<PAGE>   1

                       SECURITIES AND EXCHANGE COMMISSION
                                Washington, D.C.
                                     20549

                                  FORM 10-K
---
 X   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
---  EXCHANGE ACT OF 1934

     For the fiscal year ended July 31, 1997

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

Commission file number 0-14491

                               ARBOR DRUGS, INC.                          
----------------------------------------------------------------------------
            (Exact name of registrant as specified in its charter)

                Michigan                            38-2054345             
     -------------------------------    ------------------------------------
     (State or other jurisdiction of    (I.R.S. Employer Identification No.)
     incorporation or organization)

       3331 West Big Beaver, Troy, Michigan                      48084   
      ----------------------------------------                 ----------
      (Address of principal executive offices)                 (Zip Code)

Registrant's telephone number, including area code:  (248) 643-9420

Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:

                          Common Stock, $.01 par value
                          ----------------------------
                                (Title of Class)

        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. (X) Yes ( ) No

        Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. ( )

        The aggregate market value of the voting stock held by non-affiliates
of the registrant as of October 24, 1997, was $1,059,052,539.

        The number of outstanding shares of the registrant's common stock as of
October 24, 1997 was 39,498,463.

Documents Incorporated by Reference

        Certain portions of the registrant's definitive proxy statement
pursuant to Regulation 14A of the Securities Exchange Act of 1934 for the 1997
Annual Meeting of Shareholders are incorporated by reference in Part III of
this Form 10-K.

<PAGE>   2
                                     PART I

Item 1.   Business

General

        Arbor Drugs, Inc. (the "Company") is the largest Michigan-based
drugstore chain and the second largest drugstore chain operating in Michigan in
terms of total Michigan revenues.  As of July 31, 1997, the Company had 199
stores located primarily in southeastern Michigan.

        Unless the context otherwise requires, references to the "Company"
include the Company's consolidated subsidiaries.  References to a fiscal year
are to the twelve months ended July 31.

Products

        The Company's drugstores sell four principal categories of products:
prescription drugs, health and beauty aids (including proprietary drugs and
cosmetics), photofinishing and film and general merchandise.  General
merchandise includes seasonal and promotional goods, greeting cards,
convenience foods and alcoholic and nonalcoholic beverages.  In fiscal 1997,
prescription drugs accounted for approximately 53.5 percent, health and beauty
aids for approximately 19.8 percent, photofinishing and film for approximately
5.0 percent and general merchandise for approximately 21.7 percent of the
Company's net sales.  Contributions to net sales are not indicative of
contributions to income from operations because gross margins vary among
product categories and products within each category.

        The Company's business normally generates somewhat higher revenues
during its second and fourth fiscal quarters (the Christmas and summer
seasons).  The Company believes that these higher revenues,  in combination
with the fixed nature of certain administrative and store operating costs and
seasonal changes in product mix, result in higher operating income for these
periods.

Merchandising and Marketing

        The Company's merchandising  strategy  is  to  offer a broad selection
of traditional drugstore items, including both nationally advertised and
private label brand products.  Substantially all products are offered at
competitive prices.  The Company emphasizes value and customer service in
attractive, conveniently located drugstores.  It uses color, signs, packaging
and other merchandising aids to reinforce its name and low prices, and to
showcase its products.

        The pharmacy department in each drugstore carries a complete line of
both brand name and generic drugs.  The Company has been expanding its
prescription drug business by promoting the use of less costly generic drugs,
whenever possible, and by entering into arrangements with insurance companies,
health maintenance organizations ("HMOs") and other health care groups for the
sale of prescription drugs under third-party reimbursement programs.  See
"Significant Customers" below.

        As part of the Company's merchandising of pharmaceutical products, each
pharmacy department utilizes Arbortech Plus SM, a computerized pharmacy system. 
Arbortech PlusSM enables the Company's pharmacists to recall a customer's
pharmacy history, with a view to identifying possible allergies, drug
interactions or therapeutic duplication, and to provide customers with a
complete record of medication dispensed.  This system affords each of the
Company's drugstores access to this information, thus enabling customers to be
served by any store in the chain.  Arbortech PlusSM also enables the Company to
identify generic equivalents of brand name drugs, centrally control
prescription prices, increase the speed of processing


                                                                          2

<PAGE>   3

prescriptions and reduce the paperwork normally involved in, and thus expedite
the collection of amounts due the Company under, third-party reimbursement
programs.

        The Company promotes its private label Arbor(R) brand products and
presently offers approximately 1,000 such products, including a wide variety of
vitamins, products for skin, hair and personal care, health products and
proprietary drugs for colds, allergies and other ailments.  Offering private
label products enables the Company to sell products, comparable in quality to
name brand products, at substantially lower prices to its customers, but at
higher gross margins for the Company.

        The primary photo processing marketing program used by the Company is
Picture! Picture!(R), which offers a "two for the price of one" photo
processing service, with guaranteed overnight processing.  Additional programs
are Picture! Plus!SM and the Picture! Picture! Club(R), which offer customers
one print plus a free roll of film and prizes for volume photofinishing.
Picture Pronto(R), is a one-hour photo processing service offered in all stores
as of July 31, 1997.  The Company intends to offer this service in all new
locations.  All photo processing services are provided by an independent
contractor.

        The Company advertises extensively, principally through the use of
television, radio, direct mail and advertising circulars.

Expansion Program

        As of July 31, 1997, the Company operated 199 drugstores, a net
increase of 17 drugstores from the end of fiscal 1996.  During fiscal 1997, the
Company opened 20 drugstores, including 3 relocations, and purchased the
prescription files of a number of independent drugstores.  Assuming no
significant construction delays, the Company anticipates adding approximately
20 drugstore locations in Michigan during  fiscal 1998.  The Company may also
continue to purchase the prescription files of various independent drugstores,
as opportunities arise.

        In addition to adding drugstores in southeastern Michigan, the Company
has expanded, and plans to continue to expand, in other areas of Michigan.  The
Company may also expand into contiguous states.  The Company's 470,000 square
foot distribution center is expected to serve the Company's distribution needs
for the next several years. The Company expects that this expanded facility
will accommodate approximately 400 stores.

Purchasing and Distribution

        The Company centrally purchases most of its merchandise directly from
manufacturers,  enabling it  to  benefit from promotional  programs and volume
discounts that certain manufacturers offer to retailers.  Approximately 83
percent of the merchandise  purchased  by  the Company is received at its
distribution center for redistribution  to  its drugstores.  The balance of
store merchandise is shipped directly to the Company's drugstores  by
manufacturers  and  distributors  at prices negotiated at the corporate level.

Significant Customers

        In fiscal 1997, 45.5 percent of the Company's net sales (approximately
85% of pharmacy net sales) were attributable to payments by third-party
providers under prescription drug plans.  Six of such third-party providers
accounted for approximately one-third of fiscal 1997 net sales and one, Blue
Cross Blue Shield of Michigan, accounted for more than 10 percent of fiscal
1997 net sales (11.8 percent).

        The Company participates in the majority of third-party plans offered
to employer groups in its primary marketplace, the greater metropolitan Detroit
area.

                                                                          3
<PAGE>   4

Accordingly, if any employer group were to change its third-party plan, the
Company believes it is likely that it would continue to fill prescriptions for
such group under a different third-party plan.  In the event the Company were
unable to service one or more of its principal third-party provider plans,
however, the Company's revenues would be adversely affected.

Competition

        The Company's primary competitors are other drugstore chains,
independent drugstore operators, mail order distributors, hospitals, HMOs,
department stores (including discount stores) and supermarkets.  Many of the
businesses with which the Company competes are larger and have been in business
longer or have substantially greater financial resources than the Company.

        Competition remained keen during fiscal 1997 with the Company competing
on the basis of price, convenience, store design, product selection, quality
and variety.  See "Merchandising and Marketing" above.

Significant Proprietary Rights

        The Arbor(R) trade name is considered to be of material importance to
the business of the Company.  The Company also holds servicemarks for some of
its photo finishing products and pharmacy systems.

Regulatory Matters and Insurance

        All of the Company's pharmacy departments and all pharmacists employed
by the Company are licensed by the Michigan Board of Pharmacy.  The Company's
drugstores and its warehouse facility are also registered with the United
States Drug Enforcement Administration and are subject to various licensing and
regulatory requirements.  Beer and wine are sold in substantially all of the
Company's drugstores, and liquor is sold in approximately half of the
drugstores.  The sale of alcoholic beverages is regulated by the Michigan
Liquor Control Commission. By virtue of these various license and registration
requirements, the Company is obligated to observe certain rules and
regulations.  A violation of these rules and regulations could result in a
suspension or revocation of such licenses or registrations with respect to one
or more of the Company's drugstores or the distribution center.

        The Company carries general liability insurance, subject to
self-insured retentions, with respect to druggist, product, premises and
"dram-shop" claims.

Employees

        As of July 31, 1997, the Company had approximately 7,000 employees. A
majority of the drugstore employees work on a part-time basis (fewer than 35
hours per week).

         The Company's employees are not represented by unions.  The Company
believes that its relations with its employees are good.

Item 2.   Properties

        As of July 31, 1997, approximately 90 percent of the Company's 199
drugstores were leased. The leases are for various terms and periods. For
information regarding rental expense and lease commitments, see Note 4 of Notes
to Consolidated Financial Statements set forth in Item 14 below. In addition to
base rentals, the majority of the Company's store leases require additional
rentals based on a percentage of sales.  In most instances, the leases obligate
the Company to pay its pro rata share of common area maintenance charges, taxes
and insurance.

        The Company owns its 470,000 square foot distribution center, which is
located 

                                                                          4


<PAGE>   5

in Novi, Michigan.  The Company leases its 54,000 square foot executive
offices, which are located in Troy, Michigan.

Item 3.   Legal Proceedings

        In November 1993 the Securities and Exchange Commission (the "SEC")
issued a formal Order of Private Investigation relating to the Company's
reporting of certain third-party reimbursement practices and a contractual
dispute over these practices with Blue Cross of Michigan (which has been
settled).  The Company has complied with the SEC's requests for information
made in November 1993 and October 1994.

        The Company is also involved in various routine litigation incidental
to its business, none of which, in the opinion of management, is deemed to be
material.

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

        None.

Item 10.   Directors and Executive Officers of the Registrant

        Set forth below is certain information with respect to the executive
officers of the Company.

<TABLE>
<CAPTION>
        Name                   Age              Position
        ----                   ---              --------
        <S>                    <C>              <C>
        Eugene Applebaum       60               Chairman of the Board, President and Chief Executive Officer
        
        Markus M. Ernst        60               Executive Vice President, Chief Operating Officer and Director
        
        Gilbert C. Gerhard     55               Senior Vice President-Finance and Administration, Chief Financial 
                                                Officer, Secretary, Treasurer and Director

        Donald M. Stutrud      49               Senior Vice President-Store Operations
        
        Eric Bolokofsky        45               Senior Vice President-Merchandising
        
        Dennis J. Wozniak      41               Senior Vice President-Purchasing and Marketing
        
        John Enokian           64               Senior Vice President - Health Services
</TABLE>


        Mr. Applebaum is a founder of the Company and has been the President and
a Director of the Company and its predecessors since 1963.  In January 1985, Mr.
Applebaum was elected Chairman of the Board and Chief Executive Officer.  Mr.
Applebaum has been a licensed pharmacist in the State of Michigan since 1960.

        Mr. Ernst has been Executive Vice President and a Director of the
Company since 1974, having served as a director and executive officer of one of
the Company's predecessors since 1968.  Mr. Ernst has also served as Chief
Operating Officer since 1985.  Mr. Ernst joined the Company in 1968.

        Mr. Gerhard has been Senior Vice President - Finance and Administration
since February 1994.  Mr.  Gerhard has also served as Chief Financial Officer,
Secretary and Treasurer since 1983 when he joined the Company.  Mr. Gerhard was
Vice President-Finance and Administration from 1983 until February 1994.

                                                                        5
<PAGE>   6

        Mr. Stutrud has been Senior Vice President - Store Operations since
February 1991.  Mr. Stutrud served as Vice President - Store Operations from
March 1986 until January 1991.  Mr. Stutrud joined the Company in 1971.

        Mr. Bolokofsky has been Senior Vice President - Merchandising since
February 1994.  Mr. Bolokofsky served as Vice President - Merchandising from
October 1987 until February 1994.  Mr. Bolokofsky joined the Company in 1976.

        Mr. Wozniak has been Senior Vice President - Purchasing and Marketing
since February 1994.  Mr.  Wozniak served as Vice President - Purchasing from
October 1987 until February 1994.  Mr. Wozniak joined the Company in 1978.

        Mr. Enokian has been Senior Vice President - Health Services since April
1996.  Mr. Enokian served as Vice President - Health Services from February 1991
until April 1996. Mr. Enokian joined the Company in 1965 as a licensed
pharmacist.

                                                                        6
<PAGE>   7

                                    PART II


Item 5.    Market for the Registrant's Common
           Equity and Related Stockholder Matters

        The Company's Common Stock is regularly quoted on the National 
Association of Securities Dealers Automated Quotation System (NASDAQ) National
Market System under the symbol ARBR. The following table sets forth, for the
periods indicated, the high and low closing sale prices for the Company's Common
Stock and cash dividends paid.

<TABLE>
<CAPTION>
                                    Common Stock Prices                       
                                    -------------------                       Dividends
     Quarter Ended                  High            Low                       Per Share
                                    ----            ---                       ---------
     <S>                            <C>           <C>                           <C>             
     Fiscal 1996*
     ----------- 

     October 31                     $13.25        $10.83                        $.033
     January 31                      15.50         12.00                         .047
     April 30                        15.00         12.92                         .047
     July 31                         14.50         11.92                         .047

     Fiscal 1997*
     ----------- 

     October 31                     $17.33        $12.08                        $.047
     January 31                      19.75         14.92                         .060
     April 30                        19.75         16.38                         .060
     July 31                         25.19         17.75                         .060

     Fiscal 1998
     -----------

     October 31 (through
     October 24)                    $27.63        $21.50                        $.060
</TABLE>

*All data has been restated to give effect to the December 1996 3-for-2 stock
 split.

        The Company intends to continue to declare quarterly cash dividends on
its Common Stock, subject to the Company's earnings, financial condition,
capital requirements and other such factors as are deemed relevant by the Board
of Directors.

        On October 24, 1997, there were approximately 12,900 shareholders of 
record of the Company (including individual participants in security position
listings).

                                                                        7

<PAGE>   8
Item 6.   Six Year Summary of Selected Financial Data

The following tables set forth selected consolidated financial data for each of
the fiscal years shown.


<TABLE>
<CAPTION>
                                           1997          1996          1995          1994         1993           1992
                                           ----          ----          ----          ----         ----           ---- 
<S>                                      <C>            <C>           <C>           <C>          <C>            <C>
RESULTS OF OPERATIONS
  (In thousands, except per share
  data)

  Net sales                              $962,773       $826,130      $707,150      $618,562     $534,966       $476,848

  Operating costs and expenses:

    Cost of sales                         715,435        611,924       521,707       454,207      390,896        346,140
    Selling, general and
       administrative                     195,284        172,969       149,829       132,759      117,337        105,783
    Provision for third-party
       settlement and related
       expenses                            -              -             -              7,000       16,000         -      
                                         --------       --------      --------      --------     --------       --------
    Income from operations                 52,054         41,237        35,614        24,596       10,733         24,925
  Interest expense                         (1,609)        (1,654)       (2,035)       (1,667)      (1,738)        (2,763)
  Interest income                           1,472          1,453         1,359           995          961          1,399 
                                         --------       --------      --------      --------     --------       --------
    Income before income tax               51,917         41,036        34,938        23,924        9,956         23,561
  Provision for income tax                 17,487         14,012        11,871         9,846        3,047          7,787 
                                         --------       --------      --------      --------     --------       --------
       Net income                        $ 34,430       $ 27,024      $ 23,067      $ 14,078     $  6,909       $ 15,774 
                                         ========       ========      ========      ========     ========       ======== 
  Earnings per common
    share (a) (b) :
       Primary                              $0.87          $0.70         $0.62         $0.38        $0.19          $0.43
       Fully diluted                        $0.86          $0.70         $0.61         $0.38        $0.19          $0.43

FINANCIAL POSITION
  (at fiscal year end, in thousands)

  Current assets                         $204,490       $163,449      $148,445      $140,597     $133,827       $126,340
  Current liabilities                      83,574         70,515        67,059        72,443       71,220         66,477
  Total assets                            329,677        273,705       246,594       233,660      215,579        200,423
  Notes payable, net of current
    portion                                16,301         20,802        22,260        23,679       18,151         12,986
  Shareholders' equity                    223,011        176,169       150,716       129,964      118,473        113,874
  Shareholders' equity
    per share (a)                           $5.66          $4.68         $4.06         $3.53        $3.24          $3.13
  Dividends per share (a)                  $0.227         $0.173        $0.127        $0.102       $0.082         $0.062
</TABLE>

(a) Reflects 3-for-2 stock splits effected December 1996 and May 1995.

(b) 1994 and 1993 per share amounts include charges for the settlement of
    third-party providers' reimbursement claims and related expenses and the
    disposition of a lease dispute. Excluding these charges, 1994 and 1993
    earnings per common share would have been $ .55 and $ .49, respectively.


                                                                               8


<PAGE>   9

Item 7.    Management's Discussion and Analysis of
           Results of Operations and Financial Condition

Results of Operations:  Fiscal 1997 vs. Fiscal 1996

<TABLE>
<CAPTION>
Components of earnings:                                       Percentage
                                               Percentage      Increase
                                               of Fiscal      (Decrease)
                                Fiscal 1997    1997 Net      Compared to
                               (In Millions)     Sales       Fiscal 1996
                               -------------   ----------    -----------
<S>                                <C>          <C>             <C>
Net sales                          $962.8       100.0%           16.5%
Cost of sales                       715.4        74.3            16.9
Selling, general and
 administrative expense             195.3        20.3            12.9
                                   ------       -----           -----

Income from operations               52.1         5.4            26.2
Interest expense, net of
 interest income                      0.2          --           (31.8)
Income tax                           17.5         1.8            24.8
                                   ------       -----           -----

Net income                         $ 34.4         3.6%           27.4%
                                   ======       ======          =====
</TABLE>


        Net sales reached $962.8 million in fiscal 1997, an increase of 16.5
percent over fiscal 1996 net sales of $826.1 million.  The increase reflected an
increase in comparable store sales (sales by stores in operation for at least 12
months) of 10.0 percent and the sales made by the drugstores opened in fiscal
1997.

        Prescription drug sales accounted for 53.5 percent of net sales in
fiscal 1997, an increase from 51.3 percent in fiscal 1996.  The increases in
both absolute amount and relative contribution were primarily attributable to
the larger store base, a greater number of prescriptions filled on a
comparable-store basis and an increase in the average prescription price.  The
latter reflected price increases for certain existing brand name drugs and the
introduction of new brand name drugs, offset in part by the lower prices of
generic drugs, which are marketed as the corresponding brand name drugs lose
patent protection.

        The net sales attributable to each of the Company's three other
principal product categories increased in absolute terms as a result of the
larger store base and increased comparable store sales.   The percentage of net
sales attributable to the general merchandise and health and beauty aids
categories declined slightly (from 23.3% and 20.5%, respectively, in fiscal 1996
to 21.7% and 19.8%, respectively, in fiscal 1997).  The photofinishing and film
category increased its contribution to net sales (from 4.9% in fiscal 1996 to
5.0% in fiscal 1997).

        While net sales attributable to the general merchandise and health and
beauty aids categories continues to increase in absolute terms, as a percentage
of total sales, these categories declined slightly owing to greater growth in
the prescription drug sales category.

        The Company's gross margin declined from 25.9 percent in fiscal 1996 to
25.7 percent in fiscal 1997 primarily due to the effect of rising pharmaceutical
product costs and gross margin percentage pressure due to the reimbursement
practices of the Company's third-party providers.  Third-party providers, which
accounted for approximately 85 percent of the Company's prescription drug sales
in fiscal 1997, generally pay the Company an amount determined by formula to
reimburse it for the cost of the prescription drugs dispensed, plus a fixed
dispensing fee to compensate it for the services rendered.  As pharmaceutical
costs increase, the gross margin percentage on such sales decreases because the
dispensing fee remains the same pursuant to the applicable third-party program. 
Changes in the reimbursement


                                                                        9
<PAGE>   10

formulas of the various third-party providers with which the Company has
contracts may also affect the Company's gross margin and operating income.

        Selling, general and administrative ("SG&A") expenses decreased as a
percentage of net sales to 20.3 percent in fiscal 1997 from 20.9 percent in
fiscal 1996.  The decrease was primarily attributable to the Company's efforts
to control expenses and by the higher level of net sales.

        The Company's effective tax rate (the provision for income tax as a
percentage of income before income tax) decreased to 33.7 percent in fiscal 1997
from 34.1 percent in fiscal 1996.

Results of Operations:  Fiscal 1996 vs. Fiscal 1995

<TABLE>
<CAPTION>
Components of earnings:                        Percentage      Increase
                                               of Fiscal      (Decrease)
                                Fiscal 1996    1996 Net       Compared to
                               (In Millions)    Sales         Fiscal 1995
                               -------------   ----------     -----------
<S>                                <C>          <C>             <C>
Net sales                          $826.1       100.0%           16.8%
Cost of sales                       611.9        74.1            17.3
Selling, general and
 administrative expense             173.0        20.9            15.4
                                   ------       -----           -----

Income from operations               41.2         5.0            15.8
Interest expense, net of
 interest income                       .2          --           (70.3)
Income tax                           14.0         1.7            18.0
                                   ------       -----           -----

Net income                         $ 27.0         3.3%           17.2%
                                   ======       =====           =====
</TABLE>


        Net sales reached $826.1 million in fiscal 1996, an increase of 16.8
percent over fiscal 1995 net sales of $707.2 million.  The increase reflected an
increase in comparable store sales (sales by stores in operation for at least 12
months) of 10.0 percent and the sales made by the drugstores opened in fiscal
1996.

        Prescription drug sales accounted for 51.3 percent of net sales in
fiscal 1996, an increase from 49.8 percent in fiscal 1995.  The increases in
both absolute amount and relative contribution were primarily attributable to
the larger store base, a greater number of prescriptions filled on a
comparable-store basis and an increase in the average prescription price.  The
latter reflected price increases for certain existing brand name drugs and the
introduction of new brand name drugs, offset in part by the lower prices of
generic drugs, which are marketed as the corresponding brand name drugs lose
patent protection.

        The net sales attributable to each of the Company's three other
principal product categories increased in absolute terms as a result of the
larger store base and increased comparable store sales.   The percentage of net
sales attributable to the general merchandise and health and beauty aids
categories declined slightly (from 24.4% and 21.1%, respectively, in fiscal 1995
to 23.3% and 20.5%, respectively, in fiscal 1996).  The photofinishing and film
category increased its contribution to net sales (from 4.7% in fiscal 1995 to
4.9% in fiscal 1996).

        While net sales attributable to the general merchandise and health and
beauty aids categories continues to increase in absolute terms, as a percentage
of total sales, these categories declined slightly owing to greater growth in
the prescription drug sales category.

                                                                        10
<PAGE>   11

        The Company's gross margin declined from 26.2 percent in fiscal 1995 to
25.9 percent in fiscal 1996 primarily due to the effect of rising pharmaceutical
product costs and gross margin percentage pressure due to the reimbursement
practices of the Company's third-party providers.  Third-party providers, which
accounted for approximately 83 percent of the Company's prescription drug sales
in fiscal 1996, generally pay the Company an amount determined by formula to
reimburse it for the cost of the prescription drugs dispensed, plus a fixed
dispensing fee to compensate it for the services rendered.  As pharmaceutical
costs increase, the gross margin percentage on such sales decreases because the
dispensing fee remains the same pursuant to the applicable third-party program. 
Changes in the reimbursement formulas of the various third-party providers with
which the Company has contracts may also affect the Company's gross margin and
operating income.

        Selling, general and administrative ("SG&A") expenses decreased as a
percentage of net sales to 20.9 percent in fiscal 1996 from 21.2 percent in
fiscal 1995.  The decrease was primarily attributable to the Company's efforts
to control expenses and by the higher level of net sales.

        The Company's effective tax rate (the provision for income tax as a
percentage of income before income tax) increased to 34.1  percent in fiscal
1996 from 34.0 percent in fiscal 1995.

Liquidity and Capital Resources

        During fiscal 1997, net cash was provided by operations ($32.5 million)
and through the exercise of stock options and employee stock purchase plan
purchases ($21.2 million). Cash was principally used for capital expenditures
and acquisitions ($31.4 million), cash dividends ($8.8 million) and principal
payments on debt ($5.5 million).  These activities resulted in a net cash
increase of $8.6 million.

        The Company's capital expenditures in fiscal 1997 were made primarily to
expand the Company's store base and remodel existing stores.  In addition, the
Company continued to invest in various retailing systems, such as its pharmacy
(Arbortech PlusSM) and point-of-sale computer systems.  The Company anticipates
fiscal 1998 capital expenditures of approximately $30 million for these
purposes.

        During fiscal 1997, the Company added 17 drugstores through opening new
locations.  The Company also acquired the prescription files of various
independent drugstores.  The Company's current expansion plan contemplates
adding approximately 20 new Arbor drugstores in fiscal 1998 through leasing new
sites, developing new sites and, if suitable opportunities arise, acquisitions.
Four drugstores have been opened in fiscal 1998 to date.

        The Company believes that existing cash, cash equivalents and short-term
investments, cash provided from future operations and funds available under a
$50 million line of credit will support anticipated expansion and working
capital needs arising in the ordinary course of business during fiscal 1998.  As
of July 31, 1997, the Company had no outstanding borrowings against its line of
credit.

Item 8.   Financial Statements and Supplementary Data

        The financial statements and supplementary data required by this Item
are included in the Consolidated  Financial  Statements set forth on pages F-1
through F-10, attached hereto and found immediately following the signature page
of this Report.

Item 9.   Disagreements on Accounting and Financial Disclosures

        None.

                                                                        11
<PAGE>   12
                                    PART III

Item 10.  Directors and Executive Officers of the Registrant


        Information required by this Item, which is not included in Part I
hereof, will be contained in the Proxy Statement for the Annual Meeting of
Shareholders (the "1997  Proxy Statement"), to be held on December 2, 1997,
under the caption "Election of Directors", and is incorporated herein by
reference.


Item 11.  Executive Compensation

        Information required by this Item will be contained in the 1997 Proxy
Statement  under  the captions, "Executive Compensation," "Compensation
Committee Interlocks and Insider Participation" and "Information Concerning
Meetings of the Board of Directors and Board Committees and Director
Compensation," and is incorporated herein by reference.


Item 12.  Security Ownership of Certain Beneficial Owners and Management

        Information required by this Item will be contained in the 1997 Proxy
Statement, under the caption "Beneficial Ownership of Common Stock," and is
incorporated herein by reference.

Item 13.  Certain Relationships and Related Transactions

        Information required by this Item will be contained in the 1997 Proxy
Statement under the captions, "Compensation Committee Interlocks and Insider
Participation" and "Certain Relationships and Related Transactions," and is
incorporated herein by reference.

                                   PART IV

Item 14.  Exhibits, Financial Statements and Reports on Form 8-K

         (a)  The following financial statements and financial statement
              schedules are filed as part of this Report:

              (1) Financial Statements:

                      Report of Independent Accountants

                      Consolidated Financial Statements:

                      Consolidated Balance Sheets -- July 31, 1997 and 1996

                      Consolidated Statements of Income --  Fiscal Years ended 
                        July 31, 1997, 1996 and 1995

                      Consolidated Statements of Shareholders' Equity -- Fiscal 
                        Years ended July 31, 1997, 1996 and 1995

                      Consolidated Statements of Cash Flows -- Fiscal Years 
                        ended July 31, 1997, 1996 and 1995

                      Notes to Consolidated Financial Statements

                                                           
                                                                        12

<PAGE>   13
        All financial statement schedules are omitted because they are not
applicable, not required or because the information is included in the
consolidated financial statements or notes thereto.

                (2)  Executive Compensation Plans and Arrangements

                     - 1986 Stock Option Plan
                     - 1996 Stock Option Plan
                     - Change in Control Agreements

        (b)     Reports on Form  8-K.  No Reports on Form 8-K were filed by
                the Company during the last quarter of the fiscal year ended 
                July 31, 1997.

        (c)     Exhibits

                3.1     Restated Articles of Incorporation, as amended, filed 
                        as Exhibit 3.1 to the Registrant's Annual Report on 
                        Form 10-K for the year ended July 31, 1988, are 
                        incorporated herein by reference.

                3.2     Bylaws, filed  as Exhibit 3.2 to the Registrant's Form 
                        S-1 Registration Statement (Registration No.  33-4378),
                        are incorporated herein by reference.

                4.0     Credit Agreement (the "Credit Agreement") dated as of 
                        May 14, 1992 among Arbor Drugs, Inc., NBD Bank, N.A.,
                        Manufacturers Bank, N.A., Continental Bank N.A., and
                        NBD Bank, N.A., as Agent, filed as Exhibit 10.5
                        to the Registrant's Annual Report on Form 10-K for the
                        year ended July 31, 1992, is incorporated herein by
                        reference.

                4.0A    Letter, dated June 2, 1994, from NBD Bank, N.A. (in its 
                        capacity as a Bank and as Agent), Continental Bank,
                        N.A. and Comerica Bank to Arbor Drugs, Inc.,
                        filed as Exhibit 10.3 to the Registrant's Annual Report
                        on Form 10-K for the year ended July 31, 1994, is
                        incorporated herein by reference.

                4.0B    First Amendment to Credit Agreement, dated as of 
                        August 29, 1994, among Arbor Drugs, Inc., NBD Bank,
                        N.A. (in its capacity as a Bank and as Agent),
                        Continental Bank, N.A. and Comerica Bank, filed as
                        Exhibit 10.4 to the Registrant's Annual Report on Form
                        10-K for the year ended July 31, 1994, is incorporated
                        herein by reference.

                        The Registrant undertakes to furnish to the Securities 
                        and Exchange Commission, upon request, a copy of all 
                        long-term debt instruments not filed herewith.

                10.1    Amended and Restated Arbor Drugs, Inc. Stock Option 
                        Plan, dated June 4, 1993, filed as Exhibit 10.1 to the  
                        Registrant's Annual Report on Form 10-K for the year
                        ended July 31, 1993, is incorporated herein by
                        reference.

                10.2    Arbor Drugs, Inc. 1996 Stock Option Plan, filed as 
                        Annex 1 to the Registrant's Proxy Statement for its
                        1995 Annual Meeting of Shareholders, is incorporated 
                        herein by reference.

                10.3    Change in Control Agreements, dated as of December 9, 
                        1996, with each of Eugene Applebaum, Markus M. Ernst,
                        Gilbert C. Gerhard, Donald M. Stutrud and Eric 
                        Bolokofsky.

                11.     Computation of Earnings Per Share.

                21.     Subsidiaries of the Registrant.


                                                                        13

<PAGE>   14
                23.1    Consent of Coopers & Lybrand L.L.P., independent 
                        accountants.

                27.     Financial Data Schedule.


                                   SIGNATURES

        Pursuant to the requirements of Section 13 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, on October 24, 1997.

                                ARBOR DRUGS, INC.


                                By: /s/ Eugene Applebaum 
                                    -----------------------------------------
                                    Eugene Applebaum, 
                                    Chairman of the Board, Chief Executive 
                                    Officer and President


        Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on October 24, 1997.


<TABLE>
<CAPTION>
Signature                               Capacity
---------                               --------
<S>                                     <C>
/s/ Eugene Applebaum          
------------------------------
Eugene Applebaum                        Chairman of the Board, Chief Executive Officer and President
                                        (Principal Executive Officer)


/s/ Markus M. Ernst           
------------------------------
Markus M. Ernst                         Executive Vice President, Chief Operating Officer and Director

/s/ Gilbert C. Gerhard        
------------------------------
Gilbert C. Gerhard                      Senior Vice President-Finance and Administration, Chief Financial 
                                        Officer, Secretary, Treasurer and Director (Principal Financial and 
                                        Accounting  Officer)

/s/ David B. Hermelin         
------------------------------
David B. Hermelin                       Director


/s/ Spencer M. Partrich       
------------------------------
Spencer M. Partrich                     Director


/s/ Laurie M. Shahon          
------------------------------
Laurie M. Shahon                        Director


/s/ Samuel Valenti III        
------------------------------
Samuel Valenti III                      Director
                                                                           
</TABLE>


                                                                        14
<PAGE>   15





                       ARBOR DRUGS, INC. AND SUBSIDIARIES

                                 _____________





             REPORT ON AUDITS OF CONSOLIDATED FINANCIAL STATEMENTS
                          AS OF JULY 31, 1997 AND 1996
                FOR THE YEARS ENDED JULY 31, 1997, 1996 AND 1995







                                                                        15
<PAGE>   16



                       ARBOR DRUGS, INC. AND SUBSIDIARIES

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                 _____________


<TABLE>
<CAPTION>
                                                             Pages
                                                             -----
<S>                                                        <C>
Report of Independent Accountants                             F-2


Financial Statements:

  Consolidated Balance Sheets -- July 31, 1997 and 1996       F-3

  Consolidated Statements of Income -- Fiscal Years ended
    July 31, 1997, 1996 and 1995                              F-4

  Consolidated Statements of Shareholders' Equity --
    Fiscal Years ended July 31, 1997, 1996 and 1995           F-4

  Consolidated Statements of Cash Flows -- Fiscal Years
    ended July 31, 1997, 1996 and 1995                        F-5

  Notes to Consolidated Financial Statements               F-6 - F-10
</TABLE>



        All financial statement schedules are omitted because they are not
applicable, not required or because the information is included in the
consolidated financial statements or notes thereto.

                                                                        16

<PAGE>   17
                       REPORT OF INDEPENDENT ACCOUNTANTS


To the Shareholders and Board of
Directors of Arbor Drugs, Inc.:


We have audited the accompanying consolidated balance sheets of Arbor
Drugs, Inc. and Subsidiaries as of July 31, 1997 and 1996, and the related
consolidated statements of income, shareholders' equity, and cash flows for each
of the three years in the period ended July 31, 1997. These financial statements
are the responsibility of the Company's management.  Our responsibility is to
express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. 
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Arbor
Drugs, Inc. and Subsidiaries as of July 31, 1997 and 1996, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended July 31, 1997, in conformity with generally accepted accounting
principles.





/s/ Coopers & Lybrand L.L.P.
------------------------------
Detroit, Michigan
September 26, 1997





                                      F-2
<PAGE>   18

CONSOLIDATED BALANCE SHEETS
ARBOR DRUGS, INC. AND SUBSIDIARIES

<TABLE>
<CAPTION>
July 31,                                                        1997            1996
-------------------------------------------------------------------------------------
<S>                                                         <C>             <C>
(Dollars in thousands)
ASSETS
Current assets:
Cash and cash equivalents                                    $ 43,537        $ 34,955
    Short-term investments                                        335             855
    Accounts receivable                                        25,565          17,507
    Inventory                                                 131,700         106,283
    Prepaid expenses                                            3,353           3,849
-------------------------------------------------------------------------------------
      Total current assets                                    204,490         163,449
-------------------------------------------------------------------------------------
Property and equipment:
    Land and land improvements                                 23,124          16,928
    Buildings                                                  27,795          23,879
    Furniture, fixtures and equipment                          71,700          65,874
    Leasehold improvements                                     45,075          40,036
      Less accumulated depreciation                           (63,745)        (57,598)
-------------------------------------------------------------------------------------
                                                              103,949          89,119
-------------------------------------------------------------------------------------
Intangible assets                                              21,238          21,137
-------------------------------------------------------------------------------------
         Total assets                                        $329,677        $273,705
=====================================================================================
LIABILITIES
Current liabilities:
    Notes payable, current portion                           $    611        $  1,568
    Accounts payable                                           60,422          51,014
    Accrued rent and other                                     10,639           9,285
    Accrued compensation and benefits                           8,466           6,687
    Income tax payable                                          3,436           1,961
-------------------------------------------------------------------------------------
         Total current liabilities                             83,574          70,515
-------------------------------------------------------------------------------------
Notes payable, net of current portion                          16,301          20,802
Deferred income tax                                             6,023           5,538
Minority interest in subsidiaries                                 768             681
-------------------------------------------------------------------------------------
                                                               23,092          27,021
-------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Preferred stock: $.01 par value;
    2,000,000 shares authorized;
    none issued                                                    --             --
Common stock: $.01 par value;
    40,000,000 shares authorized;
    39,416,331 and 37,624,749 issued
    and outstanding, respectively                                 394             251
Additional paid-in capital                                     74,870          53,812
Retained earnings                                             147,747         122,106
-------------------------------------------------------------------------------------
                                                              223,011         176,169
-------------------------------------------------------------------------------------
     Total liabilities & shareholders' equity                $329,677        $273,705
=====================================================================================
</TABLE>


The accompanying notes are an integral part of the consolidated financial
statements.



                                      F-3
<PAGE>   19


CONSOLIDATED STATEMENTS OF INCOME
ARBOR DRUGS, INC. AND SUBSIDIARIES


<TABLE>
<CAPTION>
  Fiscal Years Ended July 31,      1997                   1996          1995
-------------------------------------------------------------------------------
 (Dollars in thousands, except per share data)
  <S>                          <C>                      <C>           <C>
  Net sales                             $962,773        $826,130       $707,150
  Costs and expenses:
   Cost of sales                         715,435         611,924        521,707
   Selling, general and administrative   195,284         172,969        149,829
-------------------------------------------------------------------------------
    Income from operations                52,054          41,237         35,614
  Interest expense                        (1,609)         (1,654)        (2,035)
  Interest income                          1,472           1,453          1,359
-------------------------------------------------------------------------------
    Income before income tax              51,917          41,036         34,938
  Provision for income tax                17,487          14,012         11,871
-------------------------------------------------------------------------------
        Net income                       $34,430         $27,024        $23,067
===============================================================================
  Weighted average number of common
   shares outstanding (in thousands):
    Primary                               39,481          38,376         37,467
    Fully diluted                         40,027          38,376         37,634
===============================================================================
  Earnings per common share:
    Primary                                 $.87            $.70           $.62
    Fully diluted                           $.86            $.70           $.61
===============================================================================
  Cash dividend per common share           $.227           $.173          $.127
===============================================================================
</TABLE>



               CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                           
                           Common  Stock        Additional              
                           --------------       Paid-In         Retained
(In thousands)             Shares  Amount       Capital         Earnings        TOTAL
-----------------------------------------------------------------------------------------
<S>                        <C>     <C>          <C>             <C>             <C>
Balance, July 31, 1994      16,340 $163          $46,621        $ 83,180        $129,964
Net income                      --   --               --          23,067          23,067
Cash dividends of $.127
  per share                     --   --               --          (4,681)         (4,681)
Exercise of options and
 stock purchase plan           179    2            2,364              --           2,366
Three-for-two stock split    8,247   83              (83)             --              --
-----------------------------------------------------------------------------------------
Balance, July 31, 1995      24,766  248           48,902         101,566         150,716
Net income                      --   --               --          27,024          27,024
 Cash dividends of $.173
  per share                     --   --               --          (6,484)         (6,484)
 Exercise of options and
  stock purchase plan          317    3            4,910              --           4,913
-----------------------------------------------------------------------------------------
Balance, July 31, 1996      25,083  251           53,812         122,106         176,169
Net income                      --   --               --          34,430          34,430
Cash dividends of $.227
 per share                      --   --               --          (8,789)         (8,789)
Exercise of options and
 stock purchase plan         1,342   13           21,188              --          21,201
Three-for-two stock split   12,991  130             (130)             --              --
-----------------------------------------------------------------------------------------
Balance, July 31, 1997      39,416 $394          $74,870        $147,747        $223,011
=========================================================================================
</TABLE>

The accompanying notes are an integral part of the consolidated financial
statements.

                                      F-4


<PAGE>   20



CONSOLIDATED STATEMENTS OF CASH FLOWS
ARBOR DRUGS, INC. AND SUBSIDIARIES


<TABLE>
<CAPTION>
     Fiscal Years Ended July 31,                     1997          1996         1995
--------------------------------------------------------------------------------------
     <S>                                             <C>          <C>         <C>
     (Dollars in thousands)
     Operating activities:
     Net income                                        $34,430    $27,024      $23,067
     Adjustments to reconcile to net
       cash provided by operations:
          Depreciation                                  12,368     11,971       10,886
          Amortization                                   4,113      4,471        4,601
          Deferred income tax                              310        304       (1,053)
          Changes in operating assets
           and liabilities:
             Accounts receivable                        (8,058)    (3,487)      (1,238)
             Inventory                                 (25,417)   (16,730)      (6,155)
             Prepaid expenses                              758        351        1,829
             Accounts payable                            9,408        673       (2,577)
             Third-party settlement
              and related expenses                          --         --       (5,000)
             Accrued expenses                            3,133      3,176        1,049
             Income tax payable                          1,475       (372)       1,136
--------------------------------------------------------------------------------------
             Net cash provided
              by operations                             32,520     27,381       26,545
--------------------------------------------------------------------------------------
Investing activities:
     Purchase of property and equipment, net           (27,198)   (24,707)     (16,700)
     Purchase of intangible assets                      (4,214)    (3,842)      (3,873)
     Sale, (purchase) or maturity of
      short-term investments                               520       (685)       1,094
--------------------------------------------------------------------------------------
              Net cash used in
               investing activities                    (30,892)   (29,234)     (19,479)
--------------------------------------------------------------------------------------
Financing activities:
     Principal payments on debt                         (5,458)    (1,419)      (1,373)
     Dividends paid                                     (8,789)    (6,484)      (4,681)
   Proceeds from exercise of stock options
    and stock purchase plan                             21,201      4,913        2,366
--------------------------------------------------------------------------------------
              Net cash provided by
               (used in) financing activities            6,954     (2,990)      (3,688)
--------------------------------------------------------------------------------------
   Net increase (decrease) in cash
        and cash equivalents                             8,582     (4,843)       3,378
   Cash and cash equivalents at
        beginning of year                               34,955     39,798       36,420
--------------------------------------------------------------------------------------
   Cash and cash equivalents at
        end of year                                    $43,537    $34,955      $39,798
======================================================================================
</TABLE>


The accompanying notes are an integral part of the consolidated financial
statements.



                                      F-5
<PAGE>   21
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ARBOR DRUGS, INC. AND SUBSIDIARIES

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

The preparation of these consolidated financial statements, in order to be
presented in conformity with generally accepted accounting principles, requires
that management use estimates and assumptions regarding events anticipated and
transpired, together with their potential effects upon the reported amounts of
assets and liabilities, as well as the disclosures and assessments of contingent
assets and liabilities, at the date of the financial statements, and in
determining the reported amounts of revenues, costs and expenses of the
reporting periods. Actual results could differ from those estimates.
        
STOCK REPURCHASE PLAN
On July 25, 1996, the Board of Directors authorized management to repurchase up
to 1,500,000 shares of the Company's common stock in the open market, at prices
acceptable to management. Shares purchased under the program will be retired.
No shares have been purchased to date.

BASIS OF OPERATION

The consolidated financial statements include Arbor Drugs, Inc. ("Company") and
its subsidiaries, whose primary business activity is the operation of
drugstores, principally in southeastern Michigan. All significant intercompany
transactions have been eliminated in consolidation.
        
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company considers all highly liquid investments with a maturity of three
months or less to be cash equivalents. Short-term investments include all
liquid investments with a maturity greater than three months and are stated at
cost, which approximates market.

RECEIVABLES
The Company has contractual arrangements with third-party providers of
insurance, enabling the Company to obtain reimbursement from these carriers for
prescription services performed by the Company for benefit of its customers.
Consequently, significant revenue and accounts receivable result from these
arrangements.
        
INVENTORY VALUATION
Inventories are stated at the lower of cost or market assuming a last-in,
first-out cost flow. Had the first-in, first-out method for determining cost
been used, inventories would have been increased by approximately $27,973,000
and $25,607,000 at July 31, 1997 and 1996, respectively.

PROPERTY AND EQUIPMENT
All property and equipment are recorded at cost. Maintenance and repair costs
are charged to expense as incurred. Upon retirement or disposal, the asset cost
and related accumulated depreciation are eliminated from the respective
accounts and the resulting gain or loss is included in the results of
operations for the period.

DEPRECIATION
Depreciation is computed using primarily the straight-line method based on the
following range of estimated useful lives:


<TABLE>
 <S>                                                         <C>
 Buildings .................................................  40 years
 Furniture, fixtures and equipment and land improvements....  5 to 20 years
 Leasehold improvements.....................................  Lesser of lease term 
                                                              or useful lives,
                                                              ranging from 5 to 
                                                              20 years
</TABLE>

INCOME TAX
Deferred tax assets and liabilities are recognized for temporary differences at
the tax rate expected to be in effect when the related asset is recovered or
the related liability is settled.

PREOPENING EXPENSES
Preopening expenses of retail drugstores are charged to income as incurred.

ADVERTISING
Advertising production costs are expensed the first time the related
advertising takes place. Advertising expense for the years ended July 31, 1997,
1996 and 1995 was approximately $14,400,000, $15,146,000 and $14,774,000,
respectively.

CONTINGENCIES
The Company is a defendant in claims and lawsuits arising in the ordinary
course of business. In the opinion of management and the Company's outside
counsel, although the outcome of such litigation cannot be forecast with
certainty, the ultimate disposition should not have a material adverse effect
on the Company's consolidated financial condition or results of operations.
        
                                      F-6

<PAGE>   22


EARNINGS PER SHARE
Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per
Share," was issued in February 1997 and is effective for interim and annual
periods beginning after December 15, 1997. Earlier adoption is not permitted.
If earnings per share were calculated using SFAS No. 128, "earnings per share"
would have been $.89, $.72 and $.62 for fiscal 1997, 1996 and 1995,
respectively, and "earnings per share--assuming dilution" would have been $.87,
$.70 and $.62 for fiscal 1997, 1996 and 1995, respectively.

2. INTANGIBLE ASSETS:

 Intangible assets consist of the following:
 July 31,                          1997                 1996
 ------------------------------------------------------------
                                       (Dollars in thousands)
 Prescription customer files     $16,536              $19,026
 Leaseholds                        2,954                3,091
 Developed software                4,860                5,067
 Other                            13,687               12,274
 ------------------------------------------------------------
                                  38,037               39,458
 Less accumulated amortization    16,799               18,321
 ------------------------------------------------------------
                                 $21,238              $21,137
 ============================================================


Prescription customer files and other intangible assets consist primarily of
amounts, other than leaseholds, allocated upon the purchase of assets of
existing retail operations and are generally amortized over a period not to
exceed 15 years.

Leaseholds represent the amounts paid for, or allocated to, beneficial lease
agreements assumed by the Company upon purchase of assets of existing retail
operations or leases. Amortization is recorded using the straight-line method
over the term of the related lease agreement.

All intangible assets are evaluated for potential impairment of value on an
on-going basis. Such evaluations consider current, as well as anticipated,
operating results, measured on the basis of undiscounted cash flows, of the
operation relative to the asset. Usefulness of the underlying asset in the
operation of the Company is also a basis of evaluation. Additionally, trends
and other circumstances are used in such evaluations and estimates.

3. NOTES PAYABLE:

Approximate fair market values are as follows:
<TABLE>
<CAPTION>
July 31,                                                                1997              1996
-----------------------------------------------------------------------------------------------
<S>                                                                   <C>              <C>
                                                                         (Dollars in thousands)
Mortgage note payable, interest at 8.75 percent, monthly interest
 and principal installments of $60,976 through July 1, 2014             $ 6,477         $ 6,634
Mortgage note payable, interest at 9.68 percent, monthly interest
 and principal installments of $62,298 through July 1, 2012               5,904           6,071
Mortgage note payable, interest at 8.49 percent, monthly interest
 and principal installments of $42,926 through December 1, 2012           4,421           4,554
Other borrowings                                                            110             111
Senior note, interest at 9.93 percent                                        --           3,500
Line of credit term loan, interest at 7.16 percent                           --           1,500
-----------------------------------------------------------------------------------------------
                                                                         16,912          22,370
Less current portion                                                        611           1,568
-----------------------------------------------------------------------------------------------
                                                                        $16,301         $20,802
===============================================================================================
</TABLE>


As of July 31, 1997, the Company had a $50 million line of credit with no
outstanding balance. This credit facility expires November 30, 2002.

                                      F-7




<PAGE>   23

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.)

Maturities of notes payable for the next five fiscal years are approximately as
follows:

                 1998...  $501,000   1999...  $548,000   2000...  $600,000
                 2001...  $656,000   2002...  $718,000

The line of credit agreement contains certain covenants, the most restrictive
of which require the Company to maintain minimum current, debt service and
equity ratios and maintain a minimum amount of net worth. Certain property has
been pledged as collateral under terms of the mortgage notes payable.

Interest costs capitalized for the years ended July 31, 1997, 1996 and 1995 were
approximately $346,000, $552,000 and $328,000, respectively.
        
Cash paid for interest, net of capitalized interest, was approximately
$2,035,000, $1,646,000 and $2,232,000 for the years ended July 31, 1997, 1996
and 1995, respectively.

4. RENTAL EXPENSE AND LEASE COMMITMENTS:
The Company leases certain facilities, transportation, data processing and photo
development equipment under operating lease agreements expiring on various dates
through the year 2020. In addition to minimum rentals, certain lease agreements
provide for contingent rental payments based upon attainment of specified sales
volume or increases in the consumer price index. Most leases contain renewal
options for periods ranging from 5 to 30 years. The following are summaries of
rental expense and the future minimum annual rental payments required under all
operating leases:
        

Year Ended July 31,                    1997   1996
----------------------------------------------------
     (Dollars in thousands)
Rental expense:
     Minimum rentals               $19,670   $16,974
     Contingent rentals              2,057     1,846
----------------------------------------------------
                                   $21,727   $18,820
====================================================
Minimum annual rentals:
Year ending July 31:
               1998      $24,646
               1999       25,839
               2000       23,779
               2001       22,068
               2002       20,434
Remaining lease term     232,641
----------------------------------------------------
                        $349,407
====================================================


Accrued rent of $7,753,000 and $6,835,000 is included in accrued expenses as of
July 31, 1997 and 1996, respectively.

5. EMPLOYEE RETIREMENT PLANS:
The Company maintains an employee savings plan, pursuant to section 401(k) of
the Internal Revenue Code. Eligible participating employees may contribute up to
15 percent of their salaries, subject to certain limitations, for investment in
either the common stock of the Company or various other investment options.
Contributions by the Company are discretionary.
        

6. INCOME TAX:
The provision for federal income tax consists of the following:

Year Ended July 31,             1997         1996       1995
--------------------------------------------------------------
                                    (Dollars in thousands)
Currently payable               $17,177    $13,708    $10,745
Deferred                            310        304      1,126
--------------------------------------------------------------
                                $17,487    $14,012    $11,871
==============================================================

                                      F-8

<PAGE>   24

The provision for deferred income tax is attributed to the tax effect of
differences caused by the timing of expense and revenue recognition, between
financial statement and tax accounting, for certain transactions, at the tax
rates expected to be in effect when the related asset is recovered or liability
is settled. These differences are primarily attributed to the following:
        

<TABLE>
<CAPTION>
July 31,                                1997            1996
--------------------------------------------------------------
                                         (Dollars in thousands)
<S>                                <C>                 <C>
Vendor agreement discounts         $(375)               $832
Depreciation and amortization       (496)               (251)
--------------------------------------------------------------
</TABLE>


The provision for income tax, as a percentage of income before tax, was 33.7
percent, 34.1 percent and 34.0 percent in 1997, 1996 and 1995, respectively.
These rates differ from the statutory rate due to income earned on tax-exempt
investments.
        
Prepaid expenses include the current portion of deferred income taxes of
$1,965,000 and $1,790,000 in 1997 and 1996, respectively.
        
Cash paid for income taxes was approximately $10,431,000, $12,738,000 and
$8,800,000 in 1997, 1996 and 1995, respectively.
        
7. STOCK OPTION AND STOCK PURCHASE PLANS:
In fiscal 1997, the Company adopted SFAS No. 123, "Accounting for Stock-Based
Compensation." While SFAS No. 123 established financial accounting and
reporting standards for stock-based employee compensation plans using a fair
value method of accounting, it allows companies to continue to measure
compensation using the intrinsic value method of accounting as prescribed in
APB No. 25, "Accounting for Stock Issued to Employees." The Company will
continue to use its present APB No. 25 accounting treatment for stock-based
employee compensation. Accordingly, no compensation cost has been recognized
for its stock-based compensation plans.

Under the Company's 1986 and 1996 Stock Option Plans, certain of the Company's
key employees have been granted nonqualified stock options which allow the
employee to purchase shares of common stock at prices equal to market value at
the date of grant, become exercisable 12 months after grant, on a pro rata
basis, over a five-year period and expire six years after the date of grant.

The Company is currently authorized to grant options to purchase up to an
aggregate of 8,430,976 shares of its common stock, of which 7,642,352 shares
have been granted as of July 31, 1997.

Stock option transactions are summarized as follows:

<TABLE>
<CAPTION>
                                                     1997                   1996                         1995
                                      ----------------------------  ------------------------- ---------------------------
                                                  WEIGHTED-AVERAGE           Weighted-average           Weighted-average
                                        SHARES     EXERCISE PRICE   Shares    Exercise Price   Shares     Exercise Price
-------------------------------------------------------------------------------------------------------------------------
Outstanding at beginning of year        5,010,704    $ 9.35        4,298,018    $ 8.53       3,140,585       $7.34
Granted                                 1,119,150     14.83        1,107,000     11.67       1,478,027       10.11
Terminated                                (25,801)     9.08          (70,725)     9.54         (26,168)       8.50
Exercised                              (1,614,572)     8.20         (323,589)     6.11        (294,426)       3.35
-------------------------------------------------------------------------------------------------------------------------
Outstanding at end of year              4,489,481    $11.14        5,010,704    $ 9.35       4,298,018      $ 8.53
-------------------------------------------------------------------------------------------------------------------------
Options exercisable at year-end         1,196,983                  1,797,333                 1,302,120
=========================================================================================================================

<CAPTION>

                                    Options Outstanding                                  Options Exercisable
-------------------------------------------------------------------------------  ----------------------------------------
                                        Weighted-average
                              Number    Remaining Years       Weighted-average    Number       Weighted-average
Range of Exercise Prices   Outstanding   of Contractual Life   Exercise Price   Exercisable     Exercise Price
-------------------------------------------------------------------------------------------------------------------------
<S>                         <C>         <C>                     <C>              <C>             <C>
$7.78 to $9.00             1,155,172            2.08            $8.15             911,158          $8.76
$10.11 to $14.83           3,334,309            4.23            12.18             285,825          11.45
-------------------------------------------------------------------------------------------------------------------------
$7.78 to $14.83            4,489,481            3.67            $11.14          1,196,983          $9.40
=========================================================================================================================
</TABLE>


                                      F-9

<PAGE>   25


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT.)


The Company has an Employee Stock Purchase Plan where employees may subscribe,
through payroll withholdings, to purchase shares of the Company's common stock
at the lower of 85% of market value at the beginning or end of each calendar
quarter. Employees may not purchase in excess of 15% of gross pay under the
plan, or 25% of gross pay in combination with withholdings under the 401(k)
plan. The plan covers an aggregate of 675,000 shares.

Transactions under the Employee Stock Purchase Plan are summarized as follows:

<TABLE>
<CAPTION>
                                                                                           Weighted-average
                                                                   Weighted-average     Fair Value of Shares Issued
                                                Number of Shares     Issue Price           at Purchase Date
--------------------------------------------------------------------------------------------------------------------
<S>                                              <C>                <C>                  <C>
Shares issued during the year ended July 31,
1997                                              177,152               $13.33                  $17.36
1996                                              152,742                10.79                   13.60
1995                                               88,727                 8.20                    N/A
====================================================================================================================
</TABLE>

Had the compensation cost of the Company's stock-based compensation plans been
determined based on the fair value at the grant dates for awards under those
plans consistent with the method of SFAS No. 123, the Company's net income would
have been reduced by $1,546,000 and $718,000 for 1997 and 1996, respectively,
and earnings per share would have been reduced by $.04 and $.02 for 1997 and
1996, respectively. To determine these amounts, the fair value of each stock
option and stock purchase plan purchase has been estimated on the date of grant
using a Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1997 and 1996: risk-free interest rates of 6.39%
and 5.77%, expected volatility of 29.04% and 29.96% and dividend yield of 1.4%.
The expected weighted-average life of the stock options is 4.7 years. The
weighted-average fair value of stock options granted in 1997 and 1996 was equal
to the weighted-average exercised price. The effects of applying SFAS No. 123 in
this pro forma disclosure are not indicative of future amounts. SFAS No. 123
does not apply to awards prior to 1996. 
        
8. QUARTERLY FINANCIAL SUMMARY (UNAUDITED): 


<TABLE>
<CAPTION>

(Dollars in thousands, except per share data) 

                                                       For the Three Months Ended
----------------------------------------------------------------------------------------------------------
Fiscal Year                                     OCT. 31,        JAN. 31,        APRIL 30,       JULY 31,
1997                                              1996            1997            1997            1997
----------------------------------------------------------------------------------------------------------
<S>                                            <C>             <C>             <C>           <C>
Net sales                                       $224,973        $250,318        $238,420      $249,062
Gross profit                                      57,658          64,869          60,578        64,233
Net income                                         6,393          10,728           7,540         9,769
Earnings per share, primary and fully diluted       $.16            $.27            $.19          $.24
==========================================================================================================

<CAPTION>

                                                       For the Three Months Ended
----------------------------------------------------------------------------------------------------------
Fiscal Year                                     Oct. 31,        Jan. 31,        April 30,       July 31,
1996                                               1995            1996             1996            1996
----------------------------------------------------------------------------------------------------------
Net sales                                       $190,704        $214,501        $208,242      $212,683
Gross profit                                      49,449          56,232          53,560        54,965
Net income                                         5,125           8,711           6,057         7,131
Earnings per share, primary and fully diluted       $.13            $.23            $.16          $.19
==========================================================================================================
</TABLE>


Amounts may not total due to rounding.

                                      F-10


<PAGE>   26
<TABLE>
<CAPTION>
                INDEX TO EXHIBITS                                                               Page #
                                                                                                ------
<S>             <C>                                                                             <C>
3.1             Restated Articles of Incorporation, as amended, filed as  
                Exhibit 3.1 to the Registrant's Annual Report on
                Form 10-K for the year ended July 31, 1988, are incorporated 
                herein by reference.

3.2             Bylaws, filed  as Exhibit 3.2 to the Registrant's Form S-1 
                Registration Statement (Registration No. 33-4378), are          
                incorporated herein by reference.

4.0             Credit Agreement (the "Credit Agreement") dated as of May 14,
                1992 among Arbor Drugs, Inc., NBD Bank, N.A., Manufacturers Bank, 
                N.A., Continental Bank N.A., and NBD Bank, N.A., as Agent, filed 
                as Exhibit 10.5 to the Registrant's Annual Report on Form 10-K 
                for the year ended July 31, 1992, is incorporated herein by reference.

4.0A            Letter, dated June 2, 1994, from NBD Bank, N.A. (in its capacity 
                as a Bank and as Agent), Continental Bank, N.A. and Comerica Bank 
                to Arbor Drugs, Inc., filed as Exhibit 10.3 to the Registrant's 
                Annual Report on Form 10-K for the year  ended July 31, 1994, 
                is incorporated herein by Reference.

4.0B            First Amendment to Credit Agreement, dated as of August 29, 1994, 
                among Arbor Drugs, Inc., NBD Bank, N.A. (in its capacity as a 
                Bank and as Agent), Continental Bank, N.A. and Comerica Bank, 
                filed as Exhibit 10.4 to the Registrant's Annual Report on Form 
                10-K for the year ended July 31, 1994, is incorporated herein 
                by reference.

                The Registrant undertakes to furnish to the Securities and Exchange 
                Commission, upon request, a copy of all long-term
                debt instruments not filed herewith.

10.1            Amended and Restated Arbor Drugs, Inc. Stock Option Plan, dated 
                June 4, 1993, filed as Exhibit 10.1 to the Registrant's Annual 
                Report on Form 10-K for the year ended July 31, 1993, is        
                incorporated herein by reference.

10.2            Arbor Drugs, Inc. 1996 Stock Option Plan, filed as Annex 1 
                to the Registrant's Proxy Statement for its 1995 Annual            
                Meeting of Shareholders, is incorporated herein
                by reference.

10.3            Change in Control Agreements, dated as of December 9, 1996,  
                with each of Eugene Applebaum, Markus M. Ernst, Gilbert C.                       
                Gerhard, Donald M. Stutrud and Eric Bolokofsky.                                 27

11.             Computation of Earnings Per Share.                                              57

21.             Subsidiaries of the Registrant.                                                 58

23.1            Consent of Coopers & Lybrand L.L.P., independent accountants                    59

27.             Financial Data Schedule.                                                        60


</TABLE>



                                                                             26