipates that as hardware revenue related to the sale of Vitrea 2 software continues to account for a significant proportion of the Company's total revenue, the overall gross margin percentage in future periods will approximate the results of this quarter.

Sales and Marketing

Sales and marketing expenses increased to $1,618,000, or 44% of total revenue, for the three months ended June 30, 2001, from $1,421,000, or 57% of total revenue, for the three months ended June 30, 2000, a 14% increase.  For the six months ended June 30, 2001, sales and marketing expenses increased 29%, to $3,249,000, or 46% of total revenue, from $2,509,000, or 52% of total revenue, for the six months ended June 30, 2000.  The increases were primarily due to increased compensation costs as a result of additional personnel and increased sales commissions as a result of increased revenue.  There were also increases in expenses related to selling and promoting the Vitrea 2 product.  The Company expects sales and marketing costs to increase in future periods as a result of the cost of additional sales and customer support personnel.

Research and Development

Research and development expenses increased 4% to $811,000, or 22% of total revenue, for the three months ended June 30, 2001, compared with $778,000, or 31% of total revenue, for the same period last year. For the six month period ended June 30, 2001, research and development expenses increased 10% to $1,652,000, or 24% of total revenue, from $1,497,000, or 31% of total revenue, for the comparable period in the prior year.  The increase was primarily due to increased compensation costs resulting from additional personnel supporting the development of Vitrea 2 for the three and six months ended J une 30, 2001 compared with the three and six months ended June 30, 2000. The compensation increase was partially offset by a decrease in contract worker costs. The Company anticipates that research and development costs will increase in future periods as the Company develops software tools for applications with large potential markets, such as cardiovascular disease, disease screening applications such as colon cancer and lung cancer, and surgical and therapy planning.
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General and Administrative

General and administrative expenses increased to $752,000, or 20% of total revenue, for the three months ended June 30, 2001, from $635,000, or 25% of total revenue, for the three months ended June 30, 2000, an 18% increase.  For the six months ended June 30, 2001, general and administrative expenses increased 13%, to $1,446,000, or 21% of total revenue, from $1,283,000, or 27% of total revenue, for the six months ended June 30, 2000.  General and administrative expenses increased primarily due to compensation costs increasing and an increase in fees for various professional services and bad debt expense.  The Company believes that general and administrative expenses will increase in future periods due to increased infrastructure costs as the business grows, but that they will continue to decrease as a percentage of total revenue.

Results of Operations

The increasing revenues from Vitrea 2 shipments, net of the increased expenses attributable to the development of the Company's infrastructure and the development and promotion of the Vitrea 2 product, resulted in operating losses of $413,000 and $1,050,000 for the three and six months ended June 30, 2001, respectively, compared with operating losses of $850,000 and $1,560,000 for the three and six months ended June 30, 2000, respectively.

Interest Income

The decrease in interest income was due to a lower average balance of cash and cash equivalents during the three and six months ended June 30, 2001 compared to the three and six months ended June 30, 2000.