<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

(MARK ONE)

[X]    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
       ACT OF 1934 
                    FOR THE FISCAL YEAR ENDED JULY 31, 1998
                                       OR
[ ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 
       EXCHANGE ACT OF 1934

         FOR THE TRANSITION PERIOD FROM                          TO

                         COMMISSION FILE NUMBER 0-17521
                                   ZILA, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


<TABLE>
<CAPTION>
                            DELAWARE                                                         86-0619668
<S>                                                                            <C>
 (STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)                 (I.R.S. EMPLOYER IDENTIFICATION NO.)

             5227 NORTH 7TH STREET, PHOENIX, ARIZONA                                         85014-2800
            (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                                         (ZIP CODE)
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        REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (602) 266-6700
 
           SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:


  TITLE OF EACH CLASS              NAME OF EACH EXCHANGE ON WHICH REGISTERED

         None                                            N/A

           SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                          COMMON STOCK, $.001 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. Yes [X] 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. [ ]

         At September 30, 1998, the aggregate market value of common stock held
by non-affiliates of the Registrant was approximately $151,187,200.

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

         Indicate by check mark whether the Registrant has filed all documents
and reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ] N/A

                    APPLICABLE ONLY TO CORPORATE REGISTRANTS

         Indicate the number of shares outstanding of each of the Registrant's
classes of common stock, as of the latest practicable date.

         At September 30, 1998, the number of shares of common stock outstanding
was 35,088,046.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Materials from the Registrant's 1998 Proxy Statement have been
incorporated by reference into Part III, Items 10, 11, 12 and 13.
<PAGE>   2
                                TABLE OF CONTENTS

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                                                                                                               PAGE
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PART I   .........................................................................................................1

         Item 1.  BUSINESS........................................................................................1
         Item 2.  PROPERTIES.....................................................................................16
         Item 3.  LEGAL PROCEEDINGS..............................................................................16
         Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................17

PART II  ........................................................................................................18
         Item 5.  MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER
                  MATTERS........................................................................................18
         Item 6.  SELECTED FINANCIAL DATA........................................................................18
         Item 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
                  RESULTS OF OPERATIONS..........................................................................19
         Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................22
         Item 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                  AND FINANCIAL DISCLOSURES......................................................................22

PART III ........................................................................................................23
         Item 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY...............................................23
         Item 11.  EXECUTIVE COMPENSATION........................................................................23
         Item 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................................23
         Item 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................................23

PART IV  ........................................................................................................24
         Item 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8................................24

SIGNATURES.......................................................................................................26
</TABLE>
<PAGE>   3
                                     PART I

ITEM 1.  BUSINESS

                                     GENERAL

         Zila, Inc., a Delaware corporation, is an international manufacturer
and marketer of pharmaceutical, biomedical, dental, and nutritional products.
The Company's business is organized into three major product groups:
Pharmaceutical Products, Professional Products and Nutraceutical Products.
Unless the context otherwise indicates, the terms "Zila" and "Company" as used
herein refer to Zila, Inc. and each of its subsidiaries.

         The Pharmaceutical Products Group consists of over-the-counter and
prescription products, including the Zilactin(R) family of over-the-counter
products, Peridex(R) prescription mouth rinse and OraTest(R), an oral cancer
diagnostic system. Included in the Pharmaceutical Products Group is Zila
Pharmaceuticals, Inc., a Nevada corporation, a wholly owned subsidiary of the
Company.

         The Professional Products Group operates through the Company's wholly
owned subsidiaries Biodental Technologies Corporation, a California corporation,
and Cygnus Imaging, Inc., an Arizona corporation. Biodental Technologies
Corporation has two subsidiaries, Ryker Dental of Kentucky, Inc. a Kentucky
corporation, which does business under the name Zila Dental Supply and is a
national distributor of professional dental supplies, and Integrated Dental
Technologies, Inc., a California corporation which distributes
PracticeWorks(TM), the Company's dental practice management software. Cygnus
Imaging, Inc. ("Cygnus") is a manufacturer and marketer of digital x-ray systems
and intraoral cameras.

         The Nutraceutical Products Group includes Oxycal Laboratories,
Incorporated, an Arizona corporation, ("Oxycal") and its two subsidiaries
Inter-Cal Corporation, Inc, an Arizona corporation, and Oxycal Export, Inc. a
U.S. Virgin Islands corporation. Oxycal and its subsidiaries manufacture and
distribute a patented and enhanced form of vitamin C under the trademark
Ester-C(R).

         The Company's principal executive offices are located at 5227 North
Seventh Street, Phoenix, Arizona 85014-2800, and its telephone number is (602)
266-6700.


                                                        PRODUCTS
PHARMACEUTICAL PRODUCTS GROUP

- Zilactin(R)              The  Zilactin(R) line  includes five over-the-counter
                           ("OTC"),   non-prescription  products: Zilactin(R),
                           Zilactin(R)-B,  Zilactin(R)-L, Zilactin(R)-Lip  and
                           Zilactin(R) Baby. The  Zilactin(R) products  are
                           used topically for the purposes described below:

                           -        ZILACTIN(R) -- a protective  film for canker
                                    sores, cold sores and fever blisters.

                           -        ZILACTIN(R)-B    --   Zilactin(R)-B   is   a
                                    medicated gel containing benzocaine with the
                                    film-forming  properties  of  Zilactin(R).
                                    Zilactin(R)-B  has  been  formulated  for  a
                                    segment  of  the  market  which   prefers  a
                                    film-forming   application  with  a  topical
                                    anesthetic.  Zilactin(R)-B  quickly controls
                                    the pain  associated  with mouth sores while
                                    shielding  them from the  environment of the
                                    mouth.

                           -        ZILACTIN(R)-L   --  a  liquid  for  treating
                                    developing fever blisters and cold sores.

                           -        ZILACTIN(R)-Lip    --   Zilactin(R)-Lip   is
                                    positioned to be a premium-priced, effective
                                    alternative    to   existing    lip   balms.
                                    Zilactin(R)-Lip  prevents  sun  blisters and
                                    treats  cold  sores and dry,  chapped  lips.
                                    Most other  competing  products only perform
                                    one or two of such applications.

                                       -1-
<PAGE>   4
                           -        ZILACTIN(R)-Baby  --  Zilactin(R)-Baby  is a
                                    new  medication  for teething pain which the
                                    Company  began  distributing  in June  1997.
                                    Zilactin(R)-Baby  contains a higher level of
                                    benzocaine than competing products,  and has
                                    a cool grape flavor.  Unlike other  teething
                                    gels,  it  does  not  contain  saccharin  or
                                    coloring dyes.

                       The Zilactin(R) treatment composition is covered by
                       several patents owned by the Company. These patents cover
                       the composition and the film-forming properties of the
                       product formula. See "Business -- Patents and
                       Trademarks." Zilactin(R), Zilactin(R)-B, and
                       Zilactin(R)-L formulas incorporate these proprietary
                       treatment compositions.

                       Zilactin(R) and Zilactin(R)-B are packaged as gels in .25
                       ounce plastic tubes. Zilactin(R)-L, is a liquid packaged
                       in a 10 cc plastic bottle. The products are applied
                       directly to affected areas in quantities large enough to
                       cover the lesion with the gel or liquid. The gels contain
                       an active ingredient which forms a thin, transparent,
                       pliable film that holds the active ingredient against the
                       affected tissue and keeps the affected area clean. The
                       film can last up to six hours inside the mouth, a feature
                       which makes the formulation suitable for a variety of
                       dental applications.

                       In addition to its over-the-counter applications,
                       Zilactin(R) is being used by dentists to treat patients
                       with canker sores and other oral mucosal ulcers or
                       lesions, and has been evaluated in dental schools at
                       selected major universities. Zilactin(R) was originally
                       developed as a treatment for herpes virus lesions. The
                       most common form is Herpes Simplex Type I, which is the
                       cause of fever blisters and cold sores. Herpes Simplex
                       Type II is the cause of genital herpes. Other types of
                       herpes infections include chicken pox, shingles (herpes
                       zoster), mononucleosis and the Epstein-Barr Virus.
                       Depending principally on the availability of resources,
                       the Company may explore the development of new products,
                       including the addition of other medications into the
                       Zilactin(R) vehicle, and/or the approval of existing
                       products as recognized treatments for Type II herpes and
                       such other viruses. However, the Company currently does
                       not market Zilactin(R) as a treatment for genital herpes
                       or shingles.

                       The Company believes that superior efficacy and targeted
                       marketing efforts are the reason that three independent
                       pharmacist research studies reported that Zilactin(R) is
                       the number one OTC product pharmacists recommend for
                       treating canker sores and cold sores.

- Peridex(R)           Peridex(R) is a prescription antibacterial oral rinse
                       used between dental visits as part of a  professional
                       program for the treatment of gingivitis. The active
                       ingredient in Peridex(R) is 0.12% chloride glucomate.
                       Peridex(R) was the first rinse to receive the  American
                       Dental  Association seal   for   reduction   of   plaque
                       and    gingivitis. Peridex(R) effectively    controls
                       the   oral   bacteria associated with periodontal
                       disease,  particularly in the first and only completely
                       reversible stage,  gingivitis. Controlling   gum  disease
                       at  its  earliest   stage  is important  because,  if
                       left  untreated,  gingivitis  can progress to
                       periodontitis,  resulting in  destruction of the
                       periodontal   structure  and  supporting  bone.  The
                       Company acquired the Peridex(R) product  line from
                       Procter & Gamble on November 5, 1997 for $12.0  million
                       plus the value of acquired inventory.

- OraTest(R)           The OraTest(R) product,  a  diagnostic  adjunct  for oral
                       cancer  and site  delineation  for  biopsy  and  surgical
                       excision,  has  been  approved  for  distribution  in the
                       United Kingdom, Canada,  Australia, New Zealand, Hungary,
                       Taiwan, Belgium,  Holland,  Luxembourg,  Finland, Greece,
                       Portugal,   Bermuda  and  the  Bahamas.  The  Company  is
                       currently seeking  government  approval from the Food and
                       Drug   Administration   (the  "FDA")  to  distribute  the
                       OraTest(R) product   in   the    United    States.    The
                       OraTest(R) product continues to be marketed under the
                       name OraScreen(R) in  the  U.K.  by  the  Company's
                       licensee, Stafford-Miller (a division of Block Drug
                       Company,  Inc.) and under the name  OraScan  in Canada by
                       the  Germiphene Corporation.  The Company  will market
                       the product  under the OraTest(R) name in the U.S. and
                       other countries.

                                       -2-
<PAGE>   5
                       According to the American Cancer Society, 41,400 new
                       oral, nasopharyngeal and laryngeal cancers will be
                       diagnosed and 12,300 oral cancer related deaths will
                       occur in the U.S. this year. Worldwide, nearly 900,000
                       new cases of oral cancer occurred in 1996, and incidence
                       and mortality rates are rising. In most people, by the
                       time it is diagnosed, oral cancer has usually
                       metastasized, resulting in a poor prognosis. Those who do
                       survive frequently undergo significantly disfiguring
                       surgery. Data published in 1994 by a major dental
                       publication quotes a Harvard University economist as
                       stating that the annual cost of treating oral cancer in
                       the United States is $3.7 billion. The economist further
                       states that OraTest(R) has the potential of reducing this
                       cost by approximately 60% because of the product's
                       ability to identify oral cancer lesions far earlier than
                       they are being found today. The earlier these lesions are
                       identified, the greater the chances of reducing morbidity
                       and mortality.

PROFESSIONAL PRODUCTS GROUP

- Dental Supplies      Zila Dental Supply is a national distributor of
                       professional dental supplies, carrying brand names such
                       as Eastman Kodak, Dentsply, Sybron/Kerr and 3M. Most of
                       Zila Dental Supply's sales are through telemarketing,
                       outside sales force and direct mail.

                       Zila Dental Supply distributes consumable supplies and
                       very small equipment as well as a select group of large
                       items of dental equipment, such as compressors,
                       sterilizers, dental lights and chairs in certain
                       geographical markets and represents the products of over
                       400 dental manufacturers. The Company believes that these
                       products constitute the vast majority of supplies used in
                       the day-to-day operations of a dental practice. For
                       example, Zila Dental Supply carries a broad line of
                       dental alloys, x-ray film, composite filling materials,
                       impression materials, latex gloves, diamond and carbide
                       cutting instruments, anesthetics, asepsis and infection
                       control products, operative, hygiene and surgical
                       instruments, and a variety of other widely used items. 

                       Dentists have traditionally purchased their supplies from
                       local full-service supply companies, or from mail-order
                       firms. Historically, Zila Dental Supply has operated
                       primarily as a direct mail distributor with full-service
                       operations in certain geographical markets. The mail
                       order operation uses the efficiencies of direct mail and
                       telemarketing to provide service, convenience and
                       competitive prices. The full service operation combines
                       competitive prices with an even higher level of service
                       to the dental customer, usually resulting in a higher
                       level of sales per customer. Zila Dental Supply will
                       continue to provide the benefits of a mail order company
                       while, at the same time, seeking to expand its
                       full-service operations to other geographical markets.

- Intraoral            Cygnus manufacturers and markets intraoral cameras and 
  Cameras and          digital x-ray systems in domestic and international 
  X-Ray Systems        markets.  Cygnus' intraoral camera products include the 
                       OralVision 1000(TM) (for U.S. and Canadian markets),
                       Stylus 1000(TM) (featuring PAL video format for export),
                       and the Stylus 1500(TM). The Stylus 1500(TM) features
                       mirror image, x-ray gray scale, quad freeze frame and
                       image stabilization for tremble-free images. Rounding out
                       the Cygnus camera line are the Stylus 2000(TM), a fully
                       self-contained system, and the Gemini(TM) video
                       management device, which turns any camera into a
                       hands-free, multi-functional diagnostic system. 

                       During fiscal year 1998, Cygnus entered into an agreement
                       with Panasonic Medical and Industrial Video Company,
                       ("Panasonic") the U.S. division of Japan's Matsushita
                       Industrial Equipment Co., Ltd., which gives Cygnus
                       exclusive U.S. rights for Panasonic x-ray sensors for
                       filmless digital dental x-ray technology. CygnusRay2(TM),
                       the first product to result from the new Panasonic
                       relationship, was introduced in February 1998. The system
                       reduces exposure to x-ray energy by up to 95% and
                       eliminates the costly, time-consuming process of
                       developing x-ray film. The CygnusRay2(TM) system gives
                       dentists the ability to diagnose patients on the spot and
                       educate them with the help of on-screen enhancement
                       controls. The system's Panasonic sensors are available in
                       pediatric, standard and bite-wing sizes.

                                       -3-
<PAGE>   6
- PracticeWorks        Integrated Dental Technologies, Inc., located in Rancho
                       Cordova, California, develops and markets
                       PracticeWorks(TM), proprietary, state-of-the-art dental
                       office software. Written to be compatible with the
                       popular Windows and Windows 95 formats, PracticeWorks(TM)
                       helps in improving the operating efficiency of dental
                       practices in areas such as patient scheduling, treatment
                       planning, insurance processing, accounts receivable
                       management, patient charting, and marketing
                       communications. PracticeWorks(TM) is a true 32 bit
                       Windows(R)-based software, and is Year 2000 ready.

NUTRACEUTICAL PRODUCTS GROUP

- Ester-C(R)           Oxycal, located in Prescott, Arizona, manufactures a
                       patented and enhanced form of Vitamin C under the
                       trademark Ester-C(R). Its products are distributed by
                       Inter-Cal Corporation, an Oxycal subsidiary. Products
                       manufactured with Ester-C(R) are sold throughout the U.S.
                       and in 41 countries worldwide. Inter-Cal requires its
                       customers to display the federally-registered Ester-
                       C(R) logo on their packaging. Exciting opportunities for
                       Ester-C(R) exist among topical applications (such as skin
                       creams), chewable vitamins, nutrition bars, sport drinks
                       and food fortification. Oxycal holds two patents on the
                       use of Vitamin C metabolites and their impact on
                       pharmaceutical products as well as nutritional
                       supplements. During fiscal year 1998, Inter-Cal completed
                       development of a new liquid formulation for skin care
                       products - Ester-C(R) Topical. This product provides a
                       stable form vitamin C that penetrates to the
                       collagen-producing layers of the skin without chemicals.
                       Ordinary vitamin C is quite unstable in most health and
                       beauty care products and thus cannot provide the benefit
                       of vitamin C to the skin. Ester-C(R)Topical is non-acidic
                       and free of chemical esters.



                                    MARKETING

PHARMACEUTICAL PRODUCTS GROUP

- Strategy for         The Company's Pharmaceutical Products Group employs 
  OTC Products         three strategies to market its OTC products:

                       - Education - educate several key groups of health
                         professionals on the uniqueness and effectiveness of
                         each of the products. Targeted efforts to build
                         awareness of the product line are made by direct
                         mailings and attending medical conventions. During
                         fiscal year 1998, the Company participated in
                         thirty-seven meetings geared to dental, pharmacy and
                         medical professionals. At these meetings, Company
                         representatives have an opportunity to interact with
                         and distribute information to thousands of interested
                         health professionals.

                       - Participation - participate in retailer-driven
                         activities designed to make the OTC products available
                         at more outlets and to offer value to consumers at the
                         retail store level.

                       - Awareness - build consumer awareness of the OTC
                         products through focused efforts like targeted
                         advertising and direct mail sampling.

- Peridex(R)           Peridex(R) is marketed to healthcare professionals and
                       pharmacists with extensive support from ICS, Ltd., a
                       national contract detailing organization. Additionally,
                       detailers call upon the nation's 54 dental and 200
                       hygiene schools, as well as managed care organizations,
                       pharmacists and wholesalers, to reinforce support for
                       Peridex(R) and Zila's other brands.

                                       -4-
<PAGE>   7
- OraTest(R)           After two years of market preparation, Zila's UK
                       licensee, Stafford-Miller Ltd. (a division of Block Drug
                       Company), formally introduced OraTest(R) under the name
                       OraScreen(R)to general practitioners in the UK in April
                       1998. The marketing effort for OraScreen(R) in the UK has
                       been a multilevel strategy designed to educate dentists,
                       specialists and staff on the accuracy of the
                       OraScreen(R) product and the strong benefits of the early
                       detection of oral cancer. Health professionals have
                       become aware of OraScreen(R) through journal advertising
                       and some timely (independently authored) articles on the
                       impact of oral cancer and the benefits of early
                       intervention. The OraTest(R) product continues to be
                       marketed under the OraScan(R) name by the Germiphene
                       Corporation in Canada.

                       The Company has made extensive preparations for the U.S.
                       introduction of the OraTest(R) product. One of the
                       nation's leading dental advertising and marketing firms
                       has already prepared professional advertising and
                       training materials, and consumer education tools. A
                       national detailing force is already in place, and Zila
                       Dental Supply is well equipped to handle national
                       OraTest(R) distribution through direct mail promotion,
                       sophisticated telemarketing, outside sales force, and
                       Internet selling.

PROFESSIONAL PRODUCTS GROUP

                       Both Cygnus and PracticeWorks expend considerable effort
                       educating their distributors about the quality,
                       reliability and features of its products. They both
                       advertise their products through industry publications
                       and direct mail and exhibit their products at industry
                       trade shows. In addition, Cygnus and PracticeWorks seek
                       to stimulate interest in their products by providing
                       information and marketing materials to influential and
                       prominent experts and consultants in the dental industry.
                       Zila Dental Supply markets its products directly to the
                       end user primarily by direct mail, outside sales force,
                       trade shows and telemarketing.

NUTRACEUTICAL PRODUCTS GROUP

                       Oxycal's manufacturing and marketing division, Inter-Cal
                       Corporation, supports education and sales of its
                       value-added vitamin C products with a multi-million
                       dollar advertising program. Inter-Cal promotes the
                       patented Ester-C(R) ingredient on behalf of more than one
                       hundred manufacturers and marketers of finished
                       Ester-C(R) products. National radio advertising with
                       targeted print advertising is utilized in both the United
                       States and Canada. The advertising is assisting the
                       transition as an industry leading product in natural food
                       outlets to more broad-based availability in mass market
                       and chain stores.

                       Education and promotion to the trade is primarily
                       accomplished through the five national trade shows in the
                       U.S. and Canada. Print advertising in trade journals is
                       also used.

                       International sales activity in the forty other
                       territories is managed by the local distributors and
                       encouraged by advertising assistance and rebate programs.
                       Some corporate sponsored public relations and advertising
                       is done in the U.K.



                            MANUFACTURING AND SUPPLY

PHARMACEUTICAL PRODUCTS GROUP

                       The Company employs a network of outside manufacturers to
                       produce and package all of its products within the
                       Pharmaceutical Products Group. The following is a
                       breakdown by product line.

                                       -5-
<PAGE>   8
- Zilactin(R)          Arizona Natural Resources of Phoenix, Arizona
                       manufactures the Zilactin(R) line of products, and
                       Clinipad Corporation ("Clinipad") of Charlotte, North
                       Carolina manufactures all Zilactin(R) sample packets. The
                       Company places orders with each supplier based on its
                       anticipated needs for the products. Packaging components
                       are supplied to each manufacturer by the Company.
                       Secondary suppliers are maintained as alternate supply
                       sources, and are an integral part of the Company's
                       strategy to maintain its product pipeline.

- Peridex(R)           Peridex(R) was manufactured by Procter & Gamble through
                       June 1998. Accupac of Mainland, Pennsylvania is currently
                       seeking FDA clearance to manufacture Peridex(R). Once
                       accepted, Accupac will become the primary manufacturer of
                       Peridex(R). The Company believes it has sufficient
                       inventory of Peridex(R) to fulfill all orders until
                       Accupac receives FDA clearance.

- OraTest(R)           Fleet Laboratories Ltd. of Watford, Herts, United
                       Kingdom, ("Fleet") produces and packages the
                       OraTest(R) product under the name OraScreen(R) for
                       distribution in the UK by the Company's licensee,
                       Stafford-Miller Ltd. (a division of Block Drug Company,
                       Inc.). Fleet also manufactures the OraTest(R) product for
                       sale to other countries including Taiwan. Germiphene
                       Corporation of Brantford, Ontario, Canada, continues to
                       produce and package the OraScan(R) product at its
                       facility. The Company has also identified a US-based
                       company with the capacity to manufacture the
                       OraTest(R) kits. 

                       In order to ensure an available and stable supply of
                       Tolonium Chloride, the world's only pharmaceutical grade
                       toluidine blue, the active ingredient in the OraTest(R)
                       product, the Company established its own manufacturing
                       facility. The FDA has visited the facility and will
                       return prior to final approval of the OraTest(R) product.
                       Several test batches of toluidine blue have already been
                       manufactured at the Company's facility and all have met
                       the specifications given by the FDA with regard to the
                       finished active ingredient. In preparation for the U.S.
                       marketing of the OraTest(R) product and increasing global
                       sales, the Company is expanding its Phoenix manufacturing
                       facility with the addition of a second production line.

PROFESSIONAL PRODUCTS GROUP

                       Products distributed by Zila Dental Supply are
                       manufactured by over 400 dental manufacturers. The
                       Company's intraoral cameras are manufactured by Cygnus
                       at its Scottsdale, Arizona facility and the
                       CygnusRay2(TM) is manufactured by Panasonic.

NUTRACEUTICAL PRODUCTS GROUP

                       All products within the Nutraceutical Products Group are
                       manufactured at Oxycal's Prescott, Arizona location.



                                   COMPETITION

PHARMACEUTICAL PRODUCTS GROUP

                       All industries in which the Company sells its products
                       are highly competitive. A number of companies, almost all
                       of which have greater financial resources, marketing
                       capabilities and research and development capacities than
                       the Company, are actively engaged in the development of
                       products that may compete with the Company's products.
                       The pharmaceutical industry is characterized by extensive
                       and ongoing research efforts which may result in
                       development by other companies of products comparable or
                       superior to any that are now on the market, including
                       those sold by the Company.

                                       -6-
<PAGE>   9
- Zilactin(R)          Numerous products exist for treatment of herpes simplex
                       virus I ("HSV I") symptoms (i.e., cold sores, fever
                       blisters), including the following products: Orajel and
                       Tanac by Commerce Drug Company, Herpicin-L by Campbell
                       Laboratories, Inc., Proxigel by Reed and Carnrick, and
                       Carmex by Carma Lab, Inc. Although there can be no
                       assurance in this regard, management of the Company
                       believes that there is a substantial potential demand for
                       products that are effective in the treatment of these
                       conditions. The Company does not believe that any of
                       these treatments have achieved a dominant market share.
                       Based upon clinical studies and comments received by the
                       Company from physicians and dentists, management believes
                       that its products will be able to meet much of that
                       demand and that Zilactin(R), Zilactin(R)-B and
                       Zilactin(R)-L will provide more effective symptomatic
                       relief of HSV I infections than the treatments of the
                       Company's competitors.

- Peridex(R)           Peridex(R)competitors include generic versions and name
                       brands such as Periogard, made by Colgate Oral
                       Pharmaceuticals. Many of the competitors possess greater
                       financial resources than the Company. However, the
                       Company believes that Peridex's(R)reputation as the "gold
                       standard" of prescription antibacterial oral rinse and
                       the detailing sales force will allow the Company to
                       compete effectively in the marketplace.

- OraTest(R)           OraTest(R), which the Company believes to be the world's
                       first commercial oral cancer detection system, was
                       introduced in Canada in May 1993, in Australia in 1993
                       and in the UK in April 1998. In April 1998, regulatory
                       approvals were obtained in Portugal, Belgium, Luxembourg,
                       Holland, Finland and Greece. The OraTest(R) product will
                       be distributed by the Company in those countries not
                       covered in the license agreement with Stafford-Miller.

                       Zila(R) Tolonium Chloride is the active ingredient in the
                       Company's oral cancer detection system, OraTest(R).
                       Zila(R) Tolonium Chloride is the world's only
                       pharmaceutical grade toluidine blue, produced in
                       compliance with stringent FDA Good Manufacturing
                       Practices ("GMP") regulations. Zila(R) Tolonium Chloride
                       and its technology are protected by issued and pending
                       patents. See also "Business -- Patents and Trademarks."

PROFESSIONAL PRODUCTS GROUP

- Dental Supply        Zila Dental Supply competes with approximately 200 dental
                       supply dealers and mail order supply houses in the United
                       States, some of which have significantly greater
                       financial resources than the Company. Zila Dental
                       Supply's sales make up less than 2% of the total domestic
                       market for dental supplies. Zila Dental Supply's position
                       with respect to its competitors is difficult to determine
                       since most of the companies are privately-held and do not
                       disclose financial information. However, the Company
                       believes that approximately 50 percent of the market is
                       dominated by two public companies: Patterson Dental
                       Company and Henry Schein, Inc., both of which are very
                       active in the acquisition market in an effort to gain
                       market share.

- PracticeWorks        There are many companies marketing dental practice
                       management software with the major competitors to
                       PracticeWorks being Dentrix, sold by Henry Schein, Inc.,
                       EagleSoft, owned by Patterson Dental Company and
                       SoftDent, purchased by Dentsply New Image. All of these
                       companies possess greater financial resources than the
                       Company. However, the Company believes that
                       PracticeWorks' unique product features, expanded selling
                       organization and increasingly experienced support staff
                       make it well positioned to compete with these larger
                       competitors.

- Intraoral            Cygnus' competitors in both the intraoral camera and 
  Cameras and          digital x-ray markets include Dentsply New Image, Schick
  X-ray Systems        Technologies, Henry Schein, Inc., Trophy Radiology, and
                       Welch Allyn Dental Systems. Many of these companies
                       possess greater financial resources than the Company.
                       However, the Company believes that with the unique
                       features of Cygnus' products, its manufacturing expertise
                       and commitment to product development, Cygnus is well
                       positioned to compete with these larger competitors.

NUTRACEUTICAL PRODUCTS GROUP

                                      -7-
<PAGE>   10
- Ester-C              Within the vitamin C market, the Company's competitors
                       include all other vitamin C manufacturers, such as
                       Roche and Takeda. Many of the Company's competitors,
                       particularly those in markets other than the health food
                       and vitamin store market, have substantially greater
                       financial and other resources than the Company. The
                       Company believes that the growing number of health food
                       and vitamin distributors and retailers are increasingly
                       likely to align themselves with producers that offer a
                       wide variety of high quality products, have a loyal
                       customer base, support their brands with strong marketing
                       and advertising programs and provide consistently high
                       levels of customer service. The Company believes that it
                       competes favorably with other producers of vitamin C
                       because of the positive attributes of its Ester-C
                       product, high customer-order fill rate, strong
                       distribution network, and advertising and promotional
                       support.



                                    LICENSING

PHARMACEUTICAL PRODUCTS GROUP

                       In certain instances the Company has expanded the
                       distribution of its products by licensing certain of its
                       patents to other companies. In 1990, the Company licensed
                       Bausch & Lomb to distribute the Company's entire oral
                       care line (except for OraTest(R) in markets outside of
                       the United States with the right to use the same names,
                       formulas and packaging used by the Company. Zilactin(R)
                       was introduced by Bausch & Lomb in Canada in January 1991
                       and, under the terms of the licensing agreement, the
                       Company received royalty payments based upon a percentage
                       of the licensed products' net sales. In 1990, the Company
                       and Bausch & Lomb amended this agreement in a manner that
                       limited Bausch & Lomb's distribution rights to Canada.
                       The Company and Bausch & Lomb terminated this agreement
                       effective December 31, 1997. 

                       In 1991, the Company acquired ownership of certain
                       exclusive rights to the patents, technology and process
                       embodying the formulation and the application of the
                       OraTest(R) product. The company is obligated to pay
                       royalties to the National Technical Information Service
                       based upon certain usages of the OraTest(R) product.
                       During the 1995 fiscal year, the Company entered into a
                       licensing agreement pursuant to which Stafford-Miller
                       Ltd. (a division of Block Drug Company, Inc.) ("Block")
                       was given the right to distribute the OraTest(R) product
                       under the name OraScreen(R) in certain markets not
                       previously pursued by the Company. The Company receives
                       royalties from Block equal to a set percentage of the net
                       sales of OraScreen(R) by Block. In April 1998,
                       OraScreen(R) was launched at the British Dental
                       Association ("BDA") meeting held in Harrogate in the
                       United Kingdom. Following this meeting the BDA created
                       and distributed a booklet titled "Guidelines for Early
                       Detection." This booklet outlined the education and
                       application of OraScreen(R) in the dental office head
                       and neck examination. The early results of both training
                       of the dentists and utilization of the product have been
                       positive. Stafford-Miller is expanding from their
                       original three trainers. They are now training their
                       entire sales staff to deal with the backlog. 

                       Subsequent to year-end, the Company entered into a
                       license agreement with Nippon Shoji Kaishi, Ltd. (now
                       known as Azwell, Inc.) to obtain regulatory approval and
                       market the OraTest(R) product in Japan.

                                    GOVERNMENT REGULATIONS

General                The Company's operations are subject to extensive
                       regulation by governmental authorities in the United
                       States and other countries with respect to the testing,
                       approval, manufacture, labeling, marketing and sale of
                       pharmaceutical products. The Company devotes significant
                       time, effort and expense addressing the extensive
                       government regulations applicable to its business, and in
                       general, the trend is towards more stringent regulation.

                                      -8-
<PAGE>   11
                       On an ongoing basis, the FDA reviews the safety and
                       efficacy of marketed pharmaceutical products and monitors
                       labeling, advertising and other matters related to the
                       promotion of such products. The FDA also regulates the
                       facilities and procedures used to manufacture
                       pharmaceutical products in the United States or for sale
                       in the United States. Such facilities must be registered
                       with the FDA and all products made in such facilities
                       must be manufactured in accordance with "good
                       manufacturing practices" established by the FDA.
                       Compliance with good manufacturing practices guidelines
                       requires the dedication of substantial resources and
                       requires significant costs. The FDA periodically inspects
                       the Company's contract manufacturing facilities and
                       procedures to assure compliance. The FDA may cause a
                       recall or withdraw product approvals if regulatory
                       standards are not maintained. FDA approval to manufacture
                       a drug is site specific. In the event an approved
                       manufacturing facility for a particular drug becomes
                       inoperable, obtaining the required FDA approval to
                       manufacture such drug at a different manufacturing site
                       could result in production delays, which could adversely
                       affect the Company's business and results of operations.

                       In connection with its activities outside the United
                       States, the Company is also subject to regulatory
                       requirements governing the testing, approval,
                       manufacture, labeling, marketing and sale of
                       pharmaceutical products, which requirements vary from
                       country to country. Whether or not FDA approval has been
                       obtained for a product, approval of the product by
                       comparable regulatory authorities of foreign countries
                       must be obtained prior to marketing the product in those
                       countries. The approval process may be more or less
                       rigorous from country to country, and the time required
                       for approval may be longer or shorter than that required
                       in the United States. No assurance can be given that
                       clinical studies conducted outside of any country will be
                       accepted by such country, and the approval of any
                       pharmaceutical product in one country does not assure
                       that such product will be approved in another country.
                       The Company is also subject to worldwide governmental
                       regulations and controls relating to product safety,
                       efficacy, packaging, labeling and distribution. While not
                       all of the products which the Company plans to introduce
                       into the market are "new drugs" or "new devices," those
                       fitting the regulatory definitions are subject to a
                       stringent premarket approval process in most countries.
                       Submission of a substantial amount of preclinical and
                       clinical information prior to market introduction
                       significantly increases the amount of time and related
                       costs incurred for preparing such products for market.

                       The federal and state governments in the United States,
                       as well as many foreign governments, from time to time
                       explore ways to reduce medical care costs through health
                       care reform. These efforts have resulted in, among other
                       things, government policies that encourage the use of
                       generic drugs rather than brand name drugs to reduce drug
                       reimbursement costs. Virtually every state in the United
                       States has a generic substitution law which permits the
                       dispensing pharmacist to substitute a generic drug for
                       the prescribed brand name product. The debate to reform
                       the United States' health care system is expected to be
                       protracted and intense. Due to uncertainties regarding
                       the ultimate features of reform initiatives and their
                       enactment and implementation, the Company cannot predict
                       what impact any reform proposal ultimately adopted may
                       have on the pharmaceutical industry or on the business or
                       operating results of its pharmaceutical products group.

                       The Company submits data to the Food and Drug
                       Administration as necessary in response to the ongoing
                       monograph review of the safety and efficacy of all
                       over-the-counter drug products marketed in the U.S. As a
                       responsible manufacturer, the Company is alert to the
                       possibility that the final monographs to be issued in the
                       foreseeable future may require formula modifications of
                       certain of its products to maintain compliance with these
                       regulations, a possibility facing competitive products as
                       well. 

                       Manufacturing companies, especially those engaged in
                       health care related fields, are subject to a wide range
                       of federal, state and local laws and regulations. Concern
                       for maintaining compliance with federal, state, local and
                       foreign regulations on environmental protection,
                       hazardous waste management, occupational safety and
                       industrial hygiene has also increased substantially. The
                       Company cannot predict what additional legislation or
                       governmental action, if any, will be enacted or taken
                       with respect to the above matters and what its effect, if
                       any, will be on the Company's consolidated financial
                       position, results of operations or cash flows.

                                      -9-
<PAGE>   12
- Zilactin(R)          Zilactin(R)is marketed by the Company as a treatment for
                       the symptomatic relief of canker sores (oral mucosal
                       ulcers and lesions), cold sores and fever blisters. The
                       Company is not required to file a New Drug Application
                       ("NDA") covering these uses of Zilactin(R); however, the
                       Company may not market Zilactin(R)as a treatment of
                       genital herpes or shingles unless NDAs for such purposes
                       are filed and approved. 

                       The FDA's regulation of most of the over-the-counter drug
                       products in the United States (such as Zila's
                       Zilactin(R)family of products) has not been finalized. In
                       addition, the Federal Trade Commission ("FTC")
                       continually monitors the advertising practices of
                       consumer products companies with respect to claims made
                       relating to product functionality and efficacy.

- OraTest(R)           In 1994, the FDA approved an Investigational New Drug
                       application ("IND") for the Company's OraTest(R) product.
                       This approval is the first step in securing an NDA which
                       will enable the Company to market Oratest(R) in the
                       United States and allow the Company to manufacture the
                       product domestically for use in clinical studies and to
                       market it in 21 countries overseas. In response to the
                       FDA's requests for more information, the New Drug
                       Application ("NDA") has been resubmitted with updated
                       chemistry and manufacturing information and subsequently
                       more detailed clinical data. The Company is still
                       awaiting final approval from the FDA.

                       The company received regulatory approval to market the
                       OraTest(R)product in Australia in 1993. Approval to
                       market the OraTest(R)product in certain Caribbean
                       countries, Hungary and Taiwan has also been received. The
                       Medicines Control Agency ("MCA"), which is the regulatory
                       authority in the UK, has also granted approval for the
                       OraTest(R) product to be marketed in the UK under the
                       name OraScreen(R).

                       In January 1998, Zila submitted a Mutual Recognition
                       Procedure ("MRP") application through the MCA for
                       regulatory approval of OraScreen(R)in the European Union
                       ("EU"). In April 1998, Belgium, the Netherlands,
                       Luxembourg, Portugal, Finland and Greece were given
                       regulatory approval through this application. Zila has
                       also received licenses to sell in Greece, Luxembourg and
                       the Netherlands and is finalizing the license procedure
                       for the remaining EU member nations. The Company is
                       following up as the procedure warrants with all of the
                       remaining countries.

- Ester-C(R)           During 1995, Oxycal received an inquiry from the Federal
                       Trade Commission ("FTC") regarding certain product claims
                       made in Oxycal's advertising. This inquiry was based on
                       claims made prior to the Company's acquisition of Oxycal.
                       In December 1997, Oxycal was notified by the FTC that the
                       investigation regarding product claims made in Oxycal's
                       advertising had been closed, as Oxycal had previously
                       stopped advertising the claims in question.

                                      -10-
<PAGE>   13
                             PATENTS AND TRADEMARKS


- Zilactin(R)          The Company currently holds three US patents and two
                       Canadian patents for Zilactin(R). The Zilactin(R) formula
                       was granted a US patent on August 25, 1981, a US patent
                       covering extended applications of the basic
                       Zilactin(R) formula was granted on April 26, 1983, and a
                       US patent covering the film-forming properties of the
                       Zilactin(R) formula containing an added medicinal
                       ingredient was issued on January 14, 1992. Such patents
                       were granted for periods of seventeen years from the
                       grant dates and give the Company the right to exclude
                       others from making, using or selling the patent-protected
                       products in the United States. The Canadian patent, which
                       covers the composition and extended applications, was
                       granted on December 3, 1985. Patent applications are
                       currently pending in numerous foreign countries and
                       patents are expected to be issued on these applications
                       in the near future. 

                       The Company registered the trademark Zilactin(R) with the
                       United States Patent and Trademark Office effective July
                       9, 1985. The Company has also registered the trademarks
                       "Zila(R)", Zilactin(R)-B, and Zilactin(R)-L in the United
                       States. The Company believes that widespread use of the
                       "Zila(R)" trademark as a dominant prefix to several
                       product names will afford reasonable protection for the
                       "Zila(R)" trademark as well as other marks in which
                       "Zila(R)" is a dominant prefix. The Company is also
                       taking steps under applicable international treaties to
                       register the "Zila(R)" trademark. The names "Zila(R)" and
                       Zilactin(R) are registered in Canada.

- Peridex(R)           Peridex(R) as a brand name has become the "gold standard"
                       within the dental industry for prescription oral rinses
                       in both the U.S. and Canada. Concurrent with the purchase
                       of the Peridex(R) brand from Procter & Gamble, Zila
                       Pharmaceuticals purchased the trademark rights to
                       Peridex(R). Accordingly, Procter & Gamble has assigned
                       the Peridex(R) trademark to the Company for each country
                       where it has been previously registered, except for
                       certain countries in Western Europe. The Company recorded
                       its trademark assignment for Peridex(R) with the U.S.
                       Patent and Trademark office on June 26, 1998 and with the
                       Canadian Registrar of Trademarks on July 3, 1998.
                       Additionally, the Company is in the process of recording
                       trademark assignments in other countries where the
                       Peridex(R) trademark had been previously registered by
                       Procter & Gamble. As international sales opportunities
                       continue to develop, the Company intends to register the
                       Peridex(R) trademark in countries where it has not been
                       previously registered.

- OraTest(R)           The Company has patents pending on Zila(R) Tolonium
                       Chloride (the active ingredient of the OraTest(R)
                       product), and its manufacturing process in both the U.S.
                       and internationally under "PCT" and "convention"
                       applications throughout the world.

                       The Company registered the trademark OraTest(R) with the
                       United States Patent and Trademark office effective June
                       19, 1998. The Company is marketing OraTest(R) under the
                       name OraScreen(R) in the UK and as a result has
                       registered OraScreen(R) as a trademark in the EU. The
                       Company has selected the name OraTest(R) when the product
                       is introduced in the United States and other countries.
                       The Company registered the trademarks OraTest(R) and
                       OraScreen(R) in Canada on May 22, 1998. The Company is in
                       the process of being protected through trademarks in all
                       countries where the product is planned for introduction.

- Ester-C(R)           Three U.S. patents were issued in connection with
                       Ester-C(R), in 1989, 1990 and 1992. All three patents
                       expire in the year 2006. The first patent covers
                       compositions for administering vitamin C. Ester-C(R) is
                       the only vitamin C on the market that contains theonate
                       and other C metabolites. The second and third patents
                       cover the metabolite technology which improved the
                       absorption of vitamin C from the Ester-C(R) formulation
                       and is applicable to a wide variety of other
                       non-prescription and prescription drugs. Oxycal has filed
                       and is currently pursuing corresponding patent
                       applications in all major foreign countries. Most patents
                       have already been issued on these foreign applications
                       and remainder are being diligently pursued. 

                       Recently Oxycal developed Ester-C(C) Topical Concentrate,
                       a stable form of vitamin C that penetrates the skin to
                       help produce collagen and supporting structures. Oxycal
                       has filed a patent application for the Ester-C(C) Topical
                       Concentrate product and method of manufacturing. 

                       The Company has three major and several minor trademarks
                       issued by the United States Patent and Trademark office
                       in the United States. The Ester-C(R) trademark was issued
                       in August 1985; the EC(R) logo trademark was issued in
                       January 1990; and the CV-Flex(R) trademark was issued in
                       August 1990. The Company also has trademarks issued in 36
                       foreign countries with trademarks pending in other
                       countries.


                                      -11-
<PAGE>   14
                                    EMPLOYEES

         As of July 31, 1998, the Company and its operating subsidiaries had 212
employees in the following categories:

            Categories                      Number of Employees
-----------------------------------      -------------------------
        Executive Officers                           6
               Sales                                66
   Accounting and Administration                    69
    Purchasing and Distribution                     32
           Manufacturing                            39

         No employees are represented by a labor union, nor are there any
current labor relations complaints on file with any agency. The Company believes
its relationship with its employees is good.



                CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS

           This discussion is provided as permitted by the Private Securities
Litigation Reform Act of 1995. 

- Forward-             The disclosure and analysis in this report and in the 
  Looking              Company's 1998 Annual Report to Shareholders contain 
  Statements           some forward-looking statements. Forward-looking
                       statements give the Company's current expectations or
                       forecasts of future events, and may be identified by the
                       fact that they do not relate strictly to historical or
                       current facts. In particular, forward-looking statements
                       include statements relating to future actions,
                       prospective products or product approvals, future
                       performance or results of current and anticipated
                       products, sales efforts, expenses, the outcome of
                       contingencies such as legal proceedings, and financial
                       results. Many factors discussed in Part I of this report,
                       for example government regulation, competition, and the
                       supply of raw materials, will be important in determining
                       future results.

                       Any or all forward-looking statements in this report, in
                       the 1998 Annual Report to Shareholders, and in any other
                       public statements may turn out to be wrong. They can be
                       affected by inaccurate assumptions or by known or unknown
                       uncertainties. No forward-looking statement can be
                       guaranteed, and actual results may differ materially.

                       The Company undertakes no obligation to publicly update
                       forward-looking statements. Shareholders are advised to
                       consult further disclosures on related subjects in the
                       Company's other reports to the SEC. The following
                       cautionary discussion of risks, uncertainties and
                       possible inaccurate assumptions are factors that the
                       Company's management believes could cause actual results
                       to differ materially from expected and historical
                       results. Factors other than those included below could
                       also adversely affect the Company's business results.

- Uncertainties of     The rigorous clinical testing and an extensive regulatory
  Regulatory           approval process mandated by the FDA and equivalent
  Approval             foreign authorities before the Company can market any
                       drug can take a number of years and require the
                       expenditure of substantial resources. Obtaining such
                       approvals and completing such testing is a costly and
                       time consuming process, and approval may not be
                       ultimately obtained. The length of the FDA review period
                       varies considerably, as does the amount of clinical data
                       required to demonstrate the safety and efficacy of a
                       specific product. The Company may also decide to replace
                       the compounds in testing with modified or optimized
                       compounds, thus extending the testing process. In
                       addition, delays or rejections may be encountered based
                       upon changes in FDA policy during the period of product
                       development and FDA regulatory review of each submitted
                       new drug application or product license application.
                       Similar delays may also be encountered in other
                       countries. There can be no assurance that even after such
                       time and expenditures, regulatory approval will be
                       obtained for any products developed by the Company.

                                      -12-
<PAGE>   15
                       A marketed product, its manufacturer and its
                       manufacturing facilities are also subject to continual
                       review and periodic inspections, and later discovery of
                       previously unknown problems with a product, manufacturer
                       or facility may result in restrictions on such product or
                       manufacturer, potentially including withdrawal of the
                       product from the market.

- Introduction of      Zila has not yet received final FDA approval for 
  OraTest(R) In the    OraTest(R). As of July 31, 1998, Zila has  
  United States        invested approximately $6.0 million in the
                       development of OraTest(R) and has also made a 
                       significant financial investment to secure FDA
                       approval of OraTest(R) and to prepare for the
                       introduction of OraTest(R) to the United States market.
                       The failure of the FDA to approve OraTest(R) would make
                       it impossible for Zila to recoup this investment through
                       sales of OraTest(R) in the United States. If regulatory
                       approval is granted, such approval may entail limitations
                       on the indicated uses for which the product may be
                       marketed. Further, even if such regulatory approval is
                       obtained, the FDA will require post-marketing reporting,
                       and may require surveillance programs to monitor the
                       usage or side effects of OraTest(R). 

                       If FDA approval of OraTest(R) is received, the Company
                       must establish a marketing and sales force with technical
                       expertise to market directly to the dental professional
                       or it must obtain the assistance of a pharmaceutical
                       company with a large sales force. It is possible that the
                       Company might not be successful in gaining market
                       acceptance of OraTest(R).

- Dependence on        A large percentage of the Company's revenues result from
  Key Products         sales of Ester-C, Peridex(R), and the Zilactin(R) family
                       of products. If any of these major products were to
                       become subject to a problem such as loss of patent
                       protection, unexpected side effects, regulatory
                       proceedings, publicity affecting user confidence, or
                       pressure from competing products, or if a new, more
                       effective treatment should be introduced, the impact on
                       the Company's revenues could be significant.

- Possible Claims      The Company could be exposed to possible claims for 
  Relating to          personal injury resulting from allegedly  defective
  Products             products manufactured by third parties with which it has
                       entered into manufacturing  agreements. The
                       Company maintains product liability insurance coverage
                       for claims arising from the use of all its products.
                       However, the Company could be subject to product
                       liability claims in excess of its insurance coverage. Any
                       significant product liability claims not within the scope
                       of the Company's insurance coverage could have a material
                       adverse effect on the Company. 

- Competition;         The pharmaceutical industry is highly competitive. A 
  Research and         number of companies, many of which  have greater
  Development          financial resources, marketing capabilities and research
                       and development capacities than the Company, are actively
                       engaged in the development of products similar to those
                       products produced and marketed by the Company. The
                       pharmaceutical industry is characterized by extensive and
                       ongoing research efforts. Other companies may succeed in
                       developing products superior to those marketed by the
                       Company. Such companies may even succeed in developing a
                       cure for herpes simplex virus, which would substantially
                       reduce the potential market for symptomatic treatments
                       such as Zilactin(R). In addition, Zila Dental Supply
                       faces significant competition, primarily from a various
                       number of dental supply dealers and mail order supply
                       houses in the United States. PracticeWorks and Cygnus
                       also face significant competition from providers of
                       dental practice management software and intra-oral camera
                       systems. Many of the competing providers of these
                       products have significantly greater market share and
                       financial resources than PracticeWorks and Cygnus. In
                       addition, new competitors may enter into PracticeWorks'
                       markets from time to time. It may be difficult for
                       PracticeWorks and Cygnus to maintain or increase sales
                       volume and market share due to such competition.

- Generic              In the U.S., competition with producers of generic 
  Competition          products is a major challenge. The Company's loss of any
                       of its product's patent protection could leads to a
                       dramatic loss in sales of the product in the U.S. market.

                                      -13-
<PAGE>   16
- Dependence on        Zila relies on a combination of patent, copyright, 
  Proprietary          trademark and trade secret protection, nondisclosure 
  Rights               agreements and licensing arrangements to establish and 
                       protect its proprietary rights. Zila owns and has
                       exclusive licenses to a number of United States and
                       foreign patents and patent applications, and intends to
                       seek additional patent applications as it deems
                       appropriate. Whether patents will issue from any of these
                       pending applications or, if patents do issue, that any
                       claims allowed will be sufficiently broad to cover Zila's
                       products or to effectively limit competition against Zila
                       is uncertain. Furthermore, any patents that may be issued
                       to Zila may be challenged, invalidated or circumvented.
                       Litigation may result from the Company's use of
                       registered trademarks or common law marks and, if
                       litigation against Zila were successful, a resulting loss
                       of the right to use a trademark could reduce sales of
                       Zila's products and could result in a significant damages
                       award. Although Zila intends to defend the proprietary
                       rights, policing unauthorized use of proprietary
                       technology and products is difficult. International
                       operations may be affected by changes in intellectual
                       property legal protections and remedies in foreign
                       countries in which in the Company does business.

- Raw Materials        Raw materials essential to the Company's business are
                       generally readily available. However, certain raw
                       materials and components used in the manufacture of the
                       pharmaceutical products are available from limited
                       sources, and in some cases, a single source. Any
                       curtailment in the availability of such raw materials
                       could be accompanied by production delays, and in the
                       case of products for which only one raw material supplier
                       exists, could result in a material loss of sales. In
                       addition, because raw material sources for pharmaceutical
                       products must generally be approved by regulatory
                       authorities, changes in raw material suppliers could
                       result in production delays, higher raw material costs
                       and loss of sales and customers.

- Future Capital       The development of the Company's products will require 
  Requirements         the commitment of substantial  resources to conduct the 
  and Uncertainty      time-consuming research and development, clinical 
  of Future            studies and  regulatory activities necessary to bring 
  Funding              any potential product to market and to establish
                       production, marketing and sales capabilities. The Company
                       may need to raise substantial additional funds for these
                       purposes. The Company may seek such additional funding
                       through collaborative arrangements and through public or
                       private financings. The inability to obtain sufficient
                       funds may require the Company to delay, scale back or
                       eliminate some or all of its research and product
                       development programs, to limit the marketing of its
                       products or to license third parties the rights to
                       commercialize products or technologies that the Company
                       would otherwise seek to develop and market itself.

- Possible             The market price for Common Stock has fluctuated 
  Volatility of        significantly in the past. Management of  Zila believes 
  Common Stock         that such fluctuations may have been caused by 
  Price                announcements of new products, quarterly fluctuations 
                       in the results of operations and other factors, including
                       changes in conditions of the pharmaceutical industry in
                       general. Stock markets have experienced extreme price
                       volatility in recent years. This volatility has had a
                       substantial effect on the market prices of securities
                       issued by Zila and other pharmaceutical and health care
                       companies, often for reasons unrelated to the operating
                       performance of the specific companies. Zila anticipates
                       that the market price for Common Stock may continue to be
                       volatile.

- Issuance of          The Company's Board of Directors has the authority, 
  Preferred Stock      without any further vote by the Company's stockholders,
                       to issue up to 2,500,000 shares of Preferred Stock in one
                       or more series and to determine the designations, powers,
                       preferences and relative, participating, optional or
                       other rights thereof, including without limitation, the
                       dividend rate (and whether dividends are cumulative),
                       conversion rights, voting rights, rights and terms of
                       redemption, redemption price and liquidation preference.
                       On October 17, 1997, the Company issued 30,000 shares of
                       its Series A Convertible Preferred Stock as well as
                       warrants to purchase 360,000 shares of common stock to
                       various investors for consideration of $30.0 million. As
                       of July 31, 1998, 1,200 shares of the Series A Preferred
                       Stock have been converted into shares of the Company's
                       common stock.

                                      -14-
<PAGE>   17
                       The Preferred Stock is convertible into shares of the
                       Company's common stock at a conversion rate based on the
                       price of such common stock at the date of issuance.
                       However, if the market price of the Company's common
                       stock does not appreciate by a fixed percentage at
                       various measurement dates, the holders of the Preferred
                       Stock have the right to receive additional shares of the
                       Company's common stock upon conversion, based on a
                       repricing formula. Per guidance from the Emerging Issues
                       Task Force, the intrinsic value of the beneficial
                       conversion feature of the Preferred Stock has been
                       measured and recognized as an embedded dividend and such
                       non-cash embedded dividend has been deducted from net
                       income in the accompanying consolidated statement of
                       operations to arrive at the amount of net income
                       available to common shareholders. Additionally, because
                       the Preferred Stock has conditions for redemption that
                       are not solely within the control of the Company, it has
                       been classified outside of permanent equity in the
                       accompanying consolidated balance sheet and has been
                       accredited to its redemption value.

- Environment          The Company is subject to federal, state and local laws
  and Controlled       and regulations governing the use,  generation, 
  Use of               manufacture, storage, discharge, handling and disposal 
  Hazardous Materials  of certain materials and wastes used in its operations,
                       some of which are classified as "hazardous." The Company
                       could be required to incur significant costs to comply
                       with environmental laws and regulations as its research
                       activities are increased, and the operations, business
                       and future profitability of the Company could be
                       adversely affected by current or future environmental
                       laws and regulations. Although the Company believes that
                       its safety procedures for handling and disposing
                       materials comply with such laws and regulations, the risk
                       of accidental contamination or injury from these
                       materials cannot be eliminated. In the event of such an
                       accident, the Company could be held liable for any
                       damages that result and any such liability could exceed
                       the resources of the Company.

 - Year 2000           The Company is currently working to mitigate
   Compliance          the extent of any "Year 2000" problems that
                       may exist at the Company and may have an effect
                       on its business, but it has not yet completed
                       this evaluation. However, the Company does not expect
                       that the costs to address the problem will be material,
                       and it does not expect that the consequences of
                       incomplete or untimely resolution of the problem
                       will materially impact the operation of its business.
                       The Company has not incurred, and does not expect
                       to incur, any specific quantifiable cost that can
                       be directly and solely related to the Year 2000
                       issue. The Company's PracticeWorks(R) software is
                       programmed in such a manner that it is Year 2000 ready.

                                      -15-
<PAGE>   18
ITEM 2.  PROPERTIES


- Corporate            On January 4, 1991, the Company purchased a 16,000 
  Headquarters         square foot building located at 5227 North Seventh 
                       Street, Phoenix, Arizona 85014-2800. The Company moved
                       its corporate headquarters to this location on February
                       8, 1991. The purchase price of the building was
                       approximately $600,000. The Company paid 25% of the
                       purchase price in cash and obtained a loan for the
                       balance of the purchase price. The Company has refinanced
                       the mortgage with Bank One, Arizona (the "Bank"). The
                       terms of the refinancing include interest to be payable
                       monthly on the unpaid balance at an interest rate of nine
                       percent (9.00%). The refinanced mortgage loan is
                       amortized over 20 years and is due on April 1, 2001.

- Manufacturing        The Company leases 3,502 square feet for a manufacturing
  Facility             facility in Phoenix, Arizona. This facility produces 
                       toluidine blue which will be used in the manufacture of
                       OraTest(R). The facility is leased under a three year
                       agreement which expires April 30, 1999, and is located in
                       an area with property available for expansion. The
                       agreement has an option to renew for an additional five
                       years. Monthly lease payments are $1,922. The Company
                       does not currently intend to invest in any other plants
                       or manufacturing facilities. The Company's products are
                       currently manufactured by Clinipad, Arizona Natural
                       Resources and Germiphene. Together with the Company's
                       laboratory facilities, the Company believes that these
                       manufacturers are capable of performing all necessary
                       production functions. See "Item 1. Business --
                       Manufacturing and Distribution."

- OXYCAL               The Company's Oxycal subsidiary, owns 2.79 Acres and
                       occupies a 27,440 square foot facility located at 533
                       Madison Avenue, Prescott, Arizona 86301. There are no
                       liens on this property. This facility manufactures and
                       distributes a patented and enhanced form of Vitamin C
                       under the trademark Ester-C(r).

- Other                The Company's subsidiaries holds additional leases on
                       five separate facilities. Bio-Dental leases 25,000 square
                       feet of office/warehouse space in a concrete building
                       located at 11291 Sunrise Park Drive, Rancho Cordova,
                       California. The current lease rate for the Rancho Cordova
                       facility is $9,837 per month, and is constant for the
                       duration of the lease. The lease for the Rancho Cordova
                       facility expires on November 30, 2001, however Bio-Dental
                       has an option to renew the lease for two subsequent
                       five-year terms. Bio-Dental's administrative offices are
                       located in the Rancho Cordova facility. Zila Dental
                       Supply leases 19,200 square feet in an office/warehouse
                       complex at 172 Lisle Industrial Avenue, Lexington,
                       Kentucky. The current lease rate is $2,800 per month, and
                       expires on October 31, 1998. On may 31, 1996, IDT entered
                       into a three year lease for 2,000 square feet beginning
                       July 15, 1996 in an office complex at 6021-A West 71st
                       Street, Indianapolis, Indiana. The current lease rate is
                       $1,783 per month, and expires on July 14, 1999.
                       Bio-Dental is a guarantor of this lease. On April 1,
                       1997, Cygnus entered into a five year lease for 6,042
                       square feet of office/warehouse space located at 8240 E.
                       Gelding Suite 101, Scottsdale, Arizona. The current lease
                       rate is $4,048 per month and increases every twelve
                       months with the monthly lease payment to be $4,350 in the
                       final year. Oxycal leases 6,250 square feet of warehouse
                       space located at 8601 E. Laredo, Prescott Valley,
                       Arizona. The facility is leased under a one-year
                       agreement, which expires April 30, 1999. Monthly lease
                       payments are $2,500. This agreement contains two options
                       to renew for one year each, one of which has been used.


ITEM 3.  LEGAL PROCEEDINGS

         In July 1995, one of Zila's subsidiaries, Bio-Dental, was named as a
defendant, along with Bio-Dental's transfer agent and a shareholder of
Bio-Dental ("Shareholder"), in a lawsuit. The lawsuit alleges that Bio-Dental
wrongfully failed to register 200,000 Bio-Dental shares in the name of the
plaintiffs which were pledged as security by the Shareholder for a debt owed by
the Shareholder to the plaintiffs. Bio-Dental denied all of the material
allegations of the lawsuit against it and has asserted various affirmative
defenses. Bio-Dental accrued a liability of $450,000 in September 1996 because
it believed a loss was probable at that time. This amount was Bio-Dental's best
estimate of the loss in the event the outcome of the litigation was unfavorable
to Bio-Dental. In November 1996, Bio-Dental was granted a summary judgment in
which the court ruled in favor of Bio-Dental. In February 1997, the plaintiffs
started the process 

                                      -16-
<PAGE>   19
to appeal the judgment. Subsequently, the appellate court upheld the lower
court's summary judgment in favor of Bio-Dental. Accordingly, Bio-Dental
reversed $375,000 representing the remaining amount of the accrued liability.

         Upon consummation of the Company's merger with Bio-Dental, each of the
outstanding shares of Bio-Dental common stock was converted into .825 shares of
the Company's Common Stock. Subsequent to the merger with Bio-Dental, the
Company's stock transfer agent was presented with a certificate purporting to
represent 220,000 shares of Bio-Dental common stock which did not appear on the
records of Bio-Dental's stock transfer agent as of the closing date. The Company
is currently investigating this matter and has not determined whether any shares
of the Company's common stock are required to be issued in exchange for the
shares purportedly represented by this certificate.

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

         The Company did not submit any matter to a vote of its security holders
during the fourth quarter of the fiscal year covered by this report.

                                      -17-
<PAGE>   20
                                     PART II

ITEM 5.  MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

         Information regarding the market for Zila, Inc.'s common stock (the
"Common Stock") and related stockholder matters is set forth below. The
following table sets forth, for the fiscal periods shown, the high and low
quotations in dollars per share for the Common Stock as reported by the National
Association of Securities Dealers Automated Quotation System ("NASDAQ").

<TABLE>
<CAPTION>
                                                                   HIGH              LOW
                                                                   ----              ---
<S>                                                                <C>              <C>
         FISCAL YEAR ENDED JULY 31, 1998
                        First Quarter                              8 7/8             6
                        Second Quarter                             8                 5 5/8
                        Third Quarter                              8 3/8             7
                        Fourth Quarter                             8 1/4             6 1/4

         FISCAL YEAR ENDED JULY 31, 1997
                        First Quarter                              7 7/8             6 1/4
                        Second Quarter                             8 3/8             6 3/8
                        Third Quarter                              9 3/8             6 7/16
                        Fourth Quarter                             8 1/8             6 7/16
</TABLE>

         The number of stockholders of record of the Common Stock as of July 31,
1998 and September 30, 1998 were approximately 3,344 and 3,351, respectively. As
of July 31, 1998 there are 28,800 shares of the Company's preferred stock
outstanding (See "Item 1 -- Additional Information").

         The Company has not paid dividends on the Common Stock. It is the
present policy of the Company's Board of Directors to retain future earnings to
finance the growth and development of the Company's business. Any future
dividends will be at the discretion of the Company's Board of Directors and will
depend upon the financial condition, capital requirements, earnings and
liquidity of the Company as well as other factors the Company's Board of
Directors may deem relevant.

ITEM 6.  SELECTED FINANCIAL DATA

         The following tables summarize selected financial information derived
from the Company's audited financial statements. The information set forth below
is not necessarily indicative of results of future operations and should be read
in conjunction with the Company's Consolidated Financial Statements and related
Notes and with "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
                                                                  Fiscal Year Ended July 31
                                        --------------------------------------------------------------------------------
Statement of Operations Data                    1998(1)          1997             1996             1995             1994
                                                ----             ----             ----             ----             ----
<S>                                     <C>               <C>              <C>               <C>             <C>
Net Sales                               $ 61,942,765      $38,592,252      $37,479,546       $35,064,245     $22,474,672
Licensing Fees and Royalty  Revenue          164,345           72,640        2,100,484         1,956,654       1,732,277
Net Income (Loss)                          2,301,068      (6,458,377)        1,217,298       (1,282,357)         558,748
Net Income (Loss) to Common Shareholder  (5,013,532)      (6,458,377)        1,217,298       (1,282,357)         558,748
Net Income (Loss) Per Share To Common
Shareholder                                   (0.15)           (0.20)            0.04             (0.04)            0.02
</TABLE>


<TABLE>
<CAPTION>
                                                                             At July 31
                                        --------------------------------------------------------------------------------
Balance Sheet Data                              1998(1)          1997             1996              1995            1994
                                                ----             ----             ----              ----            ----
<S>                                     <C>               <C>              <C>               <C>             <C>
Current Assets                          $ 27,992,138      $10,779,049      $13,251,960       $12,010,497     $11,011,202
Current Liabilities                        8,777,242        5,804,965        6,672,497         6,401,072       5,557,594
Total Assets                              69,863,877       23,604,032       25,309,781        16,691,859      15,085,434
Long-Term Debt                             1,355,547          375,908          382,006         1,136,239         437,586
Total Liabilities                         10,132,789        6,180,873        7,054,503         7,537,311       5,995,180
Series A Convertible Redeemable
 Preferred Stock                          33,801,930
Shareholders' Equity                      25,929,158       17,423,159       18,255,278         9,154,548       9,090,254
</TABLE>

(1)  The increase in the amounts above between 1997 and 1998 is primarily the 
     result of the acquisitions discussed in Note 2 to the financial statements.

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

                                      -18-
<PAGE>   21
COMPANY OVERVIEW

         The following discussion and analysis should be read in conjunction
with "Selected Financial Data" and the audited Consolidated Financial Statements
and Notes thereto.

         Zila is a world-wide manufacturer and marketer of pharmaceutical,
biomedical, dental and nutritional products. The Company has three major
operating groups: Pharmaceutical Products, Professional Products and
Nutraceutical Products. The Pharmaceutical Products Group consists of
over-the-counter and prescription products, including the Zilactin(R) family of
over-the-counter products, Peridex(R) prescription mouth rinse, and OraTest(R),
an oral cancer diagnostic system. The Professional Products Group includes Zila
Dental Supply ("Zila Dental"), a national distributor of professional dental
supplies, Cygnus Imaging ("Cygnus"), a manufacturer and marketer of digital
x-ray systems and intraoral cameras, and Integrated Dental Technologies, Inc.,
which distributes PracticeWorks, a dental practice management software. The
Nutraceutical Products Group is comprised of Oxycal Laboratories, Incorporated
("Oxycal") and its Inter-Cal Subsidiary, which are manufacturers and
distributors of a patented and enhanced form of vitamin C under the trademark
Ester-C(R).

         On November 5, 1997, the Company's Zila Pharmaceuticals, Inc.
subsidiary completed its acquisition of the Peridex(R) product line, a
prescription anti-bacterial oral rinse from The Procter & Gamble Company
("P&G"). The purchase price was $12.0 million plus the value of acquired
inventory. The Company paid $10.0 million and will make the final two payments
of $1.0 million in November of 1998 and 1999.

         On November 10, 1997, the Company acquired Oxycal, paying $28.0 million
for all outstanding shares of Oxycal. The Company raised the funds to consummate
the Merger through a private placement of 30,000 shares of the Company's Series
A Convertible Redeemable Preferred Stock ("Preferred Stock") and warrants to
purchase 360,000 shares of the Company's Common Stock for $30.0 million.

         The Peridex and Oxycal acquisitions were accounted for using the
purchase method of accounting for business combinations. In connection with the
Oxycal acquisition, the excess of assets over liabilities assumed relate
principally to trademarks and goodwill, which are amortized over 25 and 20
years, respectively. In connection with the Peridex acquisition, the excess has
been allocated to goodwill and is being amortized over 12 years. Results of
operations of Peridex and Oxycal have been included in the Company's statement
of operations from their respective acquisition dates.

OPERATING RESULTS

         Fiscal year ended July 31, 1998. For the fiscal year ended July 31,
1998, the Company had net income of $2,301,068 compared to net loss of
$6,458,377 for 1997. Net income available to common shareholders has been
reduced in the amount of $7,314,600 by the accretion of an embedded dividend on
the Series A Preferred Stock issued in November 1997. As a result, for the
fiscal year 1998, the Company had a net loss available to common shareholders of
$5,013,532 after taking into account the non-cash embedded dividend.

         Net sales during the 1998 fiscal year totaled $61,942,765 compared to
net sales of $38,592,252 for the prior fiscal year, an increase of 60.5%.
Pharmaceutical Products Group net sales in 1998 were $15,512,038 compared to
$6,739,571, a 130.2% increase. The increase is primarily due to the acquisition
in the second quarter of Peridex and continued growth in the Zilactin(R) line of
products. Net sales for the Professional Products Group were $34,188,419 in 1998
compared to $31,852,681 in 1997, an increase of 7.3%. The increase was primarily
driven by improved software and dental supply sales. Net sales during the 1998
fiscal year for the Nutraceutical Products Group were $12,242,308 and are
directly attributable to the acquisition of Oxycal in the second fiscal quarter.

         Cost of products sold were $30,676,673 for the fiscal year ended July
31, 1998, a 30.3% increase from $23,542,342 for the fiscal year ended July 31,
1997 due to increased sales resulting primarily from the acquisitions of Oxycal
and Peridex. Cost of sales as a percentage of net sales decreased to 49.5%
during fiscal year 1998 compared to 61.0% in fiscal year 1997. This decrease is
primarily due to lower costs as a percentage of revenues relating to the Oxycal
and Peridex(R) product lines.

                                      -19-
<PAGE>   22
         The Company incurred selling, general and administrative expenses of
$28,129,922 during the fiscal year ended July 31, 1998, an increase of
$7,995,668 over the prior fiscal year. These increases are attributable mainly
to the Oxycal and Peridex acquisitions and expenses relating to regulatory,
pre-marketing and clinical activities associated with the OraTest(R) oral cancer
detection system.

         Merger related expenses due to the Bio-Dental Merger were $371,865
during the fiscal year 1997. Impairment charges during fiscal year 1997 of 
$587,659 relate to an impairment loss recognized to reduce the carrying value of
certain Bio-Dental long-lived assets which include goodwill and software rights.

         Depreciation and amortization expenses increased $1,615,528 from
$1,154,428 in the prior fiscal year to $2,769,956 in fiscal year 1998. The
increases are mainly due to the additional amortization of intangibles and
goodwill from the Oxycal and Peridex acquisitions that occurred during fiscal
year 1998.

         Interest income increased $118,144 from $201,630 in the prior fiscal
year to $319,774 during fiscal year 1998 due to higher cash balances. Interest
expense increased from $79,450 in fiscal year 1997 to $334,646 in fiscal year
1998. The increase was attributable to additional debt obligations during fiscal
year 1998 related to the Peridex acquisition.

         During the year ended July 31, 1998, the Company returned to
profitability and as a result recorded an income tax benefit of $2,600,000
($800,000 of which was attributable to the exercise of common stock options and
therefore was credited to capital in excess of par value). In the past, the
Company had fully offset its net deferred tax asset with valuation allowance due
to the Company's lack of earnings history.

         Fiscal year ended July 31, 1997. For the fiscal year ended July 31,
1997, the Company had a net loss of $6,458,377 compared to net income of
$1,217,298 for 1996.

         Net sales during the 1997 fiscal year totaled $38,592,252 compared to
net sales of $37,479,546 for the prior fiscal year, an increase of 3.0%.
Pharmaceutical Products Group net sales in 1997 were $6,739,571 compared to
$5,978,131 in 1996, a 12.7 % increase. The increase was primarily due to the
sales of Zilactin-B(R) which have continued to increase since its introduction
in the first quarter of fiscal year 1995. Net sales for the Professional
Products Group were $31,852,681 in 1997 compared to $31,501,415 in 1996, an
increase of 1.1%.

         Licensing fees and royalty revenues were $72,640 for fiscal year 1997
compared to $2,100,484 for the prior fiscal year. Approximately $1,235,000 in
royalty revenues earned in fiscal year 1996 were related to the licensing
agreement between Bio-Dental and Denticator International, Inc. ("DII"). In July
1996, Zila Dental Supply disposed of its rights to receive future royalty
payments from DII in exchange for a lump sum payment of approximately
$7,500,000. In addition, amounts were recorded in fiscal year 1996 attributable
to the licensing of OraTest(R) for markets in the United Kingdom and the United
States by the Stafford-Miller Company and The Procter & Gamble Company,
respectively. Of these amounts, $625,000 was paid by Procter & Gamble as a
one-time licensing fee required in connection with the termination of its
licensing agreement with the Company.

         Cost of products sold were $23,542,342 for the fiscal year ended July
31, 1997, a 5.0% decrease from $24,771,193 for the fiscal year ended July 31,
1996. Cost of sales as a percentage of net sales decreased to 61.0% during
fiscal year 1997 as compared to 66.1% in fiscal year 1996 due primarily to lower
costs resulting from the restructuring of IDT.

         The Company incurred $20,154,254 of selling, general and administrative
expenses during the fiscal year ended July 31, 1997, an increase of $1,817,470,
or 10% over the fiscal year ended July 31, 1996. Approximately $1,423,000 of the
increases were attributable to costs associated with the funding of OraTest(R)
research, start-up manufacturing costs and staffing. The Company also incurred
approximately $807,745 of additional litigation costs during fiscal year 1997.

         Merger related expenses increased $225,190 from $146,675 in the prior
fiscal year to $371,865 due to the Bio-Dental merger. Impairment charges during
fiscal year 1997 of $587,659 relate to an impairment loss recognized to reduce
the carrying value of IDT's long-lived assets which include goodwill and
software rights.

                                      -20-
<PAGE>   23
         Depreciation and amortization expenses increased $390,764 from $763,664
in the prior fiscal year to $1,154,428 in fiscal year 1997. The increases are
mainly due to the additional amortization costs related to purchased technology
rights as compared to the previous fiscal year.

         Interest income increased $53,782 from $147,848 in the prior fiscal
year to $201,630 during fiscal year 1997. Interest expense decreased from
$471,607 in fiscal year 1996 to $79,450 in fiscal year 1997. The decrease was
attributable to lower debt obligations during fiscal year 1997 as compared to
fiscal year 1996.

INFLATION

         Inflation has had no material effect on the operations or financial
condition of the Company.

LIQUIDITY AND CAPITAL RESOURCES

         At July 31, 1998, the Company had net working capital of $19,214,896,
and its current ratio (the ratio of current assets to current liabilities) was
3.2 to 1. At July 31, 1997, the Company had net working capital of $4,974,084
and its current ratio was 1.9 to 1.

         Trade accounts receivable net at July 31, 1998 were $7,161,240 compared
to trade accounts receivable at July 31, 1997 of $2,822,687. Trade accounts
receivable net as a percentage of quarterly net sales of $16,594,627 were 43.2%
at July 1998 as compared to 29.1% at July 31, 1997 which had quarterly net sales
of $9,712,162. The increase is due mainly to extended terms granted in
connection with the launch of new product lines in the camera and digital x-ray
business and receivables related to Oxycal and Peridex.

         At July 31, 1998, the Company had inventories of $11,550,009, an
increase of $7,263,382 from inventories at July 31, 1997. The increase is mainly
due to inventories acquired in the Oxycal and Peridex acquisitions. During the
fourth quarter of fiscal year 1998, the Company increased its inventory of
Peridex(R) to prepare for a short-term stoppage in production due to a change in
contract manufacturers of Peridex(R). The Company believes current inventories
are at levels necessary to support market expansion and maintain adequate
liquidity.

         Operating cash flows for fiscal year 1998 increased when compared to
fiscal year 1997, primarily because the Company generated net income in the
current year and had a net loss in the prior year, offset in part by the
differences in the net changes in working capital items in each year.

         Approximately $36 million was provided by financing activities in
fiscal year 1998 that was used primarily for the acquisitions of Oxycal and
Peridex. Capital expenditures in fiscal year 1998 were approximately $1.3
million and were manufacturing related expenditures for OraTest, Oxycal and
Cygnus products.

         The Preferred Stock issued in connection with the Oxycal merger is
convertible into shares of the Company's common stock at a conversion rate based
on the price of such common stock at the date of issuance. However, if the
market price of the Company's common stock does not appreciate by a fixed
percentage at various measurement dates, the holders of the Preferred Stock have
the right to receive additional shares of the Company's common stock upon
conversion, based on a repricing formula. During the fiscal year ended 1998, the
holders of 1,200 shares of the Preferred Stock converted them into common stock.
Per guidance from the Emerging Issues Task Force, the intrinsic value of the
beneficial conversion feature of the Preferred Stock has been measured and
recognized as an embedded dividend and such non-cash embedded dividend has been
deducted from net income in the accompanying consolidated statement of
operations to arrive at the amount of net income available to common
shareholders. Additionally, because the Preferred Stock has conditions for
redemption that are not solely within the control of the Company, it has been
classified outside of permanent equity in the accompanying consolidated balance
sheet and has been accredited to its redemption value.

         Management believes that continued growth in the Company's sales of its
products will provide sufficient funding for the Company's current operating
divisions for the next twelve months. The Company may require additional
financing to fund future OraTest(R) manufacturing and marketing costs. In April
1998, the Company obtained a $2.0 million bank line of credit, which is secured
by trade accounts receivable, inventories and rights to payment. This line of

                                      -21-
<PAGE>   24
credit expires December 31, 1998. Interest is payable monthly on the unpaid
balance outstanding at the bank's prime rate (8.5% at July 31, 1998) plus .50%.
At July 31, 1998, the Company had no borrowings against this line. The Company's
Equity Line Agreement (the "Investment Agreement") with Deere Park Capital
Management allowed the Company to raise a total of $25.0 million through the
sale of its common stock. The Company was committed to sell $10.0 million of its
common stock to the investor over the commitment period and fulfilled this
commitment in January 1998. The commitment period expired in September 1998.

         Forward Looking Statements. The foregoing discussion contains
forward-looking statements and information within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934. The cautionary statements made in this Report should be read as being
applicable to all forward-looking statements whenever they appear in this
Report. Forward-looking statements, by their very nature, include risks and
uncertainties. Accordingly, the Company's actual results may differ materially
from the results discussed in the forward-looking statements. Factors that might
cause such a difference include, but are not limited to those items described
above and in Item 1 of this Annual Report on Form 10-K under the heading,
"Cautionary Factors That May Affect Future Results," and in Item 3, "Legal
Proceedings."
 
    Year 2000 Impact. The Company is currently working to mitigate the extent
of any "Year 2000" problems that may exist at the Company and may have an
effect on its business, but it has not yet completed this evaluation. However,
the Company does not expect that the costs to address the problem will be
material, and it does not expect the consequences of incomplete or untimely
resolution of the problem will materially impact the operation of its business.
The Company has not incurred, and does not expect to incur, any specific
quantifiable cost that can be directly and solely related to the Year 2000
issue. The Company's PracticeWorks(R) software is programmed in such a manner
that it is Year 2000 ready.

         New Accounting Pronouncements. In June 1997, the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 130, Reporting Comprehensive Income, and SFAS No. 131, Disclosures
About Segments of an Enterprise and Related Information. SFAS No. 130 requires
that an enterprise (a) classify items of other comprehensive income by their
nature in a financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and additional capital in
the equity section of a statement of financial position. SFAS No. 131
establishes standards for the way that public enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports to shareholders. It also establishes standards for disclosures
about products and services, geographic areas and major customers. Both
statements are effective for fiscal years beginning after December 15, 1997. The
Company believes the adoption of SFAS No. 130 will have no material impact on
the Company's financial statements. The Company has not completed evaluating the
impact of implementing the provisions of SFAS No. 131.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Consolidated financial statements, together with the related notes and
the report of Deloitte & Touche LLP and Grant Thornton, independent certified
public accountants, are set forth hereafter. Other required financial
information and schedules are set forth herein, as more fully described in Item
14 hereof.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURES

         None.

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

         Information respecting the directors of the Company is incorporated
herein by reference to the "Election of Directors" and the "Section 16(a)
Beneficial Ownership Reporting Compliance" sections of the Company's definitive
Proxy Statement for the Annual Meeting of Stockholders on December 10, 1998.

                                      -22-
<PAGE>   25
ITEM 11.  EXECUTIVE COMPENSATION

         Information responsive to this Item is incorporated herein by reference
to the "Executive Compensation" section of the Company's definitive Proxy
Statement for the Annual Meeting of Stockholders on December 10, 1998.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         Information concerning the Common Stock beneficially owned by each
director of the Company, by all officers and directors of the Company as a
group, and by each shareholder known by the Company to be the beneficial owner
of more than 5% of the outstanding Common Stock is incorporated herein by
reference to the "Principal Stockholders and Stockholdings of Management"
section of the Company's definitive Proxy Statement for the Annual Meeting of
Stockholders on December 10, 1998.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Information responsive to this Item is incorporated herein by reference
to the "Certain Transactions" section of the Company's definitive Proxy
Statement for the Annual Meeting of Stockholders on December 10, 1998.

                                      -23-
<PAGE>   26
                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

<TABLE>
<CAPTION>
                                                                                                        PAGE OR
                                                                                                   METHOD OF FILING
                                                                                                   ----------------
<S>                                                                                               <C>
  Financial Statements
(a)      (1)            Report of Deloitte & Touche LLP                                              Filed herewith
  (2)    Report of Grant Thorton LLP                                                                 Filed herewith
  (3)    Consolidated Financial Statements and Notes thereto of the Company
         including Consolidated Balance Sheets as of July 31, 1998 and 1997 and
         related Consolidated Statements of Operations, Shareholders' Equity,
         and Cash Flows for each of the years in
         the three-year period ended July 31, 1998                                                   Filed herewith

(b)      Reports on Form 8-K.
         None.
(c)
</TABLE>


<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                            DESCRIPTION                                          PAGE OR
                                                                                                   METHOD OF FILING
<S>                                                                                               <C>
2        Merger Agreement dated August 8, 1996 among Zila, Inc. Bio-Dental
         Technologies Corporation and Zila Merger Corporation                                                  A
3-A      Certificate of Incorporation, as amended                                                              B
3-B      Bylaws                                                                                                B
4-A      Specimen Stock Certificate                                                                            B
4-B      Certificate of Designations, Preferences and Rights of Series A
         Convertible Preferred Stock                                                                           L
4-C      Specimen Warrant Certificate                                                                          C
4-D      Form Stock Purchase Warrant re Series A Preferred Stock                                               L
4-E      Deere Park Capital Management Warrant
                                                                                                               J
4-F      Bartholomew Investment, L.P. Warrant                                                                  J
10-A     Revolving Line of Credit Loan Agreement dated April 8, 1991 between
         Zila, Inc. and Banc One, Arizona
                                                                                                               D
10-B#    Stock Option Award Plan (as amended through April 10, 1991)                                           E
10-C#    Non-Employee Directors Stock Option Plan (as amended through April 10, 1991)                          E
10-E#    1997 Stock Option Award Plan                                                                          L
10-G     Manufacturing and Distribution Agreement dated March 12, 1993 between
         Zila, Inc. and Germiphene Corporation                                                                 G
10-H     Agreement dated November 26, 1996 between Cheseborough Ponds USA Co
         and Zila Pharmaceuticals, Inc                                                                         H
10-I     Private Equity Line of Credit between Deere Park Capital Management
         and Zila, Inc. Dated as of April 30, 1997                                                             J
10-J     Amendment to Private Equity Line of Credit Agreement                                                  J
10-K     Registration Rights Agreement dated as of May 9, 1997 between Zila,
         Inc. and Deere Park Capital Management                                                                J
10-L     Registration Rights Agreement dated as of May 9, 1997 between Zila,
         Inc. and Bartholomew Investment, L.P                                                                  J
10-M     Merger Agreement dated as of April 3, 1997 among Zila, Inc., Cygnus
         Imaging, Inc., Cygnus Merger Corporation, and Egidio Cianciosi,
</TABLE>

                                      -24-
<PAGE>   27
<TABLE>
<CAPTION>
<S>      <C>                                                                                                <C>
         James Jenson and Kenneth Kirk                                                                         J
10-N     Securities Purchase Agreement dated as of October 17, 1997 by and
         among Zila, Inc. and certain investors                                                                L
10-O     Registration Rights Agreement dated October 17, 1997 by and among
         Zila, Inc. and certain investors                                                                      L
21       Subsidiaries of Registrant                                                                            *
23-A     Consent of Deloitte & Touche LLP (regarding Form S-8 and Form S-3
         Registration Statements)                                                                              *
23-B     Consent of Grant Thornton (regarding Form S-8 and Form S-3
         Registration Statements)                                                                              *
24-A     Power of Attorney of Joseph Hines                                                                     *
24-B     Power of Attorney of Bradley C. Anderson                                                              *
24-C     Power of Attorney of Clarence J. Baudhuin                                                             *
24-D     Power of Attorney of Carl A. Schroeder                                                                *
24-E     Power of Attorney of Patrick M. Lonergan
                                                                                                               *
24-F     Power of Attorney of Michael S. Lesser                                                                *
24-G     Power of Attorney of Curtis M. Rocca                                                                  *
24-H     Power of Attorney of Thomas B. Simone                                                                 *
27       Financial Data Schedule                                                                               *
99       The Company's 1998 Proxy Statement for the Annual Meeting of
         Stockholders to be held on December 10, 1998                                                          K


#        Management contract or compensation plan or arrangement
*        Filed herewith
A        Incorporated by reference to Exhibit 2 to the Company's Form S-4 Registration Statement
         No. 333-10107, as amended
B        Incorporated by reference to the Company's Annual Report on Form 10-K
         for the fiscal year ended July 31, 1988, as amended
C        Incorporated by reference to the Company's Annual Report on Form 10-K
         for the fiscal year ended July 31, 1994, as amended
D        Incorporated by reference to the Company's Form S-3 Registration Statement No.
         33-46239
E        Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the
         quarterly period ended January 31, 1996, as amended
F        Incorporated by reference to Exhibit 10-C to Post-Effective Amendment No. 3 to Form S-1
         Registration Statement No. 33-27739
G        Incorporated by reference to Exhibit 10-L to the Company's Annual
         Report on Form 10-K For the fiscal year ended July 31, 1993, as amended
H        Incorporated by reference to the Company's Quarterly Report for the
         quarterly period ended October 31, 1996, as amended
I        Incorporated by reference to the Company's Current Report dated February 11,
         1997
J        Incorporated by reference to the Company's Form S-3 Registration Statement No. 333-31651
K        Filed by amendment
L        Incorporated by reference to the Company's Annual Report on Form 10-K for fiscal
         year ended July 31, 1997
</TABLE>

                                      -25-
<PAGE>   28
                                   SIGNATURES

         Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report on Form 10-K to
be signed on its behalf by the undersigned, thereunto duly authorized, this 29th
day of October, 1998.

ZILA, INC., a Delaware corporation

                             By /s/ BRADLEY C. ANDERSON
                               ------------------------------------------------
                               Bradley C. Anderson
                                 Vice President
                               and Chief Financial Officer (Principal
                               Financial and Accounting Officer)

         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report on Form 10-K has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated:


<TABLE>
<CAPTION>
          SIGNATURE                                         TITLE                                  DATE
          ---------                                         -----                                  ----
<S>                                                  <C>                                      <C>
/s/      JOSEPH HINES                                Chairman of the Board,                   October 29, 1998
---------------------------------------              President, Chief Executive
  Joseph Hines                                       Officer

/s/      BRADLEY C. ANDERSON                         Vice President and Chief                 October 29, 1998
---------------------------------------              Financial Officer
  Bradley C. Anderson                                

                         *                           Director                                 October 29, 1998
---------------------------------------
  Clarence J. Baudhuin

                         *                           Director                                 October 29, 1998
---------------------------------------
  Carl A. Schroeder

                         *                           Director                                 October 29, 1998
---------------------------------------
  Patrick M. Lonergan

                         *                           Director                                 October 29, 1998
---------------------------------------
  Michael S. Lesser

                         *                           Director                                 October 29, 1998
---------------------------------------
  Curtis M. Rocca III

                         *                           Director                                 October 29, 1998
---------------------------------------
  Thomas B. Simone

*By /s/  BRADLEY C. ANDERSON                                                                  October 29, 1998
---------------------------------------
  Bradley C. Anderson
  Attorney-in-Fact

</TABLE>

                                      -26-
<PAGE>   29
INDEPENDENT AUDITORS' REPORT

Board of Directors and Shareholders
Zila, Inc.
Phoenix, Arizona


We have audited the consolidated balance sheets of Zila, Inc. and subsidiaries
(the "Company") as of July 31, 1998 and 1997, and the related consolidated
statements of operations, convertible redeemable preferred stock and
shareholders' equity, and cash flows for each of the three years in the period
ended July 31, 1998. 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. The consolidated financial statements
give retroactive effect to the merger of the Company and Bio-Dental Technologies
Corporation ("Bio-Dental") on January 8, 1997, which has been accounted for as a
pooling of interests as described in Note 1 to the consolidated financial
statements. We did not audit the consolidated statements of operations,
shareholders' equity and cash flows of Bio-Dental for the eight-month period and
year ended March 31, 1996, which statements reflect total revenues of
$22,034,442 and $33,091,216, respectively. Those financial statements were
audited by other auditors whose report has been furnished to us, and our
opinion, insofar as it relates to the amounts included for Bio-Dental for such
periods, is based solely on the report of such other auditors.


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 and the report of the other auditors provide a
reasonable basis for our opinion.


In our opinion, based on our audits and the report of the other auditors, the 
consolidated financial statements referred to above present fairly, in all 
material respects, the financial position of Zila, Inc. and subsidiaries at 
July 31, 1998 and 1997, and the results of their operations and their cash 
flows for each of the three years in the period ended July 31, 1998 in 
conformity with generally accepted accounting principles.


DELOITTE & TOUCHE LLP
Phoenix, Arizona

October 28, 1998



                                      F-1

<PAGE>   30
               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

Board of Directors and Stockholders
BIO-DENTAL TECHNOLOGIES CORPORATION
  AND SUBSIDIARIES

We have audited the consolidated statements of operations, stockholders' equity 
and cash flows of BIO-DENTAL TECHNOLOGIES CORPORATION AND SUBSIDIARIES for the 
eight months ended March 31, 1996 and for the year ended March 31, 1996 (not 
presented separately herein). 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 of Bio-Dental Technologies Corporation 
and Subsidiaries referred to above present fairly, in all material respects, 
the consolidated results of their operations and their consolidated cash flows 
for the eight months ended March 31, 1996 and for the year ended March 31, 1996 
in conformity with generally accepted accounting principles.

As discussed in note A, the Company merged with Zila, Inc. on January 8, 1997.

/s/ Grant Thornton LLP
----------------------------
Grant Thornton LLP

Sacramento, California
April 11, 1997



                                      F-2

<PAGE>   31
ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
JULY 31, 1998 AND 1997
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
ASSETS                                                              1998               1997

<S>                                                            <C>                <C>         
CURRENT ASSETS:
  Cash and cash equivalents                                    $  5,241,201       $  2,071,563
  Trade receivables, less allowance for doubtful accounts
     of $493,520 (1998) and $349,021 (1997)                       7,161,240          2,822,687
  Income tax receivable                                             250,877            494,757
  Inventories                                                    11,550,009          4,286,627
  Prepaid expenses and other current assets                       1,003,381            857,487
  Deferred income taxes                                           2,785,430            245,928
                                                               ------------       ------------

         Total current assets                                    27,992,138         10,779,049
                                                               ------------       ------------

PROPERTY AND EQUIPMENT - Net                                      4,955,861          1,865,385
PURCHASED TECHNOLOGY RIGHTS - Net                                 6,473,854          6,910,293
GOODWILL - Net                                                   17,009,914          2,693,139
TRADEMARKS - Net                                                 11,131,925             28,119
OTHER INTANGIBLE ASSETS - Net                                     2,173,352          1,200,423
OTHER ASSETS                                                        126,833            127,624
                                                               ------------       ------------


TOTAL                                                          $ 69,863,877       $ 23,604,032
                                                               ============       ============

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
  Accounts payable                                             $  4,917,626       $  3,262,904
  Accrued liabilities                                             2,251,105          2,106,572
  Deferred revenue                                                  567,956            395,594
  Short-term borrowings                                              87,598
  Current portion of long-term debt                                 952,957             39,895
                                                               ------------       ------------

         Total current liabilities                                8,777,242          5,804,965

LONG-TERM DEBT - Net of current portion                           1,355,547            375,908
                                                               ------------       ------------

          Total liabilities                                      10,132,789          6,180,873
                                                               ------------       ------------

COMMITMENTS AND CONTINGENCIES
  (Notes 10 and 11)

SERIES A CONVERTIBLE REDEEMABLE PREFERRED STOCK:
  Issued 30,000; outstanding 28,800 shares; liquidation
  preference value: $1,220 per share                             33,801,930
                                                               ------------

SHAREHOLDERS' EQUITY:
  Preferred stock, $.001 par value - authorized
   2,500,000 shares; issued 30,000 shares of Series A
   Preferred Stock
  Common stock, $.001 par value - authorized,
   65,000,000 shares; issued 34,743,575 shares
   (July 31, 1998) and 32,326,581 shares (July 31, 1997)             34,744             32,327
  Capital in excess of par value                                 43,877,560         30,360,446
  Deficit                                                       (17,982,721)       (12,969,189)
                                                               ------------       ------------

                                                                 25,929,583         17,423,584
  Less 42,546 common shares held by wholly-owned
    subsidiary (at cost)                                               (425)              (425)
                                                               ------------       ------------

        Total shareholders' equity                               25,929,158         17,423,159
                                                               ------------       ------------

TOTAL                                                          $ 69,863,877       $ 23,604,032
                                                               ============       ============
</TABLE>

    See notes to consolidated financial statements.



                                      F-3

<PAGE>   32
\ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED JULY 31, 1998, 1997 AND 1996
-------------------------------------------------------------------------------



<TABLE>
<CAPTION>
                                                 1998               1997               1996
<S>                                          <C>                <C>                <C>         
REVENUES
  Net sales                                  $ 61,942,765       $ 38,592,252       $ 37,479,546
  Licensing fees and royalty revenue              164,345             72,640          2,100,484
                                             ------------       ------------       ------------
                                               62,107,110         38,664,892         39,580,030
                                             ------------       ------------       ------------

OPERATING COSTS AND EXPENSES
  Cost of products sold                        30,676,673         23,542,342         24,771,193
  Selling, general and administrative          28,129,922         20,154,254         18,336,784
  Merger related expenses                                            371,865            146,675
  Impairment charges                                                 587,659
  Depreciation and amortization                 2,769,956          1,154,428            763,664
                                             ------------       ------------       ------------
                                               61,576,551         45,810,548         44,018,316
                                             ------------       ------------       ------------

INCOME (LOSS) FROM OPERATIONS                     530,559         (7,145,656)        (4,438,286)
                                             ------------       ------------       ------------

OTHER INCOME (EXPENSES)
  Interest income                                 319,774            201,630            147,848
  Interest expense                               (334,646)           (79,450)          (471,607)
  Gain on disposition of royalty rights                                               7,519,529
  Other income (expense)                          (14,619)           (24,832)            (1,668)
                                             ------------       ------------       ------------

     Other (expenses) income - net                (29,491)            97,348          7,194,102
                                             ------------       ------------       ------------

INCOME (LOSS) BEFORE INCOME TAXES                 501,068         (7,048,308)         2,755,816

BENEFIT (PROVISION) FOR INCOME TAXES            1,800,000            589,931         (1,538,518)
                                             ------------       ------------       ------------

NET INCOME (LOSS)                               2,301,068       $ (6,458,377)      $  1,217,298
                                                                ============       ============

PREFERRED STOCK DIVIDEND REQUIREMENT:
  SERIES A EMBEDDED DIVIDEND (NOTE 10)         (7,314,600)
                                             ------------      

NET (LOSS) INCOME AVAILABLE TO COMMON
  SHAREHOLDERS                               $ (5,013,532)     
                                             ============      

NET (LOSS) INCOME AVAILABLE TO COMMON
  SHAREHOLDERS - BASIC                       $      (0.15)      $      (0.20)      $       0.04
                                             ============       ============       ============

NET (LOSS) INCOME AVAILABLE TO COMMON
  SHAREHOLDERS - DILUTED                     $      (0.15)      $      (0.20)      $       0.04
                                             ============       ============       ============


BASIC SHARES OUTSTANDING                       33,990,947         31,530,096         30,095,552
EQUIVALENT SHARES                                                                       305,684
                                             ------------       ------------       ------------
DILUTED SHARES OUTSTANDING                     33,990,947         31,530,096         30,401,236
                                             ============       ============       ============
</TABLE>


See notes to consolidated financial statements.



                                      F-4

<PAGE>   33
\                           ZILA, INC. AND SUBSIDIARIES

      CONSOLIDATED STATEMENTS OF CONVERTIBLE REDEEMABLE PREFERRED STOCK AND
                              SHAREHOLDERS' EQUITY
                    YEARS ENDED JULY 31, 1998, 1997 AND 1996

<TABLE>
<CAPTION>
                                                                                          SHAREHOLDERS' EQUITY
                                                                    ----------------------------------------------------------------
                                                                                                                        COMMON STOCK
                                          CONVERTIBLE REDEEMABLE       COMMON STOCK                                      HELD BY    
                                             PREFERRED STOCK        --------------------   CAPITAL IN                   WHOLLY-OWNED
                                          ----------------------                 PAR       EXCESS OF                    SUBSIDIARY  
                                            SHARES       AMOUNT       SHARES     VALUE     PAR VALUE       DEFICIT       (AT COST)  
                                          ---------    ---------    ----------  --------  ------------  -------------   ------------
<S>                                       <C>          <C>          <C>         <C>       <C>           <C>             <C>         
BALANCE AUGUST 1, 1995                                              29,446,541  $ 29,447  $ 16,464,780  $  (7,311,293)     $ (425)  
  Issuance of common stock                                           1,076,299     1,076     7,227,975                              
  Exercise of common stock warrants                                    140,138       141       179,368                              
  Exercise of common stock options                                     414,351       414       753,146                              
  Common stock warrants issued for
    debt discount                                                                              135,000                              
  Change in unrealized loss on
    securities available-for-sale                                                                                                   
  Adjustment to conform year-end of
    Bio-Dental                                                                                               (416,817)              
  Net income                                                                                                1,217,298               
                                          --------   ------------   ----------  --------  ------------  -------------      ------
BALANCE, JULY 31, 1996                         -              -     31,077,329    31,078    24,760,269     (6,510,812)       (425)  
  Issuance of common stock                                             810,094       810     4,550,171                              
  Exercise of common stock warrants                                    153,665       154       478,211                              
  Exercise of common stock options                                     285,493       285       571,795                              
  Change in unrealized loss on
    securities available-for-sale                                                                                                   
  Net loss                                                                                                 (6,458,377)              
                                          --------   ------------   ----------  --------  ------------  -------------      ------
BALANCE, JULY 31, 1997                         -              -     32,326,581    32,327    30,360,446    (12,969,189)       (425)  
  Issuance of preferred stock               30,000   $ 36,555,000
  Preferred stock issuance fees                        (1,352,750)
  Conversion of preferred stock into
    common stock                            (1,200)    (1,400,320)     190,543       190     1,400,130                              
  Issuance of common stock                                           1,588,869     1,589    10,177,534                              
  Exercise of common stock warrants                                    214,609       215       609,862                              
  Exercise of common stock options                                     422,973       423       529,588                              
  Income tax benefit - stock options                                                           800,000                              
  Net income                                                                                                2,301,068
  Series A Embedded dividend                                                                               (7,314,600)              
                                          --------   ------------   ----------  --------  ------------  -------------      ------
BALANCE, JULY 31, 1998                      28,800   $ 33,801,930   34,743,575  $ 34,744  $ 43,877,560  $ (17,982,721)     $ (425)  
                                          ========   ============   ==========  ========  ============  =============      ======
</TABLE>
<TABLE>
<CAPTION>
                                               SHAREHOLDERS' EQUITY
                                        ---------------------------------
                                        UNREALIZED                       
                                         LOSS ON               TOTAL     
                                        SECURITIES             COMMON    
                                        AVAILABLE-          SHAREHOLDERS'
                                         FOR-SALE              EQUITY    
                                        ----------          -------------
<S>                                     <C>                 <C>
BALANCE AUGUST 1, 1995                  $ (27,961)          $  9,154,548 
  Issuance of common stock                                     7,229,051 
  Exercise of common stock warrants                              179,509 
  Exercise of common stock options                               753,560 
  Common stock warrants issued for                                       
    debt discount                                                135,000 
  Change in unrealized loss on                                           
    securities available-for-sale           3,129                  3,129 
  Adjustment to conform year-end of                                      
    Bio-Dental                                                  (416,817)
  Net income                                                   1,217,298 
                                        ---------           ------------
BALANCE, JULY 31, 1996                    (24,832)            18,255,278 
  Issuance of common stock                                     4,550,981 
  Exercise of common stock warrants                              478,365 
  Exercise of common stock options                               572,080 
  Change in unrealized loss on                                           
    securities available-for-sale          24,832                 24,832 
  Net loss                                                    (6,458,377)
                                        ---------           ------------
BALANCE, JULY 31, 1997                        -               17,423,159 
  Issuance of preferred stock                                            
  Preferred stock issuance fees                                          
  Conversion of preferred stock into                                     
    common stock                                               1,400,320 
  Issuance of common stock                                    10,179,123 
  Exercise of common stock warrants                              610,077 
  Exercise of common stock options                               530,011 
  Income tax benefit - stock options                             800,000 
  Net income                                                   2,301,068
  Series A Embedded dividend                                  (7,314,600)
                                        ---------           ------------
BALANCE, JULY 31, 1998                  $     -             $ 25,929,158 
                                        =========           ============
</TABLE>


See notes to consolidated financial statements.



                                      F-5

<PAGE>   34
ZILA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JULY 31, 1998, 1997 AND 1996
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                            1998                1997                 1996
                                                                        ------------        ------------        ------------
<S>                                                                     <C>                 <C>                 <C>
OPERATING ACTIVITIES:
     Net income (loss)                                                  $  2,301,068        $ (6,458,377)       $  1,217,298
     Adjustments to reconcile net income (loss) to
         net cash provided by (used in) operating activities:
         Depreciation and amortization                                     2,769,956           1,154,428             763,664
         Gain on disposition of royalty rights                                                                    (7,519,529)
         Impairment of assets                                                                    587,659
         Other                                                                                    47,381             188,325
         Discount on contractual obligation                                  288,365
         Deferred income taxes                                            (1,800,000)            715,485            (283,831)
         Change in assets and liabilities:
            Receivables, net                                               1,766,866             353,713              27,975
            Inventories                                                   (3,010,557)            129,965           1,621,034
            Prepaid expenses and other current assets                       (418,875)            (80,379)            319,813
            Other assets                                                                         368,465            (438,760)
            Accounts payable and accrued expenses                            585,526             593,105            (346,575)
            Income taxes payable                                                              (2,471,126)          2,543,689
            Deferred revenue                                                 172,362             208,033              12,404
                                                                        ------------        ------------        ------------
              Net cash provided by (used in) operating activities          2,654,711          (4,851,648)         (1,894,493)
                                                                        ------------        ------------        ------------

INVESTING ACTIVITIES:
     Purchases of short-term investments                                                        (222,615)           (214,150)
     Proceeds from sale of short-term investments                                                934,085             197,878
     Purchases of property and equipment                                  (1,276,262)           (601,172)           (880,024)
     Proceeds from sale of property and equipment                                                                      8,916
     Proceeds from disposition of royalty rights                                                                   7,890,047
     Acquisitions, net of cash acquired                                  (33,595,322)             18,142            (125,000)
     Collections of notes receivable                                                                                  32,801
     Purchases of intangible assets                                         (942,284)           (118,465)           (226,117)
                                                                        ------------        ------------        ------------

         Net cash (used in) provided by investing activities             (35,813,868)              9,975           6,684,351
                                                                        ------------        ------------        ------------

FINANCING ACTIVITIES:
     Principal payments on short-term borrowings                            (159,026)
     Net proceeds from short-term borrowings                                 246,624              41,298          (2,727,460)
     Net proceeds from long-term debt                                         93,753
     Net proceeds from issuance of common stock                           10,559,611           3,833,755             933,068
     Net proceeds from issuance of preferred stock                        28,647,250
     Principal payments on long-term debt                                 (3,059,417)           (453,721)            (12,509)
                                                                        ------------        ------------        ------------

         Net cash provided by (used in) financing activities              36,328,795           3,421,332          (1,806,901)
                                                                        ------------        ------------        ------------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                       3,169,638          (1,420,341)          2,982,957

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                             2,071,563           3,491,904             508,947
                                                                        ------------        ------------        ------------

CASH AND CASH EQUIVALENTS, END OF PERIOD                                $  5,241,201        $  2,071,563        $  3,491,904
                                                                        ============        ============        ============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
     Cash paid for interest                                             $     46,029        $     79,450        $    483,297
                                                                        ============        ============        ============

     Cash paid for income taxes                                         $     23,000        $  1,165,710        $      3,000
                                                                        ============        ============        ============
</TABLE>


                                                                     (continued)



                                      F-6

<PAGE>   35
ZILA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
YEARS ENDED JULY 31, 1998, 1997 AND 1996
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND
     FINANCING ACTIVITIES FOR 1998, 1997 AND 1996:                                    1998         1997          1996
                                                                                   -----------  -----------  -----------
<S>                                                                                <C>          <C>          <C>
     Non-cash aspects of Oxycal acquisition:
         Fair value of assets acquired other than cash and cash
            equivalents                                                            $12,787,836
                                                                                   ===========
         Liabilities assumed                                                       $ 1,213,729
                                                                                   ===========
         Intangible assets recorded in connection with acquisition of Oxycal       $14,795,040
                                                                                   ===========
     Non-cash aspects of Peridex acquisition:
         Fair value of assets acquired other than cash and cash
            equivalents                                                            $   220,000
                                                                                   ===========
         Contractual obligation recorded in connection with the acquisition
            of Peridex                                                             $ 5,570,000
                                                                                   ===========
         Goodwill recorded in connection with the acquisition of Peridex           $11,570,637
                                                                                   ===========
     Embedded dividend recorded in connection with issuance of
         Series A Convertible Redeemable Preferred Stock                           $ 7,314,600
                                                                                   ===========
     Income tax benefit attributable to exercise of common stock options           $   800,000
                                                                                   ===========
     Non-cash aspects of Cygnus acquisition:
         Stock issued                                                                           $ 1,725,000
                                                                                                ===========
         Fair value of assets acquired other than cash and cash
            equivalents                                                                         $   342,567
                                                                                                ===========
         Liabilities assumed                                                                    $   737,200
                                                                                                ===========
         Goodwill recorded in connection with the acquisition of Cygnus                         $ 2,101,491
                                                                                                ===========
     Issuance of 869,118 shares of common stock in connection with
         the acquisition of CTM                                                                              $ 7,170,223
                                                                                                             ===========
     Assumption of liabilities in connection with the acquisition of CTM                                     $    70,000
                                                                                                             ===========
</TABLE>



See notes to consolidated financial statements.                      (Concluded)



                                      F-7

<PAGE>   36
ZILA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED JULY 31, 1998, 1997 AND 1996

1. NATURE OF BUSINESS ACTIVITIES AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

   Nature of Business Activities -- Zila, Inc. ("Zila" or the "Company"), a
Delaware corporation, is a manufacturer and marketer of pharmaceutical,
biomedical, dental and nutritional products. The Company has organized its
business into three major operating groups: Pharmaceutical Products,
Professional Products and Nutraceutical Products. The Pharmaceutical Products
Group consists of over-the-counter and prescription products, including the
Zilactin family of over-the-counter products, Peridex prescription mouth rinse,
and OraTest, an oral cancer diagnostic system. The Professional Products Group
includes Zila Dental Supply ("Zila Dental"), a national distributor of
professional dental supplies, Cygnus Imaging ("Cygnus"), a manufacturer and
marketer of digital x-ray systems and intraoral cameras, and Practiceworks, a
dental practice management software company. The Nutraceutical Products Group is
presently comprised of Oxycal Laboratories and its Inter-Cal subsidiary,
manufacturers and distributors of a patented and enhanced form of Vitamin C
under the trademark Ester-C(R).

   Principles of Consolidation -- The consolidated financial statements include
the accounts of Zila, Inc. and its wholly-owned subsidiaries, Zila
Pharmaceuticals, Inc., Zila International Inc., Zila Ltd., Bio-Dental
Technologies Corporation ("Bio-Dental"), Cygnus Imaging, Inc. ("Cygnus") and
Oxycal Laboratories, Inc. ("Oxycal"). Zila International Inc. has no operations
and its assets at July 31, 1998 and 1997 consist of 42,546 shares of common
stock of the Company. All significant intercompany balances and transactions are
eliminated in consolidation.

   On January 8, 1997, the Company completed a merger with Bio-Dental. On
December 30, 1996, Bio-Dental's shareholders approved the all-stock transaction
which provided for a per share exchange of .825 shares of the Company's common
stock for each share of Bio-Dental common stock outstanding. As of January 8,
1997, Bio-Dental had 6,565,300 shares of common stock outstanding.

   The merger has been accounted for as a pooling of interests, and accordingly,
the accompanying consolidated financial statements give retroactive effect to
the Bio-Dental merger and include the combined operations of the Company and
Bio-Dental for all periods presented. Prior to the combination, Bio-Dental's
year-end was March 31. Effective August 1, 1995, Bio-Dental's results are
reported on a July 31, 1996 basis along with the results of Zila, Inc.
Bio-Dental's net loss of $416,817 for the four-month period ended July 31, 1995
is reflected as an adjustment to the deficit during the year ended July 31,
1996. For the four-month period ended July 31, 1995, Bio-Dental had revenues of
$11,056,774, operating costs and expenses of $11,631,735, and a net loss of
$416,817. Certain adjustments and reclassifications have been made to conform
previously issued Bio-Dental financial statements to classifications and
accounting policies used by the Company.



                                      F-8

<PAGE>   37
   The following table shows the effect on the results of operations as restated
for the periods prior to the combination of Bio-Dental.

<TABLE>
<CAPTION>
                                              1997           1996
                                          ------------   -------------
<S>                                       <C>            <C>
           Sales:
             Zila, Inc..................  $  3,153,812   $   5,978,131
             Bio-Dental.................    16,944,215      31,501,415
                                          ------------   -------------
           Combined sales...............  $ 20,098,027   $  37,479,546
                                          ============   =============
           Net income (loss):
             Zila, Inc..................  $   (135,528)  $    (827,337)
             Bio-Dental.................      (976,356)      2,044,635
                                          ------------   -------------
           Combined net income (loss) ..  $ (1,111,884)  $   1,217,298
                                          ============   =============
</TABLE>

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

   Cash Equivalents -- The Company considers highly liquid investments purchased
with original maturities of three months or less to be cash equivalents.

   Inventories, which consist of finished goods and raw materials, are stated at
the lower of cost (first-in, first-out method) or market.

   Property and equipment are stated at cost and are depreciated using
straight-line methods over their respective estimated useful lives, ranging from
2 to 40 years. Leasehold improvements are depreciated over the lease term or the
estimated useful life, whichever is shorter.

   Goodwill and Trademarks are being amortized on a straight-line basis over 15
to 40 years.

   Other intangible assets consist of deferred patent and licensing costs,
software rights, and covenants not to compete. Deferred patent and licensing
costs incurred in connection with the acquisition of patent rights, obtaining
Food and Drug Administration ("FDA") regulatory approvals and obtaining other
licensing rights for treatment compositions are capitalized and amortized over
the estimated benefit period not exceeding 17 years. Covenants not to compete
are amortized over the term of the agreement. Research and development costs
totaling approximately $2,853,000, $2,270,000 and $626,000 in 1998, 1997 and
1996, respectively, were expensed.

   Net (loss) income per common share - Basic net income per common share is
computed by dividing net (loss) income available to common shareholders by the
weighted average number of common shares outstanding during the year before
giving effect to stock options considered to be dilutive common stock
equivalents. Diluted net income per common share is computed by dividing net
(loss) income available to common shareholders by the weighted average number of
common shares outstanding during the year after giving effect to stock options
and warrants considered to be dilutive common stock equivalents. For the years
ended July 31, 1998 and 1997, options and warrants that would otherwise qualify
as common stock equivalents are excluded because their inclusion would have the
effect of decreasing the loss per share.


                                      F-9

<PAGE>   38

New Accounting Pronouncements -- In June 1997, the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 130, Reporting Comprehensive Income, and SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information. SFAS No. 130 requires
that an enterprise (a) classify items of other comprehensive income by their
nature in a financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and additional capital in
the equity section of a statement of financial position. SFAS No. 131
establishes standards for the way that public enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports to shareholders. It also establishes standards for disclosures
about products and services, geographic areas and major customers. Both
statements are effective for fiscal years beginning after December 15, 1997. The
Company believes the adoption of SFAS No. 130 will have no material impact on
the Company's financial statements. The Company has not completed evaluating the
impact of implementing the provision of SFAS No. 131.

   Financial Instruments -- The carrying amounts and estimated fair value of the
Company's financial instruments are as follows:

      The carrying values of cash and cash equivalents, receivables, accounts
   payable and accrued expenses approximate fair values due to the short-term
   maturities of these instruments.

      The carrying amount of long-term debt and short-term borrowings are
   estimated to approximate fair value as the actual interest rate is consistent
   with the rate estimated to be currently available for debt of similar term
   and remaining maturity.

   Financial instruments which potentially subject the Company to credit risk
consist principally of trade receivables. The Company provides credit, in the
normal course of business, to pharmaceutical wholesalers and chains, food
wholesalers and chains, rack jobbers, convenience stores, and dentists. The
Company performs ongoing credit evaluations of its customers and maintains an
allowance for credit losses.

   Certain reclassifications have been made to the 1997 and 1996 financial
statements to conform to the classifications used in 1998.

2. ACQUISITIONS

   On November 5, 1997, the Company's Zila Pharmaceuticals, Inc. subsidiary
completed its acquisition of the Peridex(R) product line ("Peridex"), a
prescription anti-bacterial oral rinse from The Procter & Gamble Company
("P&G"). The purchase price was $12,000,000 plus the value of acquired
inventory. Payment of the purchase price was structured as follows: $6,000,000
paid at closing, $1,000,000 paid within 30 days after closing, $3,000,000 paid
within 180 days after closing, $1,000,000 is payable within 12 months after
closing, and $1,000,000 is payable within 24 months after closing.


                                      F-10

<PAGE>   39

On November 10, 1997, the Company acquired, by merger, Oxycal Laboratories, Inc.
("Oxycal"). Oxycal develops, manufactures and markets a patented, enhanced form
of Vitamin C under the trademark Ester-C(R). The Company paid $28,000,000 for
all outstanding shares of Oxycal. The Company raised the funds to consummate the
Merger in a private placement of 30,000 shares of the Company's Series A
Convertible Redeemable Preferred Stock ("Preferred Stock") and warrants to
purchase 360,000 shares of the Company's common stock for $30,000,000.

   The Peridex and Oxycal acquisitions were accounted for using the purchase
method of accounting for business combinations. In connection with the Oxycal
acquisition, trademarks and goodwill of $11,096,280 and $3,698,760 were recorded
and are amortized on a straight-line basis over 25 and 20 years. In connection
with the Peridex acquisition, goodwill of $11,570,637 was recorded and is
amortized on a straight-line basis over 12 years. Results of operations of
Peridex and Oxycal have been included in the Company's statement of operations
from their respective acquisition dates.

   The following unaudited pro forma summary presents the consolidated results
of operations as if the acquisitions had occurred as of the beginning of each
period presented and do not purport to be indicative of what would have occurred
had the acquisitions been made as of those dates or of results which may occur
in the future. The unaudited pro forma summary data for the year ended July 31,
1997 combines historical financial information of the Company for the year ended
July 31, 1997 and Peridex and Oxycal for the year ended June 30, 1997. The
unaudited pro forma summary data for the year ended July 31, 1998 combines
actual financial results of the Company for the year ended July 31, 1998, which
includes Peridex and Oxycal results for the nine months ended July 31, 1998, and
Peridex and Oxycal for the three months ended September 30, 1997. The embedded
dividend for the year ended July 31, 1998 and 1997 represents 270 days of
accretion and is based on the assumption that the Preferred Stock had been
issued at the beginning of each period.

<TABLE>
<CAPTION>
                                                         1998           1997
                                                         ----           ----
<S>                                                  <C>            <C>         
         Revenues                                    $ 68,329,759   $ 65,757,902

         Net income                                  $  4,991,556   $  3,942,566

         Series A Preferred Stock embedded dividend  $  7,314,600   $  7,314,600

         Net loss available to common shareholders   $ (2,323,044)  $ (3,372,034)

         Basic loss per share                        $      (0.07)  $      (0.11)
</TABLE>

   These pro forma results have been prepared for comparative purposes only and
include certain adjustments such as the increase in amortization expense
associated with goodwill as a result of applying the purchase method of
accounting for the acquisitions.

   On April 4, 1997, the Company acquired Cygnus, a privately-held company
located in Scottsdale, Arizona that manufactures and distributes intra-oral
camera systems and other dental imaging products. The acquisition was accounted
for as a purchase and resulted in the issuance of 259,398 shares of the
Company's common stock with a market value of $1,725,000 and the recording of
approximately $2,101,000 of goodwill. The goodwill is amortized on a
straight-line basis over 15 years.


                                      F-11

<PAGE>   40
   On March 7, 1996, the Company purchased one-third of the outstanding common
stock of CTM Associates, Inc. ("CTM") from one of the three directors and
shareholders of CTM. On June 3, 1996, the Company acquired the remaining
two-thirds of the outstanding shares of CTM. The only significant asset of CTM
was the technology rights it held related to OraTest (a diagnostic for oral
cancer and site delineation device for biopsy and surgical excision) and its
right to receive certain royalties from sales of OraTest from the Company.
Accordingly, the acquisition of CTM eliminates the Company's obligation to pay
royalties to CTM on revenues generated from sales of OraTest. As consideration
for the acquisition of all of the CTM common stock, the Company issued a total
of 869,118 shares of the Company's common stock with a value of $7,170,223, paid
$125,000, and assumed certain liabilities of approximately $70,000. The
acquisition was accounted for as an acquisition of assets and the purchase price
was recorded as purchased technology rights. The purchased technology rights are
being amortized on a straight-line basis over the expected period of benefit of
17 years which is based on the remaining life of the related patents.

3. INVENTORIES

   Inventories consist of the following at July 31:

<TABLE>
<CAPTION>
                                      1998           1997
                                  ------------   ------------
<S>                               <C>            <C>         
         Finished goods.........  $  7,048,539   $  4,381,339
         Raw materials..........     4,807,214        451,563
         Inventory reserves ....      (305,744)      (546,275)
                                  ------------   ------------
         Total inventories .....  $ 11,550,009   $  4,286,627
                                  ============   ============
</TABLE>

   Amounts charged to cost of products sold to increase inventory reserves
during fiscal 1998, 1997 and 1996 were $129,880, $396,996 and $1,117,065,
respectively.

4. PROPERTY AND EQUIPMENT

   Property and equipment consists of the following at July 31:

<TABLE>
<CAPTION>
                                                                1998         1997
                                                            -----------  -----------
<S>                                                         <C>          <C>        
         Land.............................................  $   817,911  $   216,731
         Building and improvements........................    2,069,626      651,034
         Furniture and equipment..........................    2,700,739    2,234,889
         Leasehold improvements and other assets..........      374,229      387,631
         Production and warehouse equipment...............    1,912,037      118,553
                                                            -----------  -----------
         Total property and equipment.....................    7,874,542    3,608,838
         Less accumulated depreciation and amortization ..    2,918,681    1,743,453
                                                            -----------  -----------
         Property and equipment -- net....................  $ 4,955,861  $ 1,865,385
                                                            ===========  ===========
</TABLE>


                                      F-12

<PAGE>   41
5. INTANGIBLE ASSETS

   Intangible assets consist of the following at July 31:

<TABLE>
<CAPTION>
                                                                    1998          1997
                                                                    ----          ----
<S>                                                             <C>           <C>
         Purchased technology rights -- net of accumulated
          amortization of $945,619 (1998) and $509,180
          (1997)..............................................  $  6,473,854  $ 6,910,293
                                                                ============  ===========
         Goodwill -- net of accumulated amortization of
          $1,205,338 (1998) and $162,070 (1997)...............  $ 17,009,914  $ 2,693,139
                                                                ============  ===========
         Trademarks - net of accumulated amortization of
          $427,193 (1998) and $59,741 (1997) .................  $ 11,131,925  $    28,119
                                                                ============  ===========
         Patents..............................................  $  1,110,644  $   482,634
         Licensing costs......................................     1,692,853    1,086,509
         Other................................................       265,844      204,544
                                                                ------------  -----------
         Total other intangible assets........................     3,069,341    1,773,687
         Less accumulated amortization........................       895,989      573,264
                                                                ------------  -----------
         Other intangible assets -- net.......................  $  2,173,352  $ 1,200,423
                                                                ============  ===========
</TABLE>
   Licensing costs consist primarily of professional fees associated with
obtaining FDA approval for a new product, OraTest (formerly OraScan). The
recoverability of the deferred licensing costs and purchased technology rights
is dependent upon both FDA approval and sufficient revenues generated from sales
of OraTest; management believes they will receive FDA approval and generate
revenues sufficient to recover such costs. Purchased technology rights relate to
the acquisition of CTM (Note 2).

   Amortization of the Company's intangible assets during fiscal 1998, 1997 and
1996, was $2,000,090, $656,086 and $335,214, respectively.

6. SHORT-TERM BORROWINGS AND LONG-TERM DEBT

   The Company obtained a $2,000,000 bank line of credit in April 1998, which is
collateralized by trade accounts receivable, inventories and rights to payment.
This line of credit expires December 31, 1998. Interest is payable monthly on
the unpaid balance outstanding at the bank's prime rate (8.5% at July 31, 1998)
plus .50%. At July 31, 1998, the Company had no borrowings against this line.

   At July 31, 1998, short-term borrowings consisted of $87,598 for installments
due on the Company's various insurance policies.

   At July 31, 1998, long-term debt consists of a mortgage note, the Peridex
purchase commitment, and notes on equipment. The mortgage note of $354,223 at
July 31, 1998, bears interest at a fixed rate of 9.00% per year due in monthly
principal installments of $2,315, through March 2001 with a balloon payment due
April 1, 2001. The note is collateralized by the Company's land and building.
The purchase commitment of $2,000,000 (Note 2) is reduced by $141,635 for the
unamortized discount on the debt which has an imputed interest rate of 10.00%.
Also included in long-term debt at July 31, 1998 is $95,916 in various notes for
equipment and computer systems with interest rates between 3.06% and 9.44% and
maturities between two to three years.


                                      F-13

<PAGE>   42
   Aggregate annual maturities of long-term debt for the years ending July 31
are as follows:

<TABLE>
<S>                                       <C>
         1999...........................  $ 1,072,340
         2000...........................    1,079,141
         2001...........................      298,658
                                          -----------
         Total..........................    2,450,139
         Less unamortized discount .....      141,635
         Less current portion ..........      952,957
                                          -----------
         Long-term portion .............  $ 1,355,547
                                          ===========
</TABLE>

   Under the mortgage note, the Company is required to comply with financial
covenants based on certain financial ratios. At July 31, 1998, the Company was
in compliance with all required covenants.

7. LICENSING FEE INCOME AND ROYALTIES

   The Company has entered into various licensing agreements (the "Agreements").
Under the terms of the Agreements, the licensees acquire the right to
manufacture and sell the Company's products in markets previously not pursued by
the Company. In return, the Company will receive non-refundable license fees
and/or royalties equal to a fixed percentage of the net sales by the licensees
of the Company's products. One of the Agreements provides that the royalty
payments will meet certain minimum annual levels irrespective of the volume of
sales subject to the Agreement.

   During 1996, the Company received $750,000 in non-refundable licensing fees
from P&G in connection with a licensing agreement between P&G and the Company,
which was subsequently terminated on April 3, 1996. Additionally, under the
licensing agreement with P&G, the Company received $265,330 in reimbursements
for costs associated with obtaining FDA approval for OraTest.

   On July 22, 1996, Young Innovations, Inc. ("Young") acquired substantially
all of the assets and certain liabilities of Denticator International, Inc.
("DII"). Bio-Dental received approximately $7,500,000 in lieu of future
royalties that Bio-Dental was entitled to receive in connection with its
licensing agreement with DII. In addition, Young issued Bio-Dental a product
credit against future purchases from Young equal to the amounts due Bio-Dental
at the time of closing. Included in other receivables at July 31, 1997 is
$319,127 of product credits due from Young.

   During 1996, Bio-Dental earned royalties under the DII licensing agreement
totaling $1,235,069, which are included in licensing fees and royalty revenue.

8. STOCK OPTIONS AND WARRANTS

   As a result of the merger described in Note 1, each Bio-Dental stock option
or stock purchase warrant that was outstanding at the merger date can be used to
purchase .825 shares of Zila, Inc. common stock. The exercise price of
outstanding Bio-Dental options and warrants was also adjusted at the merger
date. The new exercise prices are calculated by dividing the original exercise
price by .825. The summary of activity related to options and warrants below
includes Bio-Dental options and warrants adjusted for the terms of the merger.


                                      F-14

<PAGE>   43
   a. Options -- The Company adopted the 1997 Stock Option Award Plan which
became effective on February 5, 1997, authorizing the Board of Directors to
grant options to employees and certain employee directors of the Company to
purchase up to 1,000,000 shares of the Company's common stock. The options are
issuable at an exercise price no less than market value at the date of grant.
Options may be exercised up to five to ten years from the date of grant. At July
31, 1998, 311,874 shares were available for grant under this plan.

   The Company adopted a Stock Option Award Plan which became effective on
September 1, 1988, authorizing the Board of Directors to grant options to
employees and certain employee-directors of the Company to purchase up to
4,000,000 shares of the Company's common stock. The plan was amended December 8,
1995 to increase the authorized number of shares to 5,000,000. The options are
issuable at an exercise price no less than the market value at the date of
grant. Options may be exercised at any time up to five to ten years from the
date of grant. At July 31, 1998, no shares were available for grant under this
plan.

   The Company adopted a Non-Employee Directors Stock Option Plan which became
effective October 20, 1989, authorizing the Board of Directors to grant options
to 100,000 shares to non-employee members of the Board of Directors in
increments of 2,500 shares per director each year. The plan was amended December
8, 1995 to increase the authorized number of shares to 200,000. The options are
issuable at exercise price equal to the market value at the date of grant. All
options may be exercised at any time up to five years from the date of grant. At
July 31, 1998, 70,000 shares were available for grant under this plan.

   A summary of the status of the option plans as of July 31, 1998, 1997 and
1996 and changes during the years then ended is presented below:

<TABLE>
<CAPTION>
                                                  1998                      1997                      1996
                                         ----------------------    ----------------------    ----------------------
                                                       WEIGHTED                  WEIGHTED                  WEIGHTED
                                                        AVERAGE                   AVERAGE                   AVERAGE
                                                       EXERCISE                  EXERCISE                  EXERCISE
                                           SHARES        PRICE       SHARES        PRICE       SHARES        PRICE
                                         -----------   --------    -----------   --------    -----------   --------
<S>                                      <C>           <C>         <C>           <C>         <C>           <C>
Outstanding at beginning of year ......    2,151,946     $ 4.03      1,906,575     $ 2.81      2,040,936     $ 2.35
Granted................................      586,000       5.97        712,558       6.98        354,242       4.26
Exercised..............................     (422,973)      3.15       (285,493)      1.90       (414,351)      2.28
Forfeited..............................     (248,482)      3.87       (181,694)      3.93        (74,252)      3.51
                                         -----------               -----------               -----------
Outstanding at end of year.............    2,066,491       5.26      2,151,946       4.03      1,906,575       2.81
                                         ===========               ===========               ===========
Options exercisable at year-end .......    1,494,866                 1,703,267                 1,851,575
                                         ===========               ===========               ===========
Weighted average fair value of
  options granted during the year .....  $      1.96               $      2.54               $      1.90
                                         ===========               ===========               ===========
</TABLE>

   The following table summarizes information about fixed stock options
outstanding at July 31, 1998:

<TABLE>
<CAPTION>
                                   OPTIONS OUTSTANDING                          OPTIONS EXERCISABLE
            ------------------------------------------------------------    ---------------------------
                                  NUMBER        WEIGHTED        WEIGHTED        NUMBER         WEIGHTED
                               OUTSTANDING      AVERAGE         AVERAGE      EXERCISABLE       AVERAGE
                RANGE OF           AT           REMAINING       EXERCISE          AT           EXERCISE
            EXERCISE PRICES   JULY 31, 1998  CONTRACTUAL LIFE    PRICE      JULY 31, 1998       PRICE
            ---------------   -------------  ----------------   --------    -------------      --------
<S>                           <C>            <C>                <C>         <C>                <C>
            $0.12 -- $1.31       279,752           2.83         $  1.21        279,752         $  1.21
             2.42 --  4.00       314,688           5.16            3.01        308,063            3.00
             4.24 --  6.13       706,093           6.95            5.49        372,093            5.20
             6.50 --  8.18       765,958           7.46            6.91        534,958            7.01
                               ---------                                     ---------
             0.12 --  8.18     2,066,491                                     1,494,866
                               =========                                     =========
</TABLE>


                                      F-15

<PAGE>   44
   The Company applies APB Opinion No. 25 and related interpretations in
accounting for its stock-based employee compensation plans. Accordingly, no
compensation cost has been recognized for its stock-based employee compensation
plans. Had compensation cost been computed based on the fair value of awards on
the date of grant, utilizing the Black-Scholes option-pricing model, consistent
with the method stipulated by SFAS No. 123, the Company's net (loss) income
available to common shareholders and (loss) income per share available to common
shareholders for the years ended July 31, 1998, 1997 and 1996 would have been
reduced (increased) to the pro forma amounts indicated below, followed by the
model assumptions used:

<TABLE>
<CAPTION>
                                                                                      JULY 31,
                                                                          1998           1997           1996
                                                                      -----------    -----------    -----------
<S>                                                                   <C>            <C>            <C>
           Net (loss) income available to common shareholders:
             As reported..................................            $(5,014,000)   $(6,458,000)   $ 1,217,000
             Pro forma....................................            $(6,114,000)   $(7,791,000)   $   862,000
           Net (loss) income available to common shareholders
             per basic shares outstanding:
             As reported..................................            $      (.15)   $      (.20)   $       .04
             Pro forma....................................            $      (.18)   $      (.25)   $       .03
           Black-Scholes model assumptions:
             Risk-free interest rate......................             4.2 -- 4.4%    5.5 -- 6.0%    5.5 -- 6.0%
             Expected volatility..........................                     38%            39%            39%
             Expected term................................            2 -- 6 years   2 -- 6 years   3 -- 6 years
             Dividend yield...............................                      0%             0%             0%
</TABLE>

   b. Warrants -- The Company has issued warrants to various investors,
shareholders and other third parties in connection with services provided and
purchases of the Company's stock. Activity related to such warrants, which
expire at various dates through October 2000, is summarized as follows:

<TABLE>
<CAPTION>
                                              NUMBER OF     WARRANT PRICE
                                                SHARES        PER SHARE
                                              ---------  -------------------
<S>                                          <C>         <C>
           Outstanding, August 1, 1995.....     956,902   $   .60 -- $   3.77
             Exercised....................    (140,138)     2.41 
             Expired......................     (46,092)     3.13 
                                             ----------
           Outstanding, July 31, 1996.....     770,672       .60 --     3.77
             Issued.......................     300,000    8.6125
             Exercised....................    (153,665)      .60 --     3.00
             Expired......................     (14,992)      .75 --     2.41
                                             ----------
           Outstanding, July 31, 1997.....     902,015       .60 --   8.6125
             Issued.......................     456,000     7.625 --    9.915
             Exercised....................    (214,609)      .60 --     3.00
                                             ----------
           Outstanding, July 31, 1998.....   1,143,406   $  3.00 -- $  9.915
                                             =========
</TABLE>


9. INCOME TAXES

   The consolidated income tax (benefit) provision consists of the following for
the years ended July 31:

<TABLE>
<CAPTION>
                                                        1998           1997          1996
                                                    ------------   -----------   -----------
<S>                                                 <C>            <C>           <C>
           Current:
             Federal.............................   $    (51,000)  $  (312,000)  $ 1,524,000
             State...............................         (9,000)          --        455,000
                                                    ------------   -----------   -----------
           Total current.........................        (60,000)     (312,000)    1,979,000
                                                    ------------   -----------   -----------
           Deferred:
             Federal.............................     (1,479,000)     (304,000)     (245,000)
             State...............................       (261,000)       26,000      (195,000)
                                                    ------------   -----------   -----------
           Total deferred........................     (1,740,000)     (278,000)     (440,000)
                                                    ------------   -----------   -----------
           Total consolidated income tax (benefit) 
           provision.............................   $ (1,800,000)  $  (590,000)  $ 1,539,000
                                                    ============   ===========   ===========
</TABLE>


                                      F-16

<PAGE>   45
   The reconciliation of the federal statutory rate to the effective income tax
rate for the years ended July 31 is as follows:

<TABLE>
<CAPTION>
                                                                  1998    1997    1996
                                                                  ----    ----    ----
<S>                                                               <C>     <C>     <C>
           Federal statutory rate...............................    34%    (34)%    34%
           Adjustments:
             State income taxes -- net of federal benefit.......     6      (6)      6
             Non-deductible meal and entertainment expenses ....     7       2       2
             Non-deductible acquisition expenses and other .....    14
             Non-deductible goodwill amortization ..............    74
             (Decrease) increase in valuation allowance.........  (494)     30      14
                                                                  -----   ----   -----
           Effective tax rate...................................  (359)%    (8)%    56%
                                                                  ====    ====    ====
</TABLE>

   The components of the Company's deferred income tax assets and liabilities
for the years ended July 31 are shown below:

<TABLE>
<CAPTION>
                                                                           1998          1997
                                                                       -----------   -----------
<S>                                                                    <C>           <C>
           Current deferred income tax assets:
             Net operating loss carryforwards........................  $ 7,062,000   $ 6,810,000
             Allowance for obsolete or discontinued inventory........      146,000       219,000
             Book basis vs. tax basis differences....................       49,000       227,000
             Reserve for litigation..................................       27,000       180,000
             Product warranty allowance..............................       45,000       173,000
             Allowance for doubtful accounts.........................      112,000       140,000
             Accrued vacation........................................       79,000        40,000
             Other...................................................       36,000        20,000
                                                                       -----------   -----------
           Total current deferred income tax assets..................    7,556,000     7,809,000
           Valuation allowance.......................................   (4,771,000)   (7,563,000)
                                                                       -----------   -----------
           Net deferred income tax asset.............................  $ 2,785,000   $   246,000
                                                                       ===========   ===========
</TABLE>

   Approximately $1,739,000 of the deferred tax asset before valuation allowance
relates to deductions generated by the exercise of stock options, which, if
realized, will result in an increase in capital in excess of par value.
Management believes the valuation allowance reduces deferred tax assets to an
amount that represents management's best estimate of the amount of such deferred
tax assets that more likely than not will be realized.

   Deferred income taxes reflect the tax effect of temporary differences between
the amounts of assets and liabilities recognized for financial reporting and tax
purposes. In the past, the Company had fully offset its net deferred tax asset
with a valuation allowance due to the Company's lack of earnings history. For
the year ended July 31, 1998, the Company returned to profitability and as a
result recorded an income tax benefit of $2,600,000 ($800,000 of which was
attributable to the exercise of common stock options and therefore was credited
to capital in excess of par value).

   At July 31, 1998, the Company had federal net operating loss carryforwards
totaling approximately $19,412,000 which expire, if not previously utilized,
from 1999 through 2013. Net operating loss carryforwards for state income tax
purposes, totaling approximately $7,703,000, must be utilized within five years
of the date of their origination, and expire from 1999 through 2003.

10. REDEEMABLE PREFERRED STOCK

   On November 10, 1997, the Company completed a $30,000,000 financing involving
the private placement of Series A Convertible Redeemable Preferred Stock.
Proceeds from the sale were used primarily to acquire all the outstanding shares
of Oxycal Laboratories, Inc. The Preferred Stock is convertible into shares of
the Company's common stock at a conversion rate based on the price of such
common stock at the date of issuance. However, if the market price of the
Company's common stock does not appreciate by a fixed percentage at various


                                      F-17

<PAGE>   46
measurement dates, the holders of the Preferred Stock have the right to receive
additional shares of the Company's common stock upon conversion, based on a
repricing formula. Per guidance from the Emerging Issues Task Force, the
intrinsic value of the beneficial conversion feature of the Preferred Stock has
been measured and recognized as an embedded dividend and such non-cash embedded
dividend has been deducted from net income in the accompanying consolidated
statement of operations to arrive at the amount of net (loss) income available
to common shareholders. Additionally, because the Preferred Stock has conditions
for redemption that are not solely within the control of the Company, it has
been classified outside of permanent equity in the accompanying consolidated
balance sheet and has been accreted to its redemption value. During the year,
1,200 shares of the Preferred Stock were converted into common stock.


11. COMMITMENTS AND CONTINGENCIES

   In June 1992, the Company entered into an agreement with Daleco Capital
Corporation to form a limited partnership known as Daleco Zila Partners II, L.P.
(the "Partnership"). The Company and its officers have no partnership interest
in the Partnership. The purpose of the Partnership was to provide the Company
with a means to fund the marketing program for certain new products. The
original Partnership agreement provided for a minimum of $150,000 and a maximum
of $1,562,500 to be raised by the sale of partnership units. Under the original
agreement, the Partnership will expend up to 80% of the gross partnership
proceeds for marketing and sales-related expenditures on behalf of the Company.
In 1994, the Partnership agreement was amended to increase the maximum amount of
marketing funds potentially available to the Company to be raised to $2,250,000.

   At July 31, 1998, approximately $1,820,000 has been spent. The Company is
committed to pay the Partnership a commission equal to 5% to 10% of the gross
sales of certain of the Company's new products, until such time as three times
the amount of funds expended on the Company's marketing program by the
Partnership has been paid to the Partnership. The Company has paid commissions
to the Partnership of approximately $16,000, $64,000 and $15,000, for the years
ended July 31, 1998, 1997 and 1996, respectively.

   In connection with the acquisition of patent rights in 1980, the Company
agreed to pay to Dr. James E. Tinnell, the inventor of one of the Company's
treatment compositions, a royalty of 5% of gross sales of the treatment
composition. Royalty expense to Dr. Tinnell for the years ended July 31, 1998,
1997 and 1996 was $371,943, $310,827 and $300,078, respectively.

   The Company has a New Drug Application pending with the FDA for OraTest. The
initiation of the marketing of OraTest in the United States is dependent upon
the approval of the New Drug Application by the FDA. During 1994, the FDA
approved the Company's application for an Investigational New Drug for OraTest,
which allows the Company to manufacture the product in the United States for
clinical studies and export to certain foreign countries. The Company believes
that the FDA will approve the New Drug Application and the production and
marketing of OraTest (Note 5).


                                      F-18

<PAGE>   47
   The Company leases a manufacturing facility in Phoenix, Arizona under a three
year agreement which expires April 30, 1999. The agreement has an option to
renew for an additional five years. Additionally, the Company leases offices,
warehouse facilities and certain equipment, under operating leases which expire
through 2002. Future minimum lease payments under these non-cancelable leases
are as follows:

<TABLE>
<S>                                      <C>
                     1999.........         245,503
                     2000.........         197,189
                     2001.........         187,835
                     2002.........          63,194
                                         ---------                               
                     Total........       $ 693,721
                                         =========
</TABLE>

   Rent expense for the years ended July 31, 1998, 1997 and 1996 totaled
$270,297, $209,110 and $171,096 and, respectively.

   Peridex was manufactured by Procter & Gamble through June 1998. Subsequently,
Accupac of Mainland, Pennsylvania, became the primary manufacturer and is
currently seeking FDA clearance to manufacture Peridex. The Company believes it
has sufficient inventory of Peridex to fulfill all orders until Accupac receives
FDA clearance.

   Upon consummation of the Company's merger with Bio-Dental, each of the
outstanding shares of Bio-Dental common stock was converted into .825 shares of
the Company's common stock. Subsequent to the merger, the Company's stock
transfer agent was presented with a certificate purporting to represent 220,000
shares of Bio-Dental common stock which did not appear on the records of
Bio-Dental's stock transfer agent as of the closing date. The Company is
currently investigating this matter and has not determined whether any shares of
the Company's common stock are required to be issued in exchange for the shares
purportedly represented by this certificate.

   In July 1995, one of Zila's subsidiaries, Bio-Dental, was named as a
defendant, along with Bio-Dental's transfer agent and a shareholder of
Bio-Dental ("Shareholder"), in a lawsuit. The lawsuit alleges that Bio-Dental
wrongfully failed to register 200,000 Bio-Dental shares in the name of the
plaintiffs which were pledged as security by the Shareholder for a debt owed by
the Shareholder to the plaintiffs. Bio-Dental denied all of the material
allegations of the lawsuit against it and has asserted various affirmative
defenses. Bio-Dental accrued a liability of $450,000 in September 1996 because
it believed a loss was probable at that time. This amount was Bio-Dental's best
estimate of the loss in the event the outcome of the litigation was unfavorable
to Bio-Dental. In November 1996, Bio-Dental was granted a summary judgment in
which the court ruled in favor of Bio-Dental. In February 1997, the plaintiffs
started the process to appeal the judgment. Subsequently, the appellate court
upheld the lower court's summary judgment in favor of Bio-Dental. Accordingly,
Bio-Dental reversed $375,000 representing the remaining amount of accrued
liability.

   The Company is subject to other legal proceedings and claims which arise in
the ordinary course of business. In the opinion of management, the amount of
ultimate liability with respect to these actions will not materially affect the
financial position or results of operations of the Company.


                                      F-19

<PAGE>   48
12. EMPLOYEE BENEFIT PLAN

   The Company has adopted the Zila, Inc. 401(k) Savings and Retirement Plan
(the "Plan") for the benefit of eligible employees. Employees may elect to defer
receipt of a portion of their compensation to future years. The Company may make
matching or profit sharing contributions to the Plan. During 1998, 1997, and
1996, the Company contributed approximately $39,600, $19,000 and $14,000,
respectively, to the Plan.


13. IMPAIRMENT OF ASSETS

   In connection with assessing the recoverability of goodwill and other
intangible assets in the first quarter of fiscal 1997, the Company determined
that such assets that are associated with Integrated Dental Technologies, Inc.
("IDT"), a wholly-owned subsidiary of Bio-Dental, would not likely be
recoverable. This determination was the result of IDT failing to achieve
original projections of operating results subsequent to the restructuring of IDT
in early 1996. As a result, a $587,659 impairment loss was recognized to reduce
the carrying value of these long-lived assets to fair value. Fair value was
estimated based on management's best estimate of discounted future cash flows.

14. EQUITY LINE INVESTMENT AGREEMENT

   In April 1997, the Company entered into an investment agreement (the
"Investment Agreement") with Deere Park Capital Management (the "Investor")
which allowed the Company to sell up to $25,000,000 of the Company's common
stock with the proceeds to be used to fund OraTest marketing and general
corporate purposes. Under the Investment Agreement the Company sold $13,000,000
of common stock. The option to sell stock to the Investor expired in September
1998.

   As a commitment fee for keeping the equity line available for the 12 Month
Period, the Company issued warrants dated May 7, 1997 (the "Warrants") to the
Investor exercisable for 300,000 shares of common stock at an exercise price of
$8.6125 per share. The Warrants are exercisable for a three year period
commencing October 31, 1997.

15. SEGMENTS OF BUSINESS

   The Company has organized its business into three major operating groups:
Pharmaceutical Products, Professional Products and Nutraceutical Products. The
Pharmaceutical Products Group consists of over-the-counter and prescription
products, including the Zilactin family of over-the-counter products, Peridex
prescription mouth rinse, and OraTest, an oral cancer diagnostic system. The
Professional Products Group includes Zila Dental Supply ("Zila Dental"), a
national distributor of professional dental supplies, Cygnus Imaging ("Cygnus"),
a manufacturer and marketer of digital x-ray systems and intraoral cameras, and
Practiceworks, a dental practice management software company. The Nutraceutical
Products Group is presently comprised of Oxycal Laboratories and its Inter-Cal
subsidiary, manufacturers and distributors of a patented and enhanced form of
Vitamin C under the trademark Ester-C(R).


                                      F-20

<PAGE>   49

Intersegment sales are not significant.

<TABLE>
<CAPTION>
                                                     PHARMACEUTICAL       PROFESSIONAL        NUTRACEUTICAL          TOTAL
                                                     --------------       ------------        -------------       -----------
<S>                                                  <C>                  <C>                 <C>                 <C>
          Net sales:
            1998..................................     $15,512,038         $34,188,419         $12,242,308        $61,942,765
            1997..................................       6,739,571          31,852,681                             38,592,252
            1996..................................       5,978,131          31,501,415                             37,479,546
          (Loss) income before income taxes:
            1998..................................       (680,776)           (991,833)           2,173,677            501,068
            1997..................................     (3,672,521)         (3,375,787)                            (7,048,308)
            1996..................................       (827,337)           3,583,153                              2,755,816
          Identifiable assets:
            1998..................................      28,110,922          13,552,136          28,200,919         69,863,977
            1997..................................      13,908,770           9,695,262                             23,604,032
            1996..................................      12,030,307          13,279,474                             25,309,781
          Capital expenditures:
            1998..................................         456,417             375,664             444,181          1,276,262
            1997..................................         339,095             262,077                                601,172
            1996..................................         612,175             267,849                                880,024
          Depreciation and amortization:
            1998..................................       1,590,324             571,730             607,899          2,769,956
            1997..................................         774,525             379,903                              1,154,428
            1996..................................         289,786             473,878                                763,664
</TABLE>




16. QUARTERLY FINANCIAL DATA (UNAUDITED)

    Quarterly financial information is presented in the following summary:


<TABLE>
<CAPTION>
                                                                                 
                                                                                        1997
                                                     ------------------------------------------------------------------------
                                                                                      Quarters Ended
                                                     ------------------------------------------------------------------------
                                                       October 31          January 31           April 30           July 31
                                                     --------------       ------------        -------------       -----------
<S>                                                  <C>                  <C>                 <C>                 <C>
Revenues......................................       $9,230,522           $9,779,214          $9,927,993          $9,727,163
Gross Profit..................................        3,444,608            3,720,278           3,857,956           4,099,708
Net loss......................................       (2,274,221)          (1,455,619)         (1,447,087)         (1,281,450)
Net loss per share - basic....................            (0.07)               (0.05)              (0.05)              (0.03)
Net loss per share - diluted..................            (0.07)               (0.05)              (0.05)              (0.03)
</TABLE>


<TABLE>
<CAPTION>
                                                                                 
                                                                                        1998
                                                     ------------------------------------------------------------------------
                                                                                      Quarters Ended
                                                     ------------------------------------------------------------------------
                                                       October 31          January 31           April 30           July 31
                                                     --------------       ------------        -------------       -----------
<S>                                                  <C>                  <C>                 <C>                 <C>
Revenues......................................       $10,800,182          $16,940,983         $17,723,721         $16,642,224
Gross Profit..................................         4,222,924            8,822,177           9,799,328           8,586,008 
Net income (loss).............................          (429,790)           1,281,999             220,661           1,228,198
Net loss available to common
shareholders..................................          (429,790)          (1,872,693)         (2,667,430)            (43,619)
Net loss available to common
shareholders - basic..........................             (0.01)               (0.05)              (0.08)              (0.00)
Net loss available to common
shareholder - diluted.........................             (0.01)               (0.05)              (0.08)              (0.00)
</TABLE>


                                      F-21

<PAGE>   50
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                            DESCRIPTION                                          PAGE OR
                                                                                                   METHOD OF FILING
<S>                                                                                               <C>
2        Merger Agreement dated August 8, 1996 among Zila, Inc. Bio-Dental
         Technologies Corporation and Zila Merger Corporation                                                  A
3-A      Certificate of Incorporation, as amended                                                              B
3-B      Bylaws                                                                                                B
4-A      Specimen Stock Certificate                                                                            B
4-B      Certificate of Designations, Preferences and Rights of Series A
         Convertible Preferred Stock                                                                           L
4-C      Specimen Warrant Certificate                                                                          C
4-D      Form Stock Purchase Warrant re Series A Preferred Stock                                               L
4-E      Deere Park Capital Management Warrant
                                                                                                               J
4-F      Bartholomew Investment, L.P. Warrant                                                                  J
10-A     Revolving Line of Credit Loan Agreement dated April 8, 1991 between
         Zila, Inc. and Banc One, Arizona
                                                                                                               D
10-B#    Stock Option Award Plan (as amended through April 10, 1991)                                           E
10-C#    Non-Employee Directors Stock Option Plan (as amended through April 10, 1991)                          E
10-E#    1997 Stock Option Award Plan                                                                          L
10-G     Manufacturing and Distribution Agreement dated March 12, 1993 between
         Zila, Inc. and Germiphene Corporation                                                                 G
10-H     Agreement dated November 26, 1996 between Cheseborough Ponds USA Co
         and Zila Pharmaceuticals, Inc                                                                         H
10-I     Private Equity Line of Credit between Deere Park Capital Management
         and Zila, Inc. Dated as of April 30, 1997                                                             J
10-J     Amendment to Private Equity Line of Credit Agreement                                                  J
10-K     Registration Rights Agreement dated as of May 9, 1997 between Zila,
         Inc. and Deere Park Capital Management                                                                J
10-L     Registration Rights Agreement dated as of May 9, 1997 between Zila,
         Inc. and Bartholomew Investment, L.P                                                                  J
10-M     Merger Agreement dated as of April 3, 1997 among Zila, Inc., Cygnus
         Imaging, Inc., Cygnus Merger Corporation, and Egidio Cianciosi,
         James Jenson and Kenneth Kirk                                                                         J
10-N     Securities Purchase Agreement dated as of October 17, 1997 by and
         among Zila, Inc. and certain investors                                                                L
10-O     Registration Rights Agreement dated October 17, 1997 by and among
         Zila, Inc. and certain investors                                                                      L
21       Subsidiaries of Registrant                                                                            *
23-A     Consent of Deloitte & Touche LLP (regarding Form S-8 and Form S-3
         Registration Statements)                                                                              *
23-B     Consent of Grant Thornton (regarding Form S-8 and Form S-3
         Registration Statements)                                                                              *
24-A     Power of Attorney of Joseph Hines                                                                     *
24-B     Power of Attorney of Bradley C. Anderson                                                              *
24-C     Power of Attorney of Clarence J. Baudhuin                                                             *
24-D     Power of Attorney of Carl A. Schroeder                                                                *
24-E     Power of Attorney of Patrick M. Lonergan
                                                                                                               *
24-F     Power of Attorney of Michael S. Lesser                                                                *
24-G     Power of Attorney of Curtis M. Rocca                                                                  *
24-H     Power of Attorney of Thomas B. Simone                                                                 *
27       Financial Data Schedule                                                                               *
99       The Company's 1998 Proxy Statement for the Annual Meeting of
         Stockholders to be held on December 10, 1998                                                          K


#        Management contract or compensation plan or arrangement
*        Filed herewith
A        Incorporated by reference to Exhibit 2 to the Company's Form S-4 Registration Statement
         No. 333-10107, as amended
B        Incorporated by reference to the Company's Annual Report on Form 10-K
         for the fiscal year ended July 31, 1988, as amended
C        Incorporated by reference to the Company's Annual Report on Form 10-K
         for the fiscal year ended July 31, 1994, as amended
D        Incorporated by reference to the Company's Form S-3 Registration Statement No.
         33-46239
E        Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the
         quarterly period ended January 31, 1996, as amended
F        Incorporated by reference to Exhibit 10-C to Post-Effective Amendment No. 3 to Form S-1
         Registration Statement No. 33-27739
G        Incorporated by reference to Exhibit 10-L to the Company's Annual
         Report on Form 10-K For the fiscal year ended July 31, 1993, as amended
H        Incorporated by reference to the Company's Quarterly Report for the
         quarterly period ended October 31, 1996, as amended
I        Incorporated by reference to the Company's Current Report dated February 11,
         1997
J        Incorporated by reference to the Company's Form S-3 Registration Statement No. 333-31651
K        Filed by amendment
L        Incorporated by reference to the Company's Annual Report on Form 10-K for fiscal
         year ended July 31, 1997
</TABLE>