<PAGE>   1
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                  FORM 10-QSB

(Mark One)

       [X]  QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES 
            EXCHANGE ACT OF 1934

               For the quarterly period ended September 30, 1996

       [ ]  TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

       For the transition period from                  to 
                                      ----------------    ------------------

                        Commission file number: 0-17363

                              LIFEWAY FOODS, INC.
------------------------------------------------------------------------------
       (Exact name of small business issuer as specified in it charter)

         ILLINOIS                                    36-3442829
------------------------------------------------------------------------------
(State or other jurisdiction                  (IRS Employer Identification No.)
of incorporation or organization)                                       

               7625 NORTH AUSTIN AVENUE, SKOKIE, ILLINOIS 60077
------------------------------------------------------------------------------
                   (Address of principal executive offices)

                                (847) 967-1010
                          ---------------------------                         
                          (issuer's telephone number)


------------------------------------------------------------------------------
             (Former name, former address and former fiscal year,
                        if changed since last report)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or such shorter
period that the issuer was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [X] No [ ]

               APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
                  PROCEEDINGS DURING THE PRECEDING FIVE YEARS

Check whether the issuer filed all documents and reports required to be filed
by Section 12, 13 or 15(d) of the Exchange Act after the distribution of
securities under a plan confirmed by a court. Yes [ ] No [ ]

                     APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date: AS OF NOVEMBER 11, 1996, THE
ISSUER HAD 3,774,977 SHARES OF COMMON STOCK, NO PAR VALUE, OUTSTANDING.

Transitional Small Business Disclosure Format (Check one):  Yes [ ]   No [X]


<PAGE>   2
                                     INDEX



PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS.

<TABLE>
<CAPTION>
                                                                                         PAGE
                                                                                         ----
<S>                                                                                       <C>   
      Lifeway Foods, Inc. and Subsidiaries
      September 30, 1996 and 1995

            Certified Public Accountants Report on
            Unaudited Financial Statements                                                F-2

            Consolidated Balance Sheets                                                 F-3 - F-4

            Consolidated Statements of Income                                              F-5

            Consolidated Statements of Changes in Stockholders' Equity                     F-6

            Consolidated Statements of Cash Flows                                        F-7 - F-8

            Notes to Consolidated Financial Statements                                  F-9 - F-16

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITIONS AND RESULTS OF OPERATIONS                                                4


PART II - OTHER INFORMATION                                                                   5


SIGNATURES                                                                                    7
</TABLE>



                                      2
<PAGE>   3


                        PART I - FINANCIAL INFORMATION
















                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                             FINANCIAL STATEMENTS
                          SEPTEMBER 30, 1996 AND 1995

                            [FOLLOWING PAGE IS F-1]



                                      3
<PAGE>   4
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES

                             FINANCIAL STATEMENTS

                          SEPTEMBER 30, 1996 AND 1995

                               TABLE OF CONTENTS





<TABLE>
<S>                                                              <C>
Certified Public Accountants Report on Financial Statements         F-2

Consolidated Balance Sheets -
September 30, 1996 and 1995                                      F-3 - F-4

Consolidated Statements of Income - 
for the years ended September 30, 1996 and 1995                     F-5

Consolidated Statements of Changes in Stockholders' Equity - 
for the years ended September 30, 1996 and 1995                     F-6

Consolidated Statement of Cash Flows - 
for the years ended September 30, 1996 and 1995                  F-7 - F-8

Notes to Consolidated Financial Statements - 
September 30, 1996 and 1995                                      F-9 - F16
</TABLE>








<PAGE>   5
                               ROBERT L. DeLORME
                          CERTIFIED PUBLIC ACCOUNTANT
                        1010 JORIE BOULEVARD/SUITE 300
                           OAK BROOK, ILLINOIS 60521

                               (630) 571-1800






                      CERTIFIED PUBLIC ACCOUNTANTS REPORT
                            ON FINANCIAL STATEMENTS



To the Shareholders and Directors
Lifeway Foods, Inc.
Skokie, Illinois



The accompanying balance sheets of Lifeway Foods, Inc. and Subsidiaries as of
September 30, 1996 and 1995 and the related statements of income, changes in
stockholders' equity and cash flows for the nine months then ended were not
audited by me and, accordingly, I do not express an opinion or any other form
of assurance on them.

The accompanying financial statement of Lifeway Foods, Inc. and subsidiaries
as of December 31, 1995 and for the year then ended were audited by other
auditors. They expressed an unqualified opinion on them in their report dated
February 9, 1996. They have not performed any audit procedures since that
date.



/s/ ROBERT L. DeLORME



Robert L. DeLorme, C.P.A.
Oak Brook, Illinois

October 23, 1996





                                     F-2
<PAGE>   6

                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>
                                                            (UNAUDITED)
                                                            SEPTEMBER 30,                       
                                                      -------------------------     DECEMBER 31,
ASSETS                                                   1996           1995           1995
                                                      ----------     ----------     ------------
<S>                                                   <C>            <C>            <C>       
CURRENT ASSETS
      Cash and cash equivalent                        $  788,458     $  801,696     $  702,107
      Investments                                        342,000        170,563        329,411
      Accounts receivable, net of allowance
         for doubtful accounts of $24,000 at
         September 30, 1995 and $48,000 at
         September 30, 1996 and December 31, 1995        698,975        631,122        604,621
      Other receivables                                   25,000         31,100         26,200
      Inventories                                        462,376        293,900        288,100
      Prepaid expenses and other assets                  410,655         24,663         21,206
      Deferred income taxes                               34,480              0         34,480
                                                      ----------     ----------     ----------

      TOTAL CURRENT ASSET                              2,761,944      1,953,044      2,006,125

PROPERTY AND EQUIPMENT
      Land                                               369,500        369,500        369,500
      Buildings, machinery and equipment               2,219,618      2,148,463      2,175,637
                                                      ----------     ----------     ----------
      Total property and equipment                     2,589,118      2,517,963      2,545,137
      Less:  accumulated depreciation                  1,010,462        819,967        868,769
                                                      ----------     ----------     ----------
      PROPERTY AND EQUIPMENT, NET                      1,578,656      1,697,996      1,676,368

OTHER ASSETS
      Intangible assets                                  330,343        330,343        330,343
      Less;  accumulated amortization                    253,425        206,250        221,595
                                                      ----------     ----------     ----------
      TOTAL OTHER ASSETS                                  76,918        124,093        108,748
                                                      ----------     ----------     ----------

TOTAL ASSETS                                          $4,417,518     $3,775,133     $3,791,241
                                                      ==========     ==========     ==========
</TABLE>


                SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS

                                     F-3
<PAGE>   7
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEET


LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
                                                     (UNAUDITED)
                                                     SEPTEMBER 30,                       
                                               -------------------------     DECEMBER 31,
                                                  1996           1995           1995 
                                               ----------     ----------     ------------
<S>                                            <C>            <C>            <C>       
CURRENT LIABILITIES
      Current maturities of notes payable      $   44,703     $   43,656     $   41,651
      Accounts Payable                            341,839        245,748        245,224
      Accrued expenses                            325,064        229,348        263,603
                                               ----------     ----------     ----------
      TOTAL CURRENT LIABILITIES                   711,606        518,752        550,478

LONG-TERM LIABILITIES
      Notes payable                               625,413        670,760        660,007

DEFERRED INCOME TAXES                              45,395         55.004         45,395

MINORITY INTEREST                                       0              0              0

STOCKHOLDERS' EQUITY
      Common Stock                              1,355,935      1,374,254      1,374,754
      Retained Earnings                         1,679,169      1,156,363      1,160,607
                                               ----------     ----------     ----------
      TOTAL STOCKHOLDERS' EQUITY                3,035,104      2,530,617      2,535,361
                                               ----------     ----------     ----------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY     $4,417,518     $3,775,133     $3,791,241
                                               ==========     ==========     ==========
</TABLE>


                SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS

                                     F-4
<PAGE>   8
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                       CONSOLIDATED STATEMENTS OF INCOME


<TABLE>
<CAPTION>
                                                (UNAUDITED)
                                         FOR THE NINE MONTHS ENDED                       
                                               SEPTEMBER 30,          FOR THE YEAR ENDED 
                                       ----------------------------      DECEMBER 31,    
                                           1996             1995             1995                       
                                       -----------      -----------   ------------------
<S>                                    <C>              <C>              <C>        
SALES                                  $ 3,985,736      $ 3,240,955      $ 4,497,560

COST OF GOODS SOLD                       1,808,360        1,445,326        2,244,628
                                       -----------      -----------      -----------

GROSS PROFIT                             2,177,376        1,795,629        2,252,932

OPERATING EXPENSES                       1,327,775        1,076,170        1,560,967
                                       -----------      -----------      -----------

INCOME FROM OPERATIONS                     849,601          719,459          691,965

OTHER INCOME (EXPENSE)
      Interest income                       32,124           31,950           41,326
      Interest expense                     (36,017)         (56,902)         (67,164)
      Gain on sale of assets                   689           16,011           16,001
                                       -----------      -----------      -----------
      TOTAL OTHER INCOME (EXPENSE)          (3,204)          (8,941)          (9,827)
                                       -----------      -----------      -----------

INCOME BEFORE INCOME TAXES                 846,397          710,518          682,138

PROVISION FOR INCOME TAXES                 327,835          274,037          241,413
                                       -----------      -----------      -----------

NET INCOME                             $   518,562      $   436,481      $   440,725
                                       ===========      ===========      ===========

EARNINGS PER SHARE                     $       .14      $       .12      $       .12
                                       ===========      ===========      ===========

SHARES OUTSTANDING                       3,774,977        3,787,377        3,785,377
                                       ===========      ===========      ===========
</TABLE>


                SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS

                                     F-5
<PAGE>   9
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
           CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
                                         COMMON STOCK, NO PAR VALUE
                                        10,000,000 SHARES AUTHORIZED
                                        -----------------------------
                                         SHARES ISSUED                       RETAINED
                                        AND OUTSTANDING     AMOUNT           EARNINGS
                                        ---------------   -----------      -----------
<S>                                      <C>              <C>                   <C>
BALANCES AT DECEMBER 31, 1994              3,729,777      $ 1,302,754      $   719,882

Shares exchanged in no-cash
    transaction                               55,600           72,000                0

Net income for the year ended
    December 31, 1995                              0                0          440,725
                                         -----------      -----------      -----------

BALANCES AT DECEMBER 31, 1995              3,785,377        1,374,754        1,160,607

Purchase of stock                            (10,400)         (18,819)               0

Net income for the nine months ended
    September 30, 1996                             0                0          518,562
                                         -----------      -----------      -----------

BALANCES AT SEPTEMBER 30, 1996             3,774,977      $ 1,355,935      $ 1,679,169
                                         ===========      ===========      ===========
</TABLE>


                SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS

                                     F-6
<PAGE>   10
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                        (UNAUDITED)
                                                                 FOR THE NINE MONTHS ENDED                      
                                                                       SEPTEMBER 30,        FOR THE YEAR ENDED  
                                                                 -------------------------     DECEMBER 31      
                                                                     1996          1995            1995
                                                                 ----------      ---------  ------------------
<S>                                                               <C>            <C>            <C>      
CASH FLOWS FROM OPERATING ACTIVITIES:
      Net income                                                  $ 518,562      $ 436,481      $ 440,725
      Adjustments to reconcile net income to net
         cash flows from operating activities:
              Depreciation and amortization                         173,523        166,418        230,565
              Issuance of common stock in exchange
                 for services rendered and interest expense               0         42,000         42,000
              Increase in allowance for doubtful accounts                 0              0         24,000
              Deferred income taxes                                       0          7,745        (36,344)
              Gain on sale of asset                                    (689)       (16,011)       (16,011)
              (Increase) decrease in operating assets:
                    Accounts receivable                             (94,354)      (104,411)      (101,910)
                    Other receivable                                  1,200           (200)         4,700
                    Inventories                                    (174,276)      (185,591)      (179,791)
                    Prepaid expenses and other assets              (389,449)         1,104          4,561
               Increase (decrease) in operating liabilities:
                    Accounts payable                                 96,615        (56,601)       (57,125)
                    Accrued expenses                                 61,461         55,711         89,964
                                                                  ---------      ---------      ---------
NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES                    192,593        346,645        445,334

CASH FLOWS FROM INVESTING ACTIVITIES:
      Purchase of investments                                      (112,000)             0       (167,315)
      Sale of investments                                           100,100         98,747        107,214
      Purchase of property and equipment                            (43,981)       (20,919)       (48,194)
      Proceeds from sales of assets                                       0         51,220         51,323
                                                                  ---------      ---------      ---------
NET CASH PROVIDED BY (USED) IN
     INVESTING ACTIVITIES                                           (55,881)       129,048        (56,972)

CASH FLOWS FROM FINANCING ACTIVITIES:
      Repayments of notes payable                                   (31,542)       (78,995)       (91,753)
      Purchase of treasury stock                                    (18,819)             0              0
      Payments to minority shareholders                                   0        (90,500)       (90,000)
                                                                  ---------      ---------      ---------
NET CASH USED IN FINANCING ACTIVITIES                               (50,361)      (169,495)      (181,753)
                                                                  ---------      ---------      ---------

NET INCREASE (DECREASE) IN CASH AND
     CASH EQUIVALENTS                                                86,351        306,198        206,609

CASH AND CASH EQUIVALENTS AT
     BEGINNING OF PERIOD                                            702,107        495,498        495,498
                                                                  ---------      ---------      ---------

CASH AND CASH EQUIVALENTS AT END OF PERIOD                        $ 788,458      $ 801,696      $ 702,107
                                                                  =========      =========      =========
</TABLE>


               SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS

                                     F-7
<PAGE>   11

                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS



<TABLE>
<CAPTION>
                                                              (UNAUDITED)
                                                       FOR THE NINE MONTHS ENDED                       
                                                              SEPTEMBER 30,         FOR  THE YEAR ENDED  
                                                       -------------------------        DECEMBER 31      
                                                            1996         1995              1995          
                                                       -----------     ---------    -------------------        
<S>                                                       <C>          <C>               <C>             
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:                                                       
                                                                                                         
      Cash paid for interest                              $ 36,017     $ 56,902          $ 67,164        
                                                          ========     ========          ========        
                                                                                                         
      Cash paid for income taxes                          $164,900     $193,152          $190,760        
                                                          ========     ========          ========        
                                                                                                         
SUPPLEMENTAL SCHEDULE OF NON-CASH                                                                        
    FINANCING ACTIVITIES:                                                                                
                                                                                                         
      Issuance of common stock in exchange for:                                                          
                                                                                                         
             Consulting fees                              $      0     $ 27,500          $ 27,500        
             Minority shareholders - interest expense            0       14,500            14,500        
                                                          --------     --------          --------        
                  Sub-total                                      0       42,000            42,000        
             Minority shareholders - stock                       0       30,000            30,000        
                                                          --------     --------          --------        
             Total common stock issued $                         0     $ 72,000          $ 72,000        
                                                          ========     ========          ========        
</TABLE>


                SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS

                                     F-8
<PAGE>   12
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 1 - NATURE OF BUSINESS

      Lifeway Foods, Inc. (The "Company") commenced operations in February,
      1986, and incorporated under the laws of the state of Illinois on May
      19, 1986. The Company produces Kefir, a drinkable product which is
      similar to but distinct from yogurt in several flavors sold under the
      name "Lifeway's Kefir"; a line of drinkable yogurt; a plain farmer's
      cheese sold under the name "Lifeway's Farmer's Cheese"; and a fruit
      sugar-flavored product similar in consistency to cream cheese sold under
      the name of "Sweet Kiss." The Company currently distributes its products
      throughout the Chicago metropolitan area through local food stores. In
      addition, the products are sold in the states of California, Colorado,
      Connecticut, Florida, Illinois, Indiana, Iowa, Michigan, Minnesota, New
      Hampshire, New York, Ohio, Texas and Wisconsin. The Company has also
      expanded the distribution of its products internationally by exporting
      to Eastern Europe through its wholly-owned subsidiary Lifeway
      International, Inc.

      On September 30, 1992, the Company formed a wholly-owned subsidiary
      corporation, LFI Enterprises, Inc., (LFIE) incorporated in the state of
      Illinois. LFI Enterprises, Inc. was formed for the purpose of operating
      a "Russian" theme restaurant and supper club on the property acquired by
      the Company on October 9, 1992. The restaurant/supper club commenced its
      operations in late November 1992.

      Approximately 88.2% of Consolidated revenues and 156.8% of consolidated
      net income for the year ended December 31, 1995 were derived from the
      manufacturing of liquid yogurt and cheese products.


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      A summary of the significant accounting policies applied in the
      preparation of the accompanying financial statements follows:

      Principles of Consolidation

      The consolidated financial statements include the accounts of the
      Company and its wholly-owned and majority owned subsidiaries. All
      significant intercompany accounts and transactions have been eliminated,
      including $120,000 of rent paid by LFIE to the Company in 1995 for use
      of the restaurant which is owned by the Company.

      The Company has adopted Statement of Financial Accounting Standards
      (SFAS) No. 94., "Consolidation of all Majority-owed Subsidiaries", which
      requires the consolidation of all majority-owned subsidiaries unless
      control is temporary or does not rest with the majority owners.




                                     F-9
<PAGE>   13
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

      Use of Estimates

      The preparation of financial statements in conformity with generally
      accepted accounting principles requires management to make estimates and
      assumptions that affect the reported amounts of assets and liabilities
      and disclosure of contingent assets and liabilities at the date of the
      financial statements and reported amounts of revenues and expenses
      during the reporting period. Actual results could differ from those
      estimates.

      Cash Equivalents

      All highly liquid investments purchased with a maturity of three months
      or less are considered to be cash equivalents.

      Investments

      Effective December 31, 1994, the Company adopted the provisions of
      Statement of Financial Accounting Standards No 115 " Accounting for
      certain Debt and Equity Securities" (SFAS 115). In accordance with this
      Statement, securities are classified as held-to-maturity,
      available-for-sale or trading.

      The Company's investments include certificates of deposit with maturity
      dates greater than three months and US Treasury Bonds which are all
      short term and held-to-maturity. Securities classified as
      held-to-maturity are stated at cost adjusted for amortization of
      premiums and accretion of discounts. At December 31, 1995, cost
      approximated market value. The Company does not currently have any
      trading or available-for-sale securities.

      Inventory

      Inventories are stated at lower of cost or market, cost being determined
      by the first-in, first-out method.

      Property and Equipment

      Property and equipment are stated at cost. Depreciation is computed
      using the straight line method. When assets are retired or otherwise
      disposed of, the cost and related accumulated depreciation are removed
      from the accounts, and any resulting gain or loss is recognized in
      income for the period. The cost of maintenance and repairs is charged to
      income as incurred; significant renewals and betterments are
      capitalized.

      Property and equipment are being depreciated over the following useful
      lives:

<TABLE>
<CAPTION>
                Category                       Years
                --------                       -----
                <S>                            <C>
                Buildings and improvements       31
                Machinery and equipment        5-12
                Office equipment                5-7
</TABLE>




                                     F-10
<PAGE>   14
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

      Intangible Assets

      Intangible Assets are stated at cost. Organization costs are amortized
      over five years using the straight-line method. Other intangible assets
      are amortized over the estimated useful lives of the assets using the
      straight- line method as follows:

<TABLE>
                <S>                        <C>     
                Covenant not to compete     10 years
                Trademark license          2.5 years
                U.P.C. Codes                 7 years
                Customer lists               5 years
</TABLE>

      Income Taxes

      Deferred income taxes arise from temporary differences resulting from
      income and expense items reported for financial accounting and tax
      purposes in different periods. Deferred taxes are classified as current
      or noncurrent, depending on the classification of the assets and
      liabilities to which they relate. Deferred taxes arising from temporary
      differences that are not related to an asset or liability are classified
      as current or noncurrent depending on the periods in which the temporary
      differences are expected to reverse.

      The principal sources of temporary differences are different
      depreciation methods for financial statement and tax purposes,
      capitalization of indirect costs for tax purposes, use of allowance
      method for book purposes verses the direct method for tax purposes as to
      bad debts and amortization of customer list.

      Earning Per Common Share

      Earnings per common share were computed by dividing net income by
      weighted average number of shares of common stock outstanding during the
      year. For the year ended December 31, 1995, fully diluted and primary
      earnings per share were the same as there were no potentially dilutive
      common stock equivalents outstanding. See Note 11 for fully diluted
      earnings per share for the year ended December 31, 1994.


NOTE 3 - INVENTORIES

      Inventories consisted of the following:

<TABLE>
<CAPTION>
                                            (UNAUDITED)
                                     FOR THE NINE MONTHS ENDED                     
                                            SEPTEMBER 30,        FOR THE YEAR ENDED
                                     -------------------------      DECEMBER 31    
                                         1996          1995            1995        
                                     -----------     ---------   ------------------
                <S>                     <C>          <C>             <C>           
                Finished goods          $348,197     $192,900        $199,600      
                Production supplies       53,761       45,000          42,500      
                Raw materials             60,418       56,000          46,000      
                                        --------     --------        --------      
                                        $462,376     $293,900        $288,100      
                                        ========     ========        ========      
</TABLE>




                                     F-11
<PAGE>   15
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 4 - PROPERTY AND EQUIPMENT

Property and equipment consisted of the following: 

<TABLE>
<CAPTION>
                                                      (UNAUDITED) 
                                              FOR THE NINE MONTHS ENDED                     
                                                     SEPTEMBER 30,       FOR THE YEAR ENDED 
                                              -------------------------      DECEMBER 31    
                                                 1996           1995            1995
                                              ----------     ----------  ------------------
                <S>                           <C>            <C>            <C>       
                Building and improvements     $  796,752     $  796,752     $  796,752
                Machinery and equipment        1,259,101      1,209,558      1,218,213
                Vehicles                         110,117         89,906        109,877
                Office equipment                  53,648         52,247         50,795
                                              ----------     ----------     ----------
                                              $2,219,618     $2,148,463     $2,175,637
                                              ==========     ==========     ==========
</TABLE>

      Depreciation charged to income for the nine months ended September 30,
      1996 and 1995 was $141,693 and $138,123 respectively, and $186,925 for
      the year ended December 31, 1995.

NOTE 5 - NOTES PAYABLE

<TABLE>
<CAPTION>
                                                                                      (UNAUDITED)
                                                                               FOR THE NINE MONTHS ENDED                     
                                                                                     SEPTEMBER 30,         FOR THE YEAR ENDED
                                                                               -------------------------      DECEMBER 31    
                                                                                   1996         1995              1995
                                                                               ----------     ----------   ------------------ 
      <S>                                                                        <C>          <C>              <C>      
      Mortgage note payable, 1st National Bank of Morton Grove, payable in                                              
       monthly installments of $2,548, including interest at 7.5%, with a                                               
       balloon payment of $184,900 due November 1998.  Collateralized by 
       real estate.                                                              $216,566     $229,884         $227,464 
                                                                                                                        
      Mortgage note payable, American National Bank and Trust Company of                                                
       Chicago, payable in monthly installments of $4,498 including interest                                            
       at 6.75%, with a balloon payment of $394,000 due August                                                          
       1998.  Collaterlized by real estate                                        445,665      471,791          462,638 
                                                                                                                        
      Note payable, Glenview State Bank, payable in monthly installments of                                             
       $460, including interest at 6.25%, due March, 1998.  Collateralized 
       by automobile                                                                7,885       12,741           11,556 
                                                                                 --------     --------         -------- 
                                                                                                                        
           Total                                                                  670,116      714,416          701,658 
                                                                                                                        
           Less current maturities                                                 44,703       43,656           41,651 
                                                                                 --------     --------         -------- 
                                                                                                                        
           Total                                                                 $625,413     $670,760         $660,007 
                                                                                 ========     ========         ======== 
</TABLE>

      Maturities of notes payable for the years ended December 31,are as
      follows:

<TABLE>
                     <S>                  <C>      
                     1996                 $ 41,651 
                     1997                   44,621 
                     1998                  615,386 
                                          -------- 
                                          $701,658 
</TABLE>




                                     F-12
<PAGE>   16
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 6 - PROVISION FOR INCOME TAXES

      The provision for income taxes consists of the following:

<TABLE>
<CAPTION>
                                           (UNAUDITED)                              
                                    FOR THE NINE MONTHS ENDED                       
                                          SEPTEMBER 30,         FOR THE YEAR ENDED  
                                    -------------------------      DECEMBER 31      
                                       1996          1995             1995          
                                    ----------     ----------   ------------------  
      <S>                            <C>           <C>              <C>             
      Current                                                                       
            Federal                  $ 267,136     $ 216,918        $ 225,897       
            State                       60,699        49,374           51,860       
                                     ---------     ---------        ---------       
      Total current                    327,835       266,292          277,757       
      Deferred                               0         7,745          (36,344)      
                                     ---------     ---------        ---------       
                                                                                    
      Provision for income taxes     $ 327,835     $ 274,037        $ 241,413       
                                     =========     =========        =========       
</TABLE>

      A reconciliation of the provision for income taxes and the income tax
      computed at the statutory rate is as follows:

<TABLE>
<CAPTION>
                                                             (UNAUDITED)                              
                                                      FOR THE NINE MONTHS ENDED                       
                                                            SEPTEMBER 30,         FOR THE YEAR ENDED  
                                                      -------------------------      DECEMBER 31      
                                                         1996          1995             1995          
                                                      ----------     ----------   ------------------  
      <S>                                             <C>           <C>              <C>             
      Federal income tax expense                                                             
        computed at the statutory rate                $ 267,136     $ 216,918        $ 215,228 
      State taxes, expense                               60,699        49,374           49,796 
      Book/tax, accumulated depreciation adjusted             0             0           (4,886)
      Book/tax, inventory adjustment                          0             0          (16,319)
      Permanent book/tax difference                           0         7,745           (2,406)
                                                      ---------     ---------        --------- 
                                                                                               
      Provision for income taxes                      $ 327,835     $ 274,037        $ 241,413 
                                                      =========     =========        ========= 
</TABLE>

      Amounts for deferred tax assets and liabilities as of December 31, 1995
      are as follows:

<TABLE>
      <S>                                                        <C>       
      Long-term deferred tax liabilities arising from:                     
            Temporary differences - principally                            
                   Book/tax, accumulated depreciation            $ 48,873  
                   Book/tax, accumulated amortization              (3,478) 
                                                                 --------  
            Total deferred tax liabilities                         45,395  
                                                                           
       Short-term deferred tax assets arising from:                        
                   Book/tax, allowance for doubtful accounts     $(22,176) 
                   Book/tax, inventory                            (12,304) 
                                                                 --------  
       Total deferred tax assets                                  (34,480) 
                                                                           
       Net deferred tax liability                                $ 10,915  
                                                                 ========  
</TABLE>




                                     F-13
<PAGE>   17
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 7 - CUSTOMER AND CREDIT CONCENTRATIONS

      Concentrations of credit with regard to trade accounts receivable and
      sales are limited due to the fact the Company's customers are spread
      across different geographic areas. The customers are concentrated in the
      retail food industry. Two customers accounted for 5% and 3% of 1995
      sales and 18% and 22% of trade accounts receivable as of December 31,
      1995.

NOTE 8 -  ACQUISITION OF BUSINESS LINE

      On December 27, 1990, the Company purchased the Tuscan brand-name liquid
      yogurt customer list along with a limited license of the trademark and
      use of the Tuscan liquid yogurt UPC codes from a third party. In
      addition, the third party signed a Covenant Not to Compete which states
      that, for a period of ten (10) years from the date of the agreement,
      they shall not sell, produce, market or broker liquid yogurt products in
      the United States.

      The final purchase price of the assets was determined to be $286,000,
      which was allocated accordingly:

<TABLE>
            <S>                         <C>     
            Covenant Not to Compete     $ 50,000
            Customer List                  6,000
            Trademark                     30,000
            UPC Codes                    200,000
                                        --------
                                        $286,000
                                        ========
</TABLE>

      Total amortization charged against income for the years ended December
      31, 1995 and 1994 was $43,640 and $47,241, respectively.

NOTE 9 - FORMATION OF SUBSIDIARIES

      In 1992, the Company formed Lifeway International, Inc.("LLI") as a
      majority-owned subsidiary. In exchange for 98% of the issued and
      outstanding common stock, 2,320,000 shares, the Company transferred
      $108,000 in cash. The remaining 2% of the issued and outstanding common
      stock, 46,000 shares, was transferred to other shareholders ("Minority
      Shareholders") under a qualifying Rule 144 restricted stock issue in
      exchange for $145,000 in cash. In 1993, LII executed an Investment
      Agreement with the Svyatoshino Milk Plant Ukrainian Joint-Stock Company
      (Kiev, Ukraine) in which LII was to acquire a majority-ownership
      interest in Svyatoshino.

      Due to the political situation in the Ukraine, acquisition of the
      controlling interest is not anticipated in the near future. In lieu of
      this acquisition, LII has commenced exporting Kefir to Eastern Europe.
      In light of this change in business plan, the Company extended an
      exchange offer to the Minority Shareholders. See Note 11 for additional
      information. For the years ending December 31, 1995, LII had export
      sales totaling $141,708.

      On September 30, 1992, the Company formed LFI Enterprises, Inc. (LFIE)
      as a wholly-owned subsidiary. In exchange for all of the issued and
      outstanding common stock of LFIE, the Company transferred to LFIE $1,000
      in cash.




                                     F-14
<PAGE>   18
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 10 - BUSINESS SEGMENT INFORMATION

      The Company's significant business segments include the sale of dairy
      products and the operations of a restaurant. "Corporate and other"
      includes revenues and expenses of the company's export subsidiary,
      general corporate expenses, interest expense, and interest income. The
      Company's operations, by business segment for 1995 are as follows:

<TABLE>
<CAPTION>
                                 Dairy                      Corporate                   
      1995                     Products      Restaurant      & Other       Consolidated 
      ----                     --------      ----------     ---------      ------------ 
      <S>                     <C>            <C>            <C>             <C>         
      Sales                   $3,965,707     $  390,145     $  141,708      $4,497,560  
                                                                                        
      Net Income              $  691,055     $   18,729     $ (269,059)     $  440,725  
                                                                                        
      Identifiable Assets     $3,033,742     $  654,413     $  103,086      $3,791,241  
                                                                                        
      Depreciation and                                                                  
          Amortization        $  209,567     $   12,129     $    8,869      $  230,565  
                                                                                        
      Capital Additions       $   45,494     $    2,700     $        0      $   48,194  
</TABLE>

NOTE 11 - EXCHANGE OFFER TO MINORITY SHAREHOLDERS

      During 1994, the Company determined that it would not be able to
      implement its original business plan for LII at this time (see Note 9).
      As a result, the Company conducted an exchange offer to the Minority
      Shareholders of LII, whereby each Minority Shareholder could
      alternatively exchange their shares for:

      1) restricted common shares in the Company (including shares for
         interest on their investment) or,

      2) receive a return of their original investment in cash plus interest
         on their investment paid in restricted common shares in the Company.

      During 1994, Minority Shareholders owning 8,000 shares in LII elected to
      cash out and were paid $25,000. During 1995, Minority Shareholders
      owning 28,800 shares in LII elected to cash out and were paid $90,000.
      In addition, these Minority Shareholders were entitled to 9,200
      restricted common shares in the Company as payment of interest on their
      investment in LII. During 1995, Minority Shareholders owning 9,600
      shares in LII elected to exchange their shares and were issued 26,400
      restricted common shares of the Company, including 2,400 shares as
      payment of interest on their investment in LII. The total issue of
      35,600 restricted common shares in the Company resulted in a .9%
      dilution of the current Company shareholder's interests. As of December
      31, 1995, all minority interests in LII have been exchanged or cashed
      out under the terms of the exchange offer. Had the shares been issued in
      1994, earnings per share for the year ended December 31, 1994 would have
      decreased $.0005.


NOTE 12 - COMMON STOCK ISSUE

      During 1995, the Company received consulting services valued at $27,500.
      In lieu of cash, the Company issued 20,000 shares of common stock as
      payment for these services, which resulted in a .5% dilution of the
      current Company shareholder's interest.




                                     F-15
<PAGE>   19
                     LIFEWAY FOODS, INC. AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               SEPTEMBER 30, 1996 AND 1995 AND DECEMBER 31, 1995


NOTE 13 - CONCENTRATION OF RISK

      The Company maintains cash deposits at several banks located in the
      greater Chicago, Illinois metropolitan area. Deposits at each bank are
      insured by the Federal Deposit Insurance Corporation up to $100,000.

      Bank balances of amounts reported by financial institutions which are
      categorized as follows at December 31, 1995:

<TABLE>
          <S>                                        <C>        
          Amounts insured by FDIC                    $  231,589 
          Uninsured and uncollateralized amounts        788,158 
                                                     ---------- 
                                                                
          Total bank balance                         $1,019,747 
                                                     ========== 
</TABLE>


NOTE 14 - INVESTMENTS

      The amortized cost and fair value of investments at December 31, 1995
      were:


<TABLE>
<CAPTION>
                                      Amortized      Fair   
                                        Cost         Value  
                                      ---------    --------
          <S>                         <C>          <C>      
          Certificates of Deposit     $230,000     $230,000 
                                                            
          U.S. Treasury Bond            99,411       99,411 
                                      --------     -------- 
          Total Investment            $329,411     $329,411 
                                      ========     ======== 
</TABLE>


NOTE 15 - REAL ESTATE PURCHASE AGREEMENT

      On May 3, 1996, the Company entered into a Real Estate Sales Contract 
      (the "Contract") to purchase a 110,000 square foot parcel of real
      property, zoned commercial, including a 46,000 square foot one-story
      building, located at 6431 Oakton Avenue, Morton Grove, Illinois for
      $1,325,000. The purchase enables the Company to further expand its
      production facilities and capacity. Under the terms, upon execution of
      the Contract, (1) the Company would be allowed a period of 45 days to
      inspect the property (the "inspection period"); and (2) the Company
      would place initial earnest monies totalling $10,000 in escrow. On June
      20, 1996, the Company placed additional earnest monies of $290,000 in
      the interest bearing escrow account at Chicago Title and Trust Company.
      As of September 30, 1996, earnest monies totalling $300,000 are held in
      escrow at Chicago Title and Trust Company, the direction to control is
      held by the Seller. On October 15, 1996, the Company closed on the
      purchase of the Real Estate.




                                     F-16

<PAGE>   20
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND 
        RESULTS OF OPERATIONS

(1)      Material Changes in Results of Operations

         Net income increased by $82,081, up to $518,562 for the nine month
period ending September 30, 1996, from $436,481 during the same nine month
period in 1995. The components of this increase are detailed as follows:

         Sales and cost of goods sold increased by $744,781 and $363,034,
respectively, up to $3,985,736 and $1,808,360 during the nine month period
ending September 30, 1996 from $3,240,955 and $1,445,326 during the same nine
month period in 1995, respectively. The increase is primarily attributable to
increased sales of Kefir, Farmer's Cheese and the introduction of Golden
Zesta. Costs of sales and gross margins of the Company increased
proportionately with sales.

         Operating expenses increased by $251,605, up to $1,327,775 during the
nine month period ending September 30, 1996 from $1,076,170 during the same
six month period in 1995. The increase is primarily attributable to (i) an
increase in advertising expenses due to the Company's aggressive marketing
campaign commencing in 1995; and (ii) an increase in salaries and payroll
taxes incurred as additional employees were hired to support the Company's
growth in production.

         The Company's balance in inventory increased by $168,476, up to
$462,376 during the nine-month period ending September 30, 1996, as compared
to $293,900 during the nine-month period ending September 30, 1995. The
increase is primarily due to an increase in production and sales.

         Provision for income taxes increased by $53,798, up to $327,835
during the nine month period ending September 30, 1996 from $274,037 during
the same nine month period in 1995. The increase is proportionate to the net
income increase.

(2)      Material Changes in Financial Condition

         As of the nine month period ending September 30, 1996 as compared to
the nine month period ending September 30, 1995, the Company had working
capital in the amount of $2,050,338 as compared to $1,434,292, respectively;
and cash on hand in the amounts of $788,458 as compared to $801,696,
respectively. Cash flow from operations was generated by the primary business
activity of the Company. As a result of its strong working capital position,
the Company expects all cash requirements can be met internally for the
remaining fiscal year. The decrease in cash on hand is primarily attributable
to the $300,000 in earnest money that is being held in escrow pending closing
of the purchase of real property to enable the Company to further expand its
production facilities and capacity. The earnest money on deposit is
categorized on the balance sheet under the heading entitled "Prepaid Expenses
and Other Assets." Closing occurred subsequent to the end of the fiscal quarter,
as discussed below.

         On April 24, 1996, the Company entered into a Real Estate Sales
Contract with a non-affiliated third party to purchase a 110,000 square foot
parcel of real property, zoned industrial, including a 46,000 square foot
one-story building, in Morton Grove, Illinois, for $1,325,000. The purchase
will enable the Company to further expand its production facilities and
capacity. Closing occurred on October 15, 1996, and the Company anticipates a
move in April 1997. The Company has obtained bridge financing with the
American National Bank in Chicago. It is proposed that a mortgage in the
approximate amount of $919,000, the specified terms of which have not yet been
determined, will be secured by the real estate and be payable in monthly
installments. The Company will not need to raise additional funds to meet its
cash requirements for, among others, building upgrades, additional employees,
equipment and inventory. The Company, on a gradual basis, will implement its
three-year plan to increase production resulting in increased sales. Once full
production capability is reached, the Company expects that its annual product
sales will increase significantly. The Company expects to employ up to 40 more
persons to operate this new production facility, on an as-needed basis, over
the next three years.



                                      4
<PAGE>   21


         On January 26, 1996, the Board of Directors of the Company voted to
repurchase up to 100,000 shares of the Company's Common Stock on the open
market. The decision reflects the Board's belief that the Company's Common
Stock is significantly undervalued. The resolution of the Board of Directors
gave the Company one year to repurchase the shares to be held as treasury
stock for general corporate purposes. As of September 30, 1996, the Company
has repurchased a total of 10,400 of its Common Shares.

         The Company is not aware of any circumstances or trends which would
have a negative impact upon future sales or earnings. The Company believes it
has sufficient funds available during the next fiscal year for any Common
Stock repurchases as discussed above. There have been no material fluctuations
in the standard seasonal variations of the Company's business.

                          PART II - OTHER INFORMATION


ITEM 1.  LEGAL PROCEEDINGS

         None.

ITEM 2.  CHANGES IN SECURITIES

         None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         None.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS

         None.

ITEM 5.  OTHER INFORMATION

         None.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

         (a)      Exhibits

Exhibit Number and Brief Description

         3.1   Articles of Incorporation of issuer, with Certificate, 
               and Amendments. (1)
               
         3.2   Bylaws of issuer. (1)
               
         3.3   Corrected Amendment to the Bylaws of issuer. (1)
               
         10.1  Lifeway Foods, Inc. Consulting and Services Compensation 
               Plan, dated June 5, 1995. (2)
               
         10.2  Employment Agreement between issuer and Michael 
               Smolyansky. (3)
               
         10.4  Industrial Building Lease between Lifeway Foods, Inc. 
               and Michael Smolyansky, and Addendum to Building Lease. (3)
               
               
                                      5
<PAGE>   22
               
         10.5  Stock Option Agreements. (3)
               
         10.7  Restricted Stock Plan. (3)
               
         10.9  Real Estate Sales Contract, dated April 24, 1996, to 
               purchase a 110,000 square foot parcel of real property, 
               zoned industrial, in Morton Grove, Illinois. (4)
               
         27    Financial Data Schedule. (5)

---------------

         (1)   Incorporated by reference to the issuer's registration statement 
               on Form S-18 (File No. 33-14329-C), and Post-Effective
               Amendments thereto.

         (2)   Incorporated by reference to the issuer's registration
               statement on Form S-8 (File No. 33-93306).

         (3)   Incorporated by reference to the issuer's Current Reports
               filed under cover of Form 8-K and amendments thereto.

         (4)   Incorporated by reference to the issuer's Quarterly Report 
               on Form 10-QSB for the period ended March 31, 1996.

         (5)   Filed herewith.


(b)      Reports on Form 8-K

         None.



                                      6
<PAGE>   23



                                  SIGNATURES

         In accordance with the requirements of the Exchange Act, the Company
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.


                             LIFEWAY FOODS, INC.


                             By:  /s/ MICHAEL SMOLYANSKY
                                  ---------------------------------------------
                                  Michael Smolyansky, Chief Executive Officer,
                                  Chief Financial and Accounting Officer,
                                  President, Treasurer and Director

Date:   November 11, 1996



                                      7
<PAGE>   24
                                 EXHIBIT INDEX



3.1      Articles of Incorporation of issuer, with Certificate, and
         Amendments. (1)

3.2      Bylaws of issuer. (1)

3.3      Corrected Amendment to the Bylaws of issuer. (1)

10.1     Lifeway Foods, Inc. Consulting and Services Compensation Plan, 
         dated June 5, 1995. (2)

10.2     Employment Agreement between issuer and Michael Smolyansky. (3)

10.4     Industrial Building Lease between Lifeway Foods, Inc. and 
         Michael Smolyansky, and Addendum to Building Lease. (3)

10.5     Stock Option Agreements. (3)

10.7     Restricted Stock Plan. (3)

10.9     Real Estate Sales Contract, dated April 24, 1996, to purchase a 
         110,000 square foot parcel of real property, zoned industrial, in 
         Morton Grove, Illinois. (4)

27       Financial Data Schedule. (5)

--------------

(1)      Incorporated by reference to the issuer's registration statement on 
         Form S-18 (File No. 33-14329-C), and Post-Effective Amendments 
         thereto.

(2)      Incorporated by reference to the issuer's registration statement on 
         Form S-8 (File No. 33-93306).

(3)      Incorporated by reference to the issuer's Current Reports filed under 
         cover of Form 8-K and amendments thereto.

(4)      Incorporated by reference to the issuer's Quarterly Report on Form 
         10-QSB for the period ended March 31, 1996.

(5)      Filed herewith.