NOTES TO FINANCIAL STATEMENTS

(Unaudited)

(1) Basis of Presentation

The accompanying unaudited interim financial statements of Nanophase Technologies Corporation (“Nanophase” or the “Company”) reflect all adjustments (consisting of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of the financial position and operating results of the Company for the interim periods presented. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ended December 31, 2004.

These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended December 31, 2003, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, as filed with the Securities and Exchange Commission.

(2) Description of Business

The Company was incorporated on November 30, 1989 for the purpose of developing nanocrystalline materials for commercial production and sale in domestic and international markets.

Nanophase Technologies is a nanocrystalline materials developer and commercial manufacturer with an integrated family of nanomaterial technologies. Nanophase produces engineered nanomaterials for use in a variety of diverse markets: personal care, sunscreens, abrasion-resistant applications, environmental catalysts, antimicrobial products and a variety of polishing applications, including semiconductors, hard disk drives and optics. New markets and applications also are being developed. The Company targets markets in which it feels practical solutions may be found using nanoengineered products. The Company works with leaders in these target markets to identify their material and performance requirements.

The Company also recognizes regular revenue from a technology license and revenue from the occasional sale of production equipment to its technology licensee. Neither of these activities are expected to drive the long-term growth of the business.

The Company’s typical credit terms are thirty days from shipment and invoicing.

Revenue from international sources approximated $110,000 and $318,000 for the three months ended March 31, 2004 and 2003, respectively.

The Company’s operations comprise a single business segment and all of the Company’s long-lived assets are located within the United States.

(3) Investments

Investments are classified by the Company at the time of purchase for appropriate designation and such designation is reevaluated as of each balance sheet date. The Company’s policy is to classify money market funds and certificates of deposit as investments. Investments are classified as held-to maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to maturity securities are stated at amortized cost and are adjusted to maturity for the amortization of

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premiums and accretion of discounts. Such adjustments for amortization and accretion are included in interest income. The Company’s investments are held by its investment bank who is a member of all major stock exchanges and the Securities Investor Protection Corporation (SIPC). Securities and cash held in custody by the Company’s investment bank are afforded unlimited protection through SIPC and a commercial insurer, however, it does not protect against losses from the rise and fall in market value of investments.

(4) Inventories

Inventories consist of the following:

(5) Employee Stock Options and Warrants

During the three months ended March 31, 2004, 212,859 shares of Common Stock were issued pursuant to option exercises and no shares were issued in the form of annual restricted stock grants to the Company’s outside directors, compared to no shares of Common Stock being issued pursuant to option exercises and 24,350 shares being issued in the form of annual restricted stock grants to the Company’s outside directors, in the same period in 2003. During the three months ended March 31, 2004 there were 453,001 warrants outstanding, with none being converted and no warrants were outstanding during the same period in 2003.

As permitted by Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (SFAS No. 123), the Company accounts for stock options granted to employees in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). As long as the exercise price of the options granted equals the estimated fair value of the underlying stock on the measurement date, no compensation expense is recognized by the Company for these options. SFAS No. 123 established an alternative fair value method of accounting for stock-based compensation plans. As required by SFAS No. 123 for companies using APB No. 25 for financial reporting purposes, the Company makes pro forma disclosures regarding the impact on net loss of using the fair value method of SFAS No. 123.

Pro forma information regarding net income is required by SFAS No. 123, which also requires that the information be determined as if the Company had accounted for the employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions for the three months ended March 31, 2004 and 2003. No options were granted for the three months ended March 31, 2004.

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The Black-Scholes option pricing model:

For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to expense over the vesting period of the respective option. Because SFAS No. 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma impact was not fully reflected until 2002. The pro forma impact for the three months ended March 31, 2004 and 2003 shown is meant to approximate the effects of the expensing of stock options.

The following table illustrates the effect on net loss and loss per share had compensation cost for all of the stock-based compensation plans been determined based on the grant date fair values of awards (the method described in SFAS No. 123, Accounting for Stock-Based Compensation):

(6) Significant Customers and Contingencies

Revenue from three customers constituted approximately 73.7%, 14.8% and 5.9%, respectively, of the Company’s total revenue for the three months ended March 31, 2004. Amounts included in accounts receivable on March 31, 2004 relating to these three customers were approximately $436,000, $150,000 and $356,000, respectively. Revenue from these three customers constituted approximately

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67.0%, 12.6% and 18.8% respectively, of the Company’s total revenue for the three months ended March 31, 2003. Amounts included in accounts receivable on March 31, 2003 relating to these three customers were approximately $438,000, $159,000 and $522,000, respectively.

The Company currently has supply agreements with BASF Corporation (“BASF”) and Rohm and Haas Electronic Materials (“RHEM”), the Company’s two largest customers, that have contingencies outlined in them which could potentially result in the license of technology and/or the sale of production equipment, providing capacity sufficient to meet the customer’s production needs, from the Company to the customer, if triggered by the Company’s failure to meet certain performance requirements and/or certain financial condition covenants. The financial condition covenants in the Company’s supply agreement with its largest customer, as amended on March 17, 2003, “triggers” a technology transfer (license or, optionally, an equipment sale) in the event (a) that earnings of the Company for a twelve month period ending with its most recently published quarterly financial statements are less than zero and its cash, cash equivalents and investments are less than $2,000,000, (b) of an acceleration of any debt maturity having a principal amount of more than $10,000,000 or (c) the Company’s insolvency, as further defined within the agreement. In the event of an equipment sale, upon incurring a triggering event, the equipment would be sold to the customer at 115% of the equipment’s net book value. In March 2003, the $2,000,000 “trigger” referenced above was reduced from $4,000,000 pursuant to an amendment to the supply agreement with the Company’s largest customer.

The Company believes that it has complied with all contractual requirements and that it has not had a “triggering event”. The Company further believes that the proceeds of the May 29, 2002 and September 8, 2003 private placements and its equity investment on March 23, 2004 provide sufficient cash balances to avoid the first triggering event referenced above for the foreseeable future. Further, the Company expects, although such events are not guaranteed, to receive some portion of an additional $15 million in equity capital relating to its January 22, 2004 universal shelf registration filing and an additional $2 million in possible equity capital relating to the future exercise of warrants issued in its September 2003 fundraising prior to their expiration in September 2004. If a triggering event were to occur and BASF elected to proceed with the transfer and related sale mentioned above, the Company would receive royalty payments from its customer for products sold using the Company’s technology; however, the Company would lose both significant revenue and the ability to generate significant revenue to replace that which was lost in the near term. Replacement of necessary equipment that could be purchased and removed by the customer pursuant to this triggering event could take in excess of twelve months. Any additional capital outlays required to rebuild capacity would probably be greater than the proceeds from the purchase of the assets as dictated by the Company’s agreement with the customer. Such an event would also result in the loss of many of the Company’s key staff and line employees due to economic realities. The Company believes that its employees are a critical component of its success and could be difficult to replace and train quickly. Given the occurrence of such an event, the Company might not be able to hire and retain skilled employees given the stigma relating to such an event and its impact on the Company.

(7) Contingent Liabilities

In 1998, Harbour Court LPI, a small stockholder of the Company, sued the Company in the United States District Court for the Northern District of Illinois. The complaint alleged that the Company, certain of its officers and directors, and the underwriters of the Company’s initial public offering of common stock (the “Offering”) had violated the federal Securities Exchange Act of 1934 by making supposedly fraudulent material misstatements of fact in connection with soliciting consents to proceed with the Offering from certain of the Company’s preferred stockholders. The supposed misrepresentations concerned purported mischaracterization of revenue that the Company received from its then-largest customer. The complaint further alleged that the action should be maintained as a plaintiff class action on behalf of certain former preferred stockholders whose shares of preferred stock were converted into common stock on or about the date of the Offering. The complaint sought unquantified

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compensatory damages and attorneys’ fees. Each defendant answered the complaint, denying all wrongdoing. Following certain discovery, the Company agreed to settle all claims against all defendants for $800,000, plus up to an additional $50,000 for the cost of settlement notices and administration. The settlement did not admit liability by any party. The Court ordered final approval of the settlement in January 2002 and concurrently dismissed the complaint with prejudice. In January 2003, the Court approved interim payment to plaintiffs of $17,102 in settlement administration costs. Because both the settlement and the settlement administration costs were funded by the Company’s directors and officers liability insurance, neither the settlement nor the settlement administration costs payment have had a material adverse effect on the Company’s financial position or results of operations.

In 2001, George Tatz, a purchaser of 200 shares of the Company’s common stock, filed a separate complaint in the United States District Court for the Northern District of Illinois against the Company and Joseph Cross, its president and CEO. The complaint alleged that defendants violated the federal Securities Exchange Act of 1934 by making supposedly fraudulent material misstatements of fact in connection with the Company’s public disclosures concerning the Company’s dealings with Celox, a British customer. The complaint further alleged that the action should be maintained as a plaintiff class action on behalf of certain persons who purchased shares of the Company’s common stock from April 5, 2001 through October 24, 2001. The complaint sought relief including unquantified compensatory damages, attorneys’ and expert witness’ fees. Plaintiff subsequently filed an amended complaint, alleging that the Company and four of its current or former officers (Joseph Cross; Daniel Bilicki, its vice president of sales and marketing; Jess Jankowski, its then-acting chief financial officer; and Gina Kritchevsky, its former chief technology officer) were liable under the federal Securities Exchange Act of 1934 for making supposedly fraudulent material misstatements of fact in connection with the Company’s public disclosures concerning the Company’s relationship with Celox and the Company’s purportedly improper booking, and later reversal, of $400,000 in revenue from a one-time sale to Celox treated as a bill and hold transaction. The amended complaint alleged the same putative class and sought the same relief as in plaintiff’s initial complaint. In November 2002, defendants answered the amended complaint denying all wrongdoing. Following discovery, in June 2003, the Company agreed to settle all claims against all defendants for $2,500,000. Thereafter, the Court certified the class alledged in the amended complaint. On December 1, 2003, the Court ordered final approval of the settlement and concurrently dismissed the amended complaint with prejudice. The settlement did not admit liability by any party. Because the settlement was funded by the Company’s directors and officers liability insurance, the settlement has not had a material adverse effect on the Company’s financial position or results of operations.

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