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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549


FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934



|(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, 2002
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)


|                                                                                 |  |                                                
|-------------------------------------------------------------------------------- |  | -----------------------------------------------
|Delaware
(State or Other Jurisdiction of Incorporation or Organization)          |  | 86-0619668
(I.R.S. Employer Identification No.)
|                                                                                
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|5227 North 7th Street, Phoenix, Arizona
(Address of Principal Executive Offices) |  | 85014-2800
(Zip Code)                          

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.  [X ]

At September 30, 2002, the aggregate market value of common stock held by
non-affiliates of the registrant was $ 54,127,000.

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, 2002, the number of shares of common stock outstanding
was 45,485,260.

DOCUMENTS INCORPORATED BY REFERENCE

Materials from the Registrants 2002 Proxy Statement have been
incorporated by reference into Part III, Items 10, 11, 12 and 13.



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|               |                                                                                                                   |  |  |  |  |  |  | 
|-------------- | ----------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I        
|               | Item 1. BUSINESS                                                                                                 
|               | Item 2. PROPERTIES                                                                                               
|               | Item 3. LEGAL PROCEEDINGS                                                                                        
|               | Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                      
|PART II       
|               | Item 5. MARKET FOR THE COMPANYS COMMON STOCK AND RELATED STOCKHOLDER MATTERS                                    
|               | Item 6. SELECTED FINANCIAL DATA                                                                                  
|               | Item 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                    
|               | Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                              
|               | Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND                      FINANCIAL DISCLOSURE
|PART III      
|PART IV       
|               | Item 15. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES, AND REPORTS ON FORM 8-K                                   
|SIGNATURES    
|CERTIFICATIONS
|Exhibit Index 
|EX-3.B        
|EX-23         
|EX-24.B       
|EX-24.C       
|EX-24.D       
|EX-24.E       
|EX-24.F       
|EX-24.G       
|EX-24.H       
|EX-24.I       
|EX-99.1       
|EX-99.2       



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TABLE OF CONTENTS

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|               |                                                                                               |  | Page
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|PART I         |                                                                                               |  | 3    |   
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|               | Item 1. BUSINESS                                                                              |  |      | 3  | 
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|               | Item 2. PROPERTIES                                                                            |  |      | 22 | 
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|               | Item 3. LEGAL PROCEEDINGS                                                                     |  |      | 22 | 
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|               | Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   |  |      | 23 | 
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|PART II        |                                                                                               |  | 23   |   
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|               | Item 5. MARKET FOR THE COMPANYS COMMON STOCK AND RELATED
STOCKHOLDER MATTERS                 |  |      | 23 | 
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|               | Item 6. SELECTED FINANCIAL DATA                                                               |  |      | 25 | 
|              
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|               | Item 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS |  |      | 25 | 
|              
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|               | Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                           |  |      | 37 | 
|              
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|               | Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE  |  |      | 37 | 
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|PART III       |                                                                                               |  | 37   |   
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|PART IV        |                                                                                               |  | 37   |   
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|               | Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K                     |  |      | 37 | 
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|SIGNATURES     |                                                                                               |  | 40   |   
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|CERTIFICATIONS |                                                                                               |  | 41   |   





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This Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Our actual results could differ materially from those
set forth in the forward-looking statements. Certain factors that might cause
such a difference are discussed in the section entitled Cautionary Factors
that May Affect Future Results on page 15 of this Form 10-K.




PART I




Item 1.BUSINESS

General

Zila, Inc., a Delaware corporation, is a manufacturer and marketer of
pharmaceutical, nutraceutical, and biotechnology products. In fiscal year
2002, our business was organized into the following Groups: Consumer
Pharmaceuticals, Professional Pharmaceuticals and Zila Nutraceuticals.

The Consumer Pharmaceuticals Group consists of over-the-counter products,
including the Zilactin® family of over-the-counter products. The Consumer
Pharmaceuticals Group operates under our wholly owned subsidiary, Zila
Pharmaceuticals, Inc., a Nevada corporation.

The Professional Pharmaceuticals Group includes Peridex® prescription
mouth rinse, OraTest®, an oral cancer diagnostic system, ViziLite, a
chemiluminescent light product for detection of oral mucosal abnormalities and
the plastic molded products from Zila Swab Technologies, Inc., dba Innovative
Swab Technologies (IST), a wholly owned subsidiary of the Company. The
Professional Pharmaceuticals Group (excluding OraTest® and IST) operates under
a wholly owned subsidiary of the Company, Zila Pharmaceuticals, Inc., a Nevada
corporation. The OraTest® product is sold in Europe under a wholly owned
subsidiary of the Company, Zila Limited, a United Kingdom company, and in other
parts of the world through Zila, Inc. Unless the context otherwise indicates,
the terms Zila and Company as used herein
refer to Zila, Inc. and its
subsidiaries.

The
Zila Nutraceuticals Group includes Oxycal Laboratories, Inc., an Arizona
corporation (Oxycal), and its subsidiary, Inter-Cal Corporation, Inc,
(Inter-Cal), an Arizona corporation, doing business as Zila Nutraceuticals.
Oxycal and its subsidiary manufacture and distribute a patented and unique form
of Vitamin C under the trademark Ester-C® and a line of saw palmetto products
under the Palmettx® trademark. Oxycal Export, Inc., a U.S. Virgin Islands
corporation and a wholly owned subsidiary of Oxycal, was dissolved on April 30,
2001.

Recent Developments

On December 4, 2001, we acquired the world marketing and distribution
rights (excluding the Pacific Rim) for the Food and Drug Administration (FDA)
approved ViziLite chemiluminescent light device from The Trylon Corporation
of Torrance, CA (Trylon). The rights acquired include the FDA-approved
devices and methods of conducting endoscopic examinations of body cavities
using chemiluminescent light sources. We issued 2,000,000 shares of restricted
common stock for the rights and agreed to pay royalties to Trylon on sales of
the ViziLite product.

In November 2001, we decided to sell the operations of the Zila Dental
Supply (ZDS) business. These operations were sold in two separate
transactions, during the second fiscal quarter of 2002. Our financial
statements in this report have been prepared to reflect our historical
financial position and results of operations and cash flows as adjusted for the
reclassification of the ZDS business as discontinued operations. The
historical results of the operations of the ZDS business up to November 2001
and the gain (loss) recognized on the components of the sales are reported as
discontinued operations in the accompanying consolidated financial statements.

On February 5, 2001, we announced the acquisition of the patent rights and
the Antioch, Illinois manufacturing operations for swab products from National
Healthcare Manufacturing Corporation (NHMC), headquartered in Winnipeg,
Canada. Intellectual property, inventory, plus molding, labeling, filling and
sealing equipment were included in the acquisition. The business unit is known
as Innovative Swab Technologies. We paid approximately $2.3 million in a
combination of cash and preferred stock for the unit.

On December 20, 1999, Integrated Dental Technologies, Inc. (IDT), a
subsidiary of Zila, completed the sale of

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substantially all of its assets and liabilities related to its
PracticeWorks division located in Gold River, California to InfoCure
Corporation, of Atlanta, Georgia for approximately $4.65 million. We recognized
a gain from the sale of approximately $4.7 million.

On October 28, 1999, Cygnus Technologies, Inc. (Cygnus), a subsidiary of
Zila, completed the sale of substantially all of its assets and certain of its
liabilities to Procare Laboratories, Inc., of Scottsdale, Arizona for
approximately $4.0 million. Procare is controlled by the former owner and
President of Cygnus.

Financial information for each group or segment for each of the last three
fiscal years is included in our Audited Consolidated Financial Statements and
the notes thereto and has been restated to reflect the new segments and the
discontinued operations of ZDS.

Our principal executive offices are located at 5227 North Seventh Street,
Phoenix, Arizona 85014-2800, and our telephone number is (602) 266-6700.

Products

Consumer Pharmaceuticals



| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                     
| | ----------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | - Zilactin® | The Zilactin® line includes the
following over-the-counter (OTC),
non-prescription products: Zilactin®
Cold Sore Gel, Zilactin®-B Canker Sore
Gel, Zilactin®-L Cold Sore Liquid,
Zilactin®-Lip Balm, Zilactin® Baby
Teething Gel, Zilactin® Medicated
Toothache Swabs and the new Zilactin®
Baby Teething Swabs. The Zilactin®
product line accounted for 28%, 36%
and 29% of our Companys net revenues
for fiscal years 2002, 2001 and 2000,
respectively. The Zilactin® products
are used topically for the purposes
described below:                            
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin® Cold Sore Gelcreates a
medicated bandage like film over
wounds that last up to six hours,
promoting healing and relieving pain.                                           
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin®-B Canker Sore Geltreats
wounds inside the mouth with
benzocaine. The medicated bandage like
film protects the wound and holds the
medication in place for up to six
hours.
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin®-L Cold Sore Liquid
contains pain-relieving lidocaine to
treat colds sores and fever blister
symptoms before they erupt.                                                   
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin® Lip Balmprevents sun
blisters, treats cold sores and
relieves chapped lip pain. The Paba
free formula provides SPF 24 sun
protection.                                     
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin® Baby Teething Gelhas
pain-relieving benzocaine, a cooling
ingredient to soothe babys sore gums,
and does not contain alcohol,
saccharin or coloring dyes.                
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin® Medicated Toothache Swabs
are patented, individually sealed
medicated swab applicators containing
benzocaine to provide instant relief
from toothache pain.               
|
| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Zilactin® Baby Teething Swabsare
patented, individually sealed
medicated swab applicators containing
benzocaine to provide instant pain
relief to babys gums.                      
|
| |             | We own the patent covering the
Zilactin® treatment composition which
includes the composition and the
film-forming properties of the product
formula. See Part 1. Business -
Patents and Trademarks. Zilactin®
and Zilactin®-B formulas incorporate
these proprietary treatment
compositions. Zilactin® and
Zilactin®-B are packaged as gels in
..25 ounce plastic tubes. Zilactin®-L
is a liquid packaged in a .25 ounce
plastic bottle. The products are
applied directly to affected areas in
quantities large enough to cover the
lesion with the gel or liquid.

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The gels contain an active ingredient
that forms a thin, transparent,
pliable bandage-like film, which holds
the active ingredient against the
affected tissue, keeps the affected
area clean and protects the wound from
the irritants and bacteria found
within the oral cavity.

The bandage can last up to six hours
inside the mouth, a feature that makes
the formulation suitable for a variety
of dental applications. Zilactin® Baby
Teething Gel is packed in a .33 ounce
tubes while the Zilactin® Toothache
Swabs and the Zilactin® Baby Teething
Swabs are available in an 8, 12 or 14
swab package.

In addition to its over-the-counter
applications, Zilactin® 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. We
believe that superior efficacy and
targeted marketing efforts are the
reasons that independent pharmacist
research studies reported that
Zilactin® was the number one OTC
product pharmacists recommend for
treating canker sores and cold sores
in fiscal year 2001.

Professional Pharmaceuticals





| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | 
| | ----------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Peridex®  | Peridex® 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® is 0.12% chlorhexidine
gluconate. Peridex® is the first and
only rinse to receive the American
Dental Association seal for reduction
of plaque and gingivitis. Peridex®
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. We acquired the Peridex®
product line from The Procter & Gamble
Company in November 1997.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| | - OraTest®  | The OraTest® product, a diagnostic
adjunct for oral cancer and site
delineation for biopsy and surgical
excision, is a chair-side oral rinse
or swab that can be administered by
either a medical practitioner or
dentist. OraTest® contains the active
ingredient Zila® Tolonium Chloride, a
staining agent, that will adhere to
specific cell types within the mouth
that are abnormal and that may not be
visible to physicians or dentists.
The product has been approved for
distribution in the United Kingdom,
Australia, Taiwan, Belgium, Holland,
Luxembourg, Finland, Greece, Portugal,
China, Bermuda and the Bahamas, but we
are not actively marketing it in these
countries. Currently, OraTest® is
available in the U.K., Greece,
Bahrain, China and Taiwan. We are
currently funding a Phase III clinical
study to support our application for
approval of the OraTest® product in
the United States by the FDA.
According to the American Cancer
Society, 28,900 new oral cavity and
pharyngeal cancers will be diagnosed
and approximately 7,400 oral cancer
related deaths will occur in the
United States in 2002. Oral cancer
remains one of the most debilitating
and disfiguring of all malignancies.
In most people diagnosed with oral
cancer, the disease has metastasized,
resulting in a poor prognosis because
the usual method of detecting the
disease is a visual examination.
Those who do survive frequently
undergo significantly disfiguring
surgery. When oral cancer is detected
early, survival rates are as high as
82%; detected late the survival rate
plummets to 18%.
|
| | - ViziLite | The patented, single use ViziLite
Test Kit allows healthcare providers
to improve early detection, evaluate
and monitor oral mucosal abnormalities
in those individuals at increased risk
for oral cancer in combination with a
conventional oral mucosal examination.
The disposable kit includes a 54 mm
(2 1/4 inch) plastic tube which,
when flexed, activates a non-toxic
chemical light source. The activated
ViziLite is inserted into its
retractor, a six-inch windowed hard
plastic holder. ViziLite produces a
diffuse light for approximately 10
minutes  long enough to do a thorough
visual oral examination. The kit also
includes a small bottle of 1% acetic
acid solution used prior to the
procedure to disrupt the glycoprotein
barrier of mucosal surfaces.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

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|                    |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | 
|------------------- | -------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                    | - IST Products | IST manufactures three sizes of
dry handled swab applicators for
both OEM customers and for
divisions of our Company. In
addition, IST manufactures its
own brand of disposable probe
covers (plastic sheaths used
with electronic thermometers)
sold into healthcare
distribution channels and
manufactures custom plastic
parts for OEM customers.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                   
|Zila
Nutraceuticals
|                   
|                    | - Ester-C®     | Zila Nutraceuticals, located in
Prescott, Arizona, manufactures
and distributes a patented and
unique form of Vitamin C under
the trademark Ester-C®.
Products manufactured with
Ester-C®nutritional ingredients
are sold throughout the U.S. and
in over 41 countries worldwide.
Inter-Cal requires its customers
to display the federally
registered Ester-C®logo on
their packaging. Ester-C®
nutritional ingredients are
primarily used in dietary
supplements and are available to
consumers at retail under
approximately 89 brand names
distributed by leading
supplement manufacturers and
marketers. However,
opportunities exist in topical
applications (such as skin
creams), chewable vitamins,
nutrition bars, sport drinks and
food fortification. Zila
Nutraceuticals parent company,
Oxycal, holds two patents on
certain compositions and methods
for administering vitamin C and
therapeutically active
compounds, one patent on a
stable liquid form of mineral
ascorbate, and was recently
issued a patent in the U.S. for
methods and compositions for
potentiating cancer chemotherapy
agents with Ester-C® technology.
Sales of Ester-C® accounted
for approximately 50%, 50% and
52% of Zilas net revenues for
fiscal years 2002, 2001 and
2000.
In addition to our flagship
vitamin C product for dietary
supplements, we also distribute
Ester-C® nutritional ingredients
for inclusion in a variety of
product line extensions.
Ester-C® Topical Concentrate, a
liquid formulation for skin care
products, provides a stable form
of Vitamin C that penetrates to
the collagen-producing layers of
the skin without chemicals.
Ordinary Vitamin C is quite
unstable in water, the basis of
most health and beauty care
products, and does not last long
enough for the skin to reap the
benefits of Vitamin C. Ester-C®
Topical Concentrateis
non-acidic and free of chemical
esters. Additionally, four new
forms of Ester-C®nutritional
ingredients were introduced for
use in multivitamins (Ester-C®
MV), chewable vitamins (Ester-C®
CG), effervescent (Ester-C® EG),
and beverages (Ester-C® BG.)
Ester-C®Chelated Mineral Blend
provides the benefits of
supplemental Vitamin C for
animals.
|                   
|                    | - Palmettx®    | Palmettx® is a standardized
extract of the saw palmetto
plant that retains high
concentrations of the active
phytosterol components and is
extracted without chemicals,
toxic solvents or excessive
heat. Saw Palmetto extract is
used to reduce the symptoms
associated with glandular
swelling in patients with Benign
Prostatic Hyperplasia (BPH), a
problem that affects as much as
50% of the male population by
the age of 60 years. Zila
Nutraceuticals produces
Palmettx® using a supercritical
carbon dioxide (CO2) fluid
bioprocess method, PureXtrax,
which extracts botanicals
naturally, without solvents such
as hexane and alcohol. The
process is non-hazardous to the
environment, and we believe it
assures the highest product
integrity and virtual
elimination of all enzymes,
microorganisms, viruses, molds
and spores. Inter-Cal currently
provides many forms of saw
palmetto to its customers,
including high
phytosterol-content super
critically extracted oils and
bulk powders.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

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Marketing

Consumer Pharmaceuticals



|                             |                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|---------------------------- | ---------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                             | - Strategy
for  Marketing
OTC
  Products | The Consumer Pharmaceutical Group employs
three strategies to market its Zilactin®
family of products:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                             |                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Consumer Awareness- build consumer
awareness of the OTC products through
focused efforts like targeted journal
advertising, direct mail and purchasing
incentives. A national television, print
and public relations campaign was executed
to generate awareness of our products among
cold and canker sore sufferers through
promotional vehicles and positives reaching
the demographics found within the
population.                                                                                                                                                                                                                                                                           
|                            
|                             |                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Professional Awareness- educate 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, journal advertising sample
fulfillment and attending medical
conventions. During fiscal year 2002, we
participated in over thirty meetings geared
to dental, pharmacy and medical
professionals. At these meetings, our
representatives had an opportunity to
interact with and distribute information to
thousands of interested health
professionals. These promotional efforts
are designed to build important professional
recommendations resulting in retail
purchases.
|                            
|                             |                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Trade Participation- participate in
retailer-driven activities designed to make
its OTC products available at more outlets
and to offer value to consumers at the
retail store level. Because most cold and
canker sore purchases are need driven,
these initiatives are aimed at attaining the
highest possible shelf purchases.                                                                                                                                                                                                                                                                                                                                                               
|                            
|                            
|Professional Pharmaceuticals
|                            
|                             | - Peridex®                               | During fiscal year 2002, Peridex® was marketed to healthcare
professionals and pharmacists with extensive support from Omnii
Oral Pharmaceuticals of Palm Beach, Inc., (Omnii), a national
dental profession sales and distribution organization. Omnii has a
national network of field sales representatives with significant
coverage of dental professionals.
Additionally, Omnii representatives call upon the nations 54
dental and 200 hygiene schools, as well as managed care
organizations, pharmacists and wholesalers, to reinforce support
for the Peridex® product and our other brands.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                            
|                             | - OraTest®                               | During fiscal 2002, we sold the OraTest® product through our
wholly owned subsidiary, Zila Limited in the U.K. Additionally,
Zila Limited has contracted with CPG Holdings Ltd, a third party
fulfillment organization, to warehouse and ship OraTest® products
throughout the European Union and other selected countries.
Zila will seek a partner in Europe for future
marketing and sales for the OraTest® product. Additionally, as a result of our effort to
focus on our core objectives of reducing costs, we have elected
not to fund the Ministry of Defense marketing study in the U.K. and
instead utilize the funds toward the OraTest phase III clinical
study.
In February 2002, we announced that the World Medical Trade
Organization, Inc. (WMTO) will distribute the OraTest® product
in major Asian markets including Hong Kong, Indonesia, Korea,
Malaysia, Peoples Republic of China, the Philippines, Singapore,
Taiwan, Thailand and Viet Nam. WMTO is currently developing their
marketing plan for distribution of the OraTest® product in these
countries.

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|                             |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|---------------------------- | -------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                             | - ViziLite    | In December 2001, we entered into a distributorship agreement
with Patterson Dental Company to supply certain products for the dental
industry, including the ViziLite product, in the United States and
Canada. In February 2002, Zila, Trylon and the WMTO entered into a
Memorandum of Understanding whereby we will supply products, including the
ViziLite product, to the WMTO for distribution in various countries in
the Pacific Rim. We have not had significant sales of the Vizilite
product to date. Based upon our market research, a coordinated marketing
plan has been developed to reach both opinion leaders and end-users in the
oral cavity screening process.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                            
|                             | - IST Products | IST markets its swab products to a variety of OEM
accounts in the dental, medical and cosmetic industries using independent
sales representatives and its own in-house employees. Probe covers are
sold through local, regional and national distributors and buying groups.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                            
|Zila Nutraceuticals         
|                            
|                             |                | Zila Nutraceuticals supports its value-added Ester-C®
products with a multi-million dollar advertising program
aimed at female consumers. This program includes targeted
television advertising, national radio advertising in the
U.S., Canada and the United Kingdom, as well as public
relations activities designed to convince current vitamin
C users to convert to non-acidic, rapidly absorbed and
retained Ester-C®products. Zila Nutraceuticals places
strong emphasis on its co-promotion opportunities with its
customers in order to drive food, drug and mass
distribution through product displays and other forms of
advertising assistance programs. Zila Nutraceuticals
promotes the patented Ester-C®ingredients on behalf of
400 manufacturers and marketers of finished Ester-C®
products. With the help of consumer advertising and
promotion, the Ester-C®brand is transitioning from being
a product sold primarily in natural food outlets to one
with more name recognition and more broad-based
availability in mass market, food and drug chain stores.
International sales activities are managed by local
distributors and are encouraged by advertising assistance
programs and seminars.
|                            
|Manufacturing and Supply    
|                            
|Consumer Pharmaceuticals    
|                            
|                             | - Zilactin®    | We employ a network of manufacturers to produce and package all of
our products within the Group. We place orders with each supplier based on our
anticipated needs for the products. The following is a breakdown by product line:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                            
|                             |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Arizona Natural Resources (ANR) of Phoenix, Arizona manufactured the
Zilactin® line of products in 2002. We terminated our contract with ANR on July
31, 2002. During the fourth quarter of 2002, we made the decision to move
production of the Zilactin®-L product and the packaging of the Zilactin®
Medicated Toothache Swabs and Zilactin® Baby Teething Swabs products to our
manufacturing facility in Phoenix, AZ and move the other Zilactin® products to
Contract Pharmaceuticals Ltd. located in Ontario, Canada.
|                            
|                             |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Ivers Lee Corporation, dba Sharp of West Caldwell, New Jersey manufactured all
Zilactin® sample packets in 2002.                                                                                                                                                                                                                                                                                                                                                                                                              
|                            
|                             |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | IST manufactures the Zilactin® Medicated Toothache and Baby Teething Swabs.                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                            
|                            
|Professional Pharmaceuticals
|                            
|                             | - Peridex®     | Xttrium Laboratories, Inc. (Xttrium) of Chicago, Illinois is
the manufacturer of the Peridex® product. Peridex® was manufactured by
Procter & Gamble through June 1998.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

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|                         |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | 
|------------------------ | -------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                         | - OraTest®     | Fleet Laboratories Ltd. of Watford, Herts, United Kingdom
(Fleet), produces and packages the OraTest® product for distribution in
the U.K. and for sale to other selected countries.
In order to ensure an available and stable supply of Zila®
Tolonium Chloride, the worlds only pharmaceutical grade tolonium
chloride and the active ingredient in the OraTest® product, we
established our own manufacturing facility because no other
pharmaceutical grade of tolonium chloride existed. The facility,
located in Phoenix, Arizona is certified as an approved facility for
the manufacture of Zila® Tolonium Chloride under federally
regulated Good Manufacturing Practices (GMP) standards, assuring
the pharmaceutical-grade quality required.                                                                                                                                                                                                                                                                                                                              
|                        
|                         | - ViziLite    | The ViziLite Test Kits contain a white light stick manufactured
by The OmniGlow Company of West Springfield, Massachusetts, an oral retractor
imported from China by the Asian Sourcing Corporation of Diamond
Bar, California and a 30cc vial of acetic acid rinse manufactured by ZMI of
San Diego, California. ViziLite Test Kits are assembled at our
manufacturing facility in Phoenix, Arizona.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                        
|                         | - IST Products | All IST products are manufactured at its Antioch, Illinois location.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                        
|Zila Nutraceuticals     
|                        
|                         |                | Ester C®products are manufactured at Oxycals Prescott, Arizona
location. Palmettx® oil products have been manufactured by John I.
Haas, Inc. in Yakima, Washington. Saw Palmetto Products Inc. of
Indiantown, Florida provided the Palmettx® powder products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                        
|Competition             
|                        
|                         |                | All industries in which we sell our products are highly
competitive. A number of companies, many of which have greater
financial resources, marketing capabilities and research and
development capacities than we have are actively engaged in the
development of products that may compete with our products. The
pharmaceutical industry is characterized by extensive and ongoing
research efforts that may result in development by other companies
of products comparable or superior to any that are now on the
market, including those that we sell.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                        
|Consumer Pharmaceuticals
|                        
|                         | - Zilactin®    | Numerous products exist for treatment of cold sores and canker
sores, including the following products: Orajel by Del
Pharmaceuticals, Inc., Abreva by GlaxoSmithKline, Anbesol by
Wyeth, Consumer Healthcare, Herpecin-L by Chattem, Inc., and
Carmex by Carma Lab, Inc. All of these companies have greater
financial resources. Based upon clinical
studies, consumer research and comments that we received from
physicians and dentists, we believe that our products provide
more effective symptomatic relief of cold sores and canker sores
than the treatments of our current competitors.
In 2002, intense, competitive advertising spending by Abreva,
Orajel and Anbesol encouraged many consumers to evaluate those
brands, which has had a material adverse effect on the sales of
Zilactin® products. Consumer research points to a loyal
Zilactin® user base among heavy sufferers. Plans are underway
to develop trial and repeat purchasers of the Zilactin® products
among this important group through exploitation of clinical
efficacy and product differentiation.

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Professional Pharmaceuticals



| |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| | -------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Peridex®     | Peridex® competitors include generic versions and name brands
such as Periogard, made by Colgate Oral Pharmaceuticals. Many of our
competitors possess greater financial resources than we have. However, we
believe that Peridexs® reputation as the gold standard of prescription
antibacterial oral rinse within the dental profession and our relationship
with Omnii as our distributor to
professionals should allow us to continue to compete
effectively in the healthcare professional marketplace. In
addition, initiatives in new niche markets will serve to
expand uses in markets not traditionally approached by
generic equivalents.
|
| | - OraTest®     | Because of the special chemicals required to manufacture
an oral cancer detection product such as OraTest®, there
are no known competitors to the OraTest® product. The
conventional method of using visual examinations by
medical personnel to detect oral cancer is still a widely
accepted practice.                                                                                                                                                                                                                                                                                                                                               
|
| |                | Zila® Tolonium Chloride, the active ingredient in the
OraTest® product, is the worlds only pharmaceutical grade
tolonium chloride produced in compliance with FDA current
GMP regulations. Zila® Tolonium Chloride and its
technology are protected by issued and pending patents.
See also Item 1. Business  Patents and Trademarks.                                                                                                                                                                                                                                                                                                              
| | - ViziLite    | Because ViziLite is a patented, FDA approved device,
used to view and evaluate oral mucosal
abnormalities, there are no known competitors using
the patented chemiluminescent light source.                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | - IST Products | The swab products compete with a variety of other
product delivery systems, including some that utilize swabs as part of their
configuration. The unique IST dry handle swab product provides a clean and
convenient product that is patented and is supported by a fusion plastic
molding process allowing low cost production of the key molded components.                                                                                                                                                                                                                                                                                          

Zila Nutraceuticals



| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | 
| | ----------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Ester-C®  | Within the vitamin C market, our competitors include all
other vitamin C manufacturers, such as Roche
Pharmaceuticals and Takeda Pharmaceuticals, North America
Inc. Many of our competitors, particularly those in
markets other than the health food and vitamin store
market, have substantially greater financial resources
than we do. We believe 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. We believe
that we compete favorably with other producers of vitamin
C because of the positive attributes of our Ester-C®
products, high customer-order fill rate, strong
distribution network, and advertising and promotional
support. Market data indicates that for the 52-week period
ending July 31, 2002, Ester-C® posted a 14.6% increase in
retail sales, which include food, drug and mass, while
traditional vitamin C products experienced a volume
decrease of 9.4%. We believe that Zila Nutraceuticals
commitment to research demonstrating the benefits of
Ester-C® products and its commitment to its marketing
partners and consumer focused advertising gives it a
competitive advantage.
|
| | - Palmettx® | The major competitors for supercritical carbon dioxide
(CO2) extracted saw palmetto products are Indena S.p.A.
and Euromed, both European-based companies. Domestic
competitors include US Nutraceuticals, Saw Palmetto Berry
Co-op and Bio-Botanicals.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

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Licensing

Professional Pharmaceuticals



| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | 
| | ----------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Peridex®  | On January 30, 2001, we signed a perpetual license
agreement with Xttrium whereby we granted Xttrium the right to use our
technology related to chlorhexidine gluconate, the active ingredient in
Peridex®, to produce a private label product for distribution in certain
markets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| | - OraTest®  | In 1991, we acquired ownership of certain exclusive rights
to the patents, technology and process embodying the
formulation and the application of the OraTest® product.
We are obligated to pay royalties to the National
Technical Information Service based upon certain usages of
the OraTest® product. During the 1995 fiscal year, we
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® product under the name OraScreen in certain
markets that we have not previously pursued. We received
royalties from Block equal to a set percentage of the net
sales of OraScreen by Block. This agreement was
terminated in December 1999.
|
| |             | In August 1998, we entered into a five-year distribution
and manufacturing license agreement with Nippon Shoji
Kaishi, Ltd. (now known as Azwell, Inc.) to obtain
regulatory approval, market and manufacture the OraTest®
product in Japan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |             | In June 2001, we contracted to supply Zila® Tolonium
Chloride to Denfotex Limited of the United Kingdom, for
worldwide use in photo-activated disinfections in the
tooth structure. Denfotex will sell, directly and through
third party dental product distributors, both a unit dose
of Zila® Tolonium Chloride and a laser delivery system.
We will charge Denfotex for the material supplied and
receive a royalty on each laser unit sold.                                                                                                                                                                                                                                                                                                                      
|
| | - ViziLite | In December 2001, we entered into an exclusive agreement
with Trylon to license the ViziLite technology. The
agreement provides that we pay Trylon (i) a 10% royalty on
the net sales of the ViziLite product during the first 5
years; (ii) a 5% royalty on the net sales during the
period commencing on the 5th anniversary of the Closing
Date through the 10th anniversary of the Closing date; and
(iii) a royalty on certain foreign sales. The license is
perpetual for the licensed patents, which are based on the life of the patents, unless terminated early in
accordance with the agreement for certain defaults.                                                                                                                                   

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Governmental Regulation



| |         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | 
| | ------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | General | Our 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, distribution and sale of
its products. We devote significant time, effort and
expense addressing the extensive government regulations
applicable to our business, and in general, the trend is
towards more stringent regulation. 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 current good manufacturing practices
established by the FDA. Compliance with current good
manufacturing practices requires the dedication of
substantial resources and requires significant costs. The
FDA periodically inspects both of our manufacturing
facilities and our contract manufacturing plants and
laboratories to assure compliance. The FDA may request 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 our business and results of operations.
|
| |         | In connection with our activities outside the United
States, we are also subject to regulatory requirements
governing the testing, approval, manufacture, labeling,
marketing, distribution and sale of our 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 may need to 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 any 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. We are also subject to worldwide
governmental regulations and controls relating to product
safety, efficacy, packaging, labeling and distribution.
While not all of the products that we plan 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, if
available for the prescribed brand name product.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| |         | As a responsible manufacturer, we are alert to the
possibility that the final monographs to be issued in the
foreseeable future may require formula modifications of
certain of our OTC products to maintain compliance with
these regulations, a possibility facing competitive
products as well.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

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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. We 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
our consolidated financial position, results of operations
or cash flows.



| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | 
| | ----------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Zilactin® | We market Zilactin® products as a treatment for the
symptomatic relief of canker sores (oral mucosal ulcers
and lesions), cold sores and swollen gums from teething.
We are not required to file a New Drug Application (NDA)
covering these uses of Zilactin® products.                                                                                                                                                                                                                                                                                                                                     
|
| |             | The FDAs regulation of most of the OTC drug products in
the United States (such as Zilas Zilactin® family of
products) has not been finalized. In addition, the FTC
continually monitors the advertising practices of consumer
products companies with respect to claims made relating to
product functionality and efficacy.                                                                                                                                                                                                                                                                                
|
| | - OraTest®  | Zila has not received final FDA approval for OraTest® and
is conducting a Phase III clinical trial to include in an
amended NDA. As of July 31, 2002, we had expensed
approximately $36 million for OraTest® including significant expenditures towards obtaining FDA
approval of the OraTest® product, to lease its
manufacturing facility and to prepare for the introduction
of OraTest® in the United States market. There can be no
assurance that the FDA will issue a final approval of the
OraTest® product. See additional discussion below under
Cautionary Factors That May Affect Future Results.
|
| |             | We received regulatory approval to market the OraTest®
product in Australia in 1993. Approval to market the
OraTest® product in certain Caribbean countries and
Hungary has also been received. The Medicines Control
Agency (MCA), which is the regulatory authority in the
U.K., has also granted approval for the OraTest® rinse
product to be marketed in the U.K.                                                                                                                                                                                                                                       
|
| |             | In January 1998, we submitted a Mutual Recognition
Procedure (MRP) application through the MCA for
regulatory approval of OraTest® in the European Union
(EU). In April 1998, Belgium, the Netherlands,
Luxembourg, Portugal, Finland and Greece gave their
regulatory approval through this application. We have
also received licenses to sell in Greece, Luxembourg,
Finland, Belgium, Portugal, Bahrain, Oman and the
Netherlands.                                                                                                                                                                     

Patents and Trademarks



| |             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | 
| | ----------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
| | - Zilactin® | A comprehensive United States patent covering
present film-forming Zilactin® products was issued in February 1991 and
will expire in 2008. Two United States patents and corresponding foreign
patents have been issued covering topical film-forming products. We have
a United States patent and have filed another patent application related
to the dry handle swab assembly in the Zilactin® Toothache Swabs and
Zilactin® Baby Teething Swabs. We have registered the trademarks Zila®
and Zilactin® in the United States, Canada and in several important
foreign countries and have applications pending to register these
trademarks in others. We believe that widespread use of the Zila® and
Zilactin® trademark alone and as the dominant features of other marks,
e.g., Zilactin®-B, Zilactin®-L, etc., affords reasonable protection for
the family of trademarks in which Zila® is the dominant feature.
|
| | - Peridex®  | Peridex® as a brand name has become the gold standard
within the dental industry for prescription oral rinses in both the
United States and Canada. Concurrent with the purchase of the Peridex®
brand from Procter & Gamble in November 1997, Zila Pharmaceuticals
purchased the trademark rights to Peridex®. Accordingly, Procter &
Gamble has assigned the Peridex® trademark to us for each country where
it has been previously registered. We recorded our trademark assignment
for Peridex®                                                                                                                                                                                                                                                                                                                                                                                                                     

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with the United States Patent and Trademark office in June 1998
and with the Canadian Registrar of Trademarks in July 1998.



| |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | 
| | -------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - OraTest®     | When we purchased the shares of CTM Associates, Inc. in June
1996, we acquired certain technology rights and U. S. patent rights
related to the OraTest® product. We are the exclusive licensee of the
National Institutes of Health under its United States and Canadian
patents covering a protocol for the use of toluidine blue for detection
of oral cancer. We have been issued ten United States patents related to
Zila Tolonium Chloride or the OraTest® product that expire from 2011 to
2019. We have filed applications and been issued patents in many foreign
countries covering the process that we have developed for manufacturing
our Zila® Tolonium Chloride drug substance, the drug substance itself and
methods of using the drug substance in detecting epithelial cancer and
covering other dyes that are chemically related to toluidine blue for use
in detecting epithelial cancer.
|
| |                | We registered the OraTest® trademark in the United States in June
1998 and have either pending applications for registrations or
issued registrations of this trademark in major foreign countries
in which this mark is being used or in which it may be used.
Australia and the U.S. have issued the first patent specifically
protecting the concept of using the OraTest® kit to screen for
oral cancer. We licensed the use of the trademark OraScreen in
Europe and certain other foreign countries and have obtained
registrations of the OraScreen trademark in all major European
countries and in Pacific Rim countries, which maybe important to
our future marketing and distribution strategy.                                                                                                                                                                                                 
|
| | - IST Products | With the February 1, 2001 purchase of the assets from
NHMC, we purchased the patent rights related to the Dry
Handle Swab Assembly and Unit. We were issued a new
patent covering an improved version of the swab assembly
in June 2002 and it will expire in 2019. The United
States Patent & Trademark Office issued a certificate of
registration for the Innovative trademark in July 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| | - Ester-C®     | In 1989, 1990 and 1991, three United States patents were
issued in connection with Ester-C®nutritional
ingredients. All three patents expire in the year 2007.
The first patent covers compositions for administering
vitamin C that contain vitamin C metabolites including
threonate. The second and third patents cover the
metabolite technology, which improved the absorption of
vitamin C from the Ester-C®formulation and is applicable
to a wide variety of other non-prescription and
prescription drugs. We have filed and are currently
pursuing corresponding patent applications in all foreign
countries important to its marketing and distribution
strategy.                                                                                                                                                                                                                                 
|
| |                | We have filed a new international patent application
covering improved vitamin C compositions that may have the
effect of extending protection of the improved Ester-C®
product for several additional years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| |                | Ester-C®Topical Concentrate, a stable form of vitamin C
that penetrates the skin to help produce collagen and
supporting structures, was awarded a United States patent
in March 2001 for Stable Liquid Mineral Ascorbate
Composition and Methods of Manufacturing and Use.
Corresponding patent applications are pending in several
foreign countries.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |                | We have four major and several other trademarks issued by
the United States Patent and Trademark office. The
Ester-C®trademark was issued in August 1985; the EC® logo
trademark was issued in August 1990; the C-Flex® trademark
was issued in August 1990; and the Palmettx® trademark was
issued in September 2001. We also have trademarks issued
in 36 foreign countries with trademarks pending in other
countries.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

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Employees

As of July 31, 2002, we had a total of 122 employees in the following
categories:

| |  |                               |  |                     |     |  |  |  |  |  |  | 
| |  | ----------------------------- |  | ------------------- | --- |  |  |  |  |  |  | 
| |  | Categories                    |  | Number of Employees |     |  |  | 
| |  |                               |  |                     |     |  |  | 
| |  | Executive Officers            |  |                     | 4   |  |  |  |  | 
|
|
|
|
| |  | Sales and Service             |  |                     | 13  |  |  |  |  | 
|
|
|
|
| |  | Accounting and Administration |  |                     | 40  |  |  |  |  | 
|
|
|
|
| |  | Purchasing and Distribution   |  |                     | 10  |  |  |  |  | 
|
|
|
|
| |  | Manufacturing                 |  |                     | 55  |  |  |  |  | 
| |  |                               |  |                     |     |  |  |  |  | 
| |  |                               |  |                     | 122 |  |  |  |  | 

No employees are represented by a labor union. We believe our
relationship with our employees is good.

Cautionary Factors that May Affect Future Results



| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | 
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| |  | The disclosure and analysis in this report
and in our other reports, press releases and
public statements of our officers contain
some forward-looking statements.
Forward-looking statements give our 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, any other report, 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | We undertake no obligation to publicly
update forward-looking statements.
Shareholders are advised to consult further
disclosures on related subjects in our other
reports filed with the Securities and
Exchange Commission. The following
cautionary discussion of risks,
uncertainties and possible inaccurate
assumptions are factors that our management
believes could cause actual results to
differ materially from expected and
historical results. Factors other than
those included below could also adversely
affect our business results. The following
discussion is provided pursuant to the
Private Securities Litigation Reform Act of
1995.                                                                                                                                                                                                  

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| |                                                     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | 
| | --------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Uncertainties of
  Regulatory
  Approval          | The rigorous clinical testing and an
extensive regulatory approval process
mandated by the FDA and equivalent foreign
authorities before we can market any new
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. We 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,
we will obtain regulatory approval for any
products we develop.                                       
|
| |                                                     | 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
  OraTest® in the
  United States | Zila has not received final FDA approval for
OraTest® and is conducting a Phase III
clinical trial to include in an amended NDA.
As of July 31, 2002, we had expensed
approximately $36 million for OraTest®
including a significant financial investment
towards obtaining FDA approval of the
OraTest® product, to build its manufacturing
facility and to prepare for the introduction
of OraTest® in the United States market.
There can be no assurance that the FDA will
issue a final approval of the OraTest®
product, and the failure of the FDA to
approve OraTest® would make it impossible
for us to recoup our investment through
sales of the OraTest® products in the United
States. The failure of the FDA to finally
approve the OraTest® product would have a
material adverse effect on our results of
operations. 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 the
product.
|
| |                                                     | If FDA approval of the OraTest® product is
received, we must establish a marketing and
sales force with technical expertise to
market directly to the profession or we must
obtain the assistance of a pharmaceutical
company or a distributor with a large sales
force. There is no assurance that we will be
successful in gaining market acceptance of
the OraTest® products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |                                                     | During the third quarter of 2002, we
determined that completion of the OraTest®
Phase III clinical trial will require a
substantial number of additional patients
and have been evaluating the number of
patients required to complete the study.
The requirement for the larger number of
patients is related to the tumor formation
rate within the study population and not to
the efficacy of the OraTest® product.
Factors that affect the cost and timing of
completion of the clinical trial include but
are not limited to: (i) patient enrollment
rates, (ii) tumor formation rate within the
study population (iii) compliance with the
study protocol and related monitoring, (iv)
level of funding throughout the study, and
(v) protocol modifications.                                                                                                                                                                                                                                                                                                                                                                                                       

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We have decided to transition the trial from
ILEX Oncology Services, Inc to a new global
contract research organization (CRO). We
requested proposals from several of the
largest, highest quality and most prominent
CROs with worldwide capabilities, and
received fee quotations back from each. We
are currently in the process of finalizing
our selection of the new global CRO. Each
CRO agreed that the current study could be
transitioned successfully without
compromising any of our current study data.

In order to support the larger number of
patients needed to complete the study, we
intend to increase the rate of funding for
the study and the number of clinical sites,
with the aid of a larger, more experienced
CRO with access to clinical sites in
high-density oral cancer regions around the
world. This effort is currently underway and
we believe that we will have sufficient
funds for the clinical trial for the next
fiscal year. We will, however, require
additional financing to support the OraTest®
clinical trial, regulatory, manufacturing
and marketing costs extending beyond fiscal
year 2003. We are currently considering
possible financing sources such as strategic
partners and are pursuing funding strategies
that if completed would provide significant
funding for the clinical trial. We are also
considering the possible liquidation of
certain Zila assets outside our areas of
core competency as part of Zilas new focus
on core strengths and objectives. These
assets could also provide significant
funding for the clinical trial. There is no
assurance that such funds will be available
on terms acceptable to us.

In connection with the OraTest product, we
have capitalized costs of approximately $6.1
million as of July 31, 2002. The costs
include purchased technology rights, fixed
assets, patent costs and inventory, all of
which are combined for the purpose of
testing recoverability. The recoverability
of these assets is dependent upon obtaining
FDA approval and generating sufficient
revenues from future sales of the OraTest®
products. We have prepared a
probability-weighted analysis of potential
future cashflows under various scenarios.
Significant assumptions in the analysis
include the expected date and overall
likelihood of FDA approval, cost of the
remaining phase III clinical trials, cost of
the marketing roll out, future net cashflows
associated with sales of the products and
the probabilities assigned to each possible
outcome. The assumptions included in the
analysis are updated whenever events or
changes in circumstances indicate that the
carrying amount may not be recoverable.

Relatively small changes in the probability
assumptions assigned to each potential
outcome, actual phase III testing costs in
excess of current budget or changes in the
expected date and overall likelihood of FDA
approval could result in impairment of these
assets.

We also have approximately $446,000 of Zila®
Tolonium Chloride powder, the active
ingredient in the OraTest® product, in
inventory at our manufacturing facility in
Phoenix, AZ and approximately $148,000 of OraTest® finished
product located in the U.K. We intend to realize the value
of this inventory through sales in the U.S.,
once final approval for the OraTest®
products are received from the FDA. The Company currently has sales
in Europe and Asia. The powder
inventory currently has expiration dates in
2003 and 2004, which is prior to the date we
expect sales in the United States. Previous
testing indicates that the powder product is
stable and we expect to be able to extend
the expiration dates of the entire powder
inventory through the date we expect sales
in the United States. However, no assurance
can be given that such future testing
efforts will be successful. In addition,
should FDA approval not be granted or be
significantly delayed, it may not be
possible for us to recover the value of the
powder inventory.

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| |                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | 
| | -------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
| | - Dependence on
  Key Products               | A large percentage of our revenues result
from sales of Ester-C®, Peridex®, and the
Zilactin® 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 our revenues could be significant.
Additionally, we are reliant on third party
manufacturers for a significant portion of
our Zilactin® and Peridex® products and any
supply problems resulting from regulatory
issues applicable to such parties or
failures to comply with Good Manufacturing
Practices could have a material impact on
our revenues.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| | - Possible Claims
  Relating to
  Products   | We could be exposed to possible claims for
personal injury resulting from allegedly
defective products manufactured by third
parties with whom we have entered into
manufacturing agreements. We maintain
product liability insurance coverage for
claims arising from the use of all of our
products. However, we could be subject to
product liability claims in excess of our
insurance coverage. Any significant product
liability claims not within the scope of our
insurance coverage could have a material
adverse effect on us.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| | - Competition;
  Research and 
  Development | The pharmaceutical industry is highly
competitive. A number of companies, many of
which have greater financial resources,
marketing capabilities and research and
development capacities greater than ours,
are actively engaged in the development of
products similar to the products we produce
and market. The pharmaceutical industry is
characterized by extensive and ongoing
research efforts. Other companies may
succeed in developing products superior to
those we market. 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 the Zilactin® line of
products. It may be difficult for us to
maintain or increase sales volume and market
share due to such competition.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| | - Generic
  Competition                      | In the U.S., competition with producers of
generic products is a major challenge. The
loss of any of our products patent
protection could lead to a dramatic loss in
sales of our products in the U.S. market.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | - Dependence on
  Proprietary
  Rights       | We rely on a combination of patent,
copyright, trademark and trade secret
protection, nondisclosure agreements and
licensing arrangements to establish and
protect our proprietary rights. We own and
have exclusive licenses to a number of
United States and foreign patents and patent
applications, and intend to seek additional
patent applications, as we deem 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 our products or
to effectively limit competition against us
is uncertain. Furthermore, any patents that
may be issued to us may be challenged,
invalidated or circumvented. Litigation may
result from our use of registered trademarks
or common law marks and, if litigation
against us were successful, a resulting loss
of the right to use a trademark could reduce
sales of our products and could result in a
significant damages award. Although we
intend 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 we do business.

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| |                                                                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | 
| | ----------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Raw Materials                                                         | Raw materials essential to our 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. Production delays may also be
caused by the lack of secondary suppliers.                                                                                                                                                                
|
| |                                                                         | Ascorbic acid is the major raw material in
our Ester-C® products and is subject to
periodic price fluctuations. The price of
ascorbic acid has increased approximately
43% during the first quarter of fiscal year
2003. This price increase will cause our
material component of the cost of goods sold
to increase approximately 11% in fiscal year
2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | - Future Capital
  Requirements
  and Uncertainty
  of Future
  Funding | The development of our products will require
the commitment of substantial resources to
conduct the time-consuming research and
development, clinical studies and regulatory
activities necessary to bring any potential
product to market and to establish
production, marketing and sales
capabilities. We may need to raise
substantial additional funds for these
purposes and we may seek such additional
funding through collaborative arrangements.
The inability to obtain sufficient funds may
require us to delay, scale back or eliminate
some or all of our research and product
development programs, to limit the marketing
of our products or to license third parties
the rights to commercialize products or
technologies that we would otherwise seek to
develop and market ourselves.                                                                                                                                                                              
|
| |                                                                         | On August 27, 2001, we entered into a Loan
and Security Agreement (the Agreement)
with Congress Financial Corporation
(Congress) whereby Congress would provide
a $12 million revolving line of credit to us
at an interest rate equal to the prime rate
plus 3/4 percent. The amount of funds
available to us from the line of credit is
based upon a percentage of the value of
eligible receivables and inventory and was
$4.8 million at July 31, 2002. The
obligations under the Agreement are
collateralized by various assets, including,
but not limited to our trade accounts
receivable, inventories, equipment and
intangible assets of certain of its
operating subsidiaries. Zila and all of its
direct and indirect operating subsidiaries
guarantee the obligations under the
Agreement. The Agreement expires August 17,
2004; however any amounts due under the line
of credit would be classified as current
because of certain provisions required by
Congress.
|
| |                                                                         | The Agreement contains a provision whereby
Congress can call for immediate repayment of
all amounts due under the line upon its
determination that the Company has incurred
a material adverse change. While we do
not believe that any events have occurred in
fiscal 2002 that would constitute a material
adverse change, that determination is solely
the responsibility of Congress. Under the
Agreement, we are also required to comply
with a financial covenant based on an
adjusted tangible net worth calculation. At
July 31, 2002, our adjusted tangible net
worth was $ 17.1 million compared to a
required amount of $16.0 million. If we
continue to incur additional operating
losses, reduce the value of our tangible
assets, or incur additional debt we may
become out of compliance with the covenant.                                                                                                                                                         

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| |                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | 
| | ------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Possible
  Volatility of
  Common Stock
  Price                  | The market price for our common stock has
fluctuated significantly in the past. We
believe that announcements of new products,
quarterly fluctuations in the results of
operations and other factors, including
changes in conditions of the pharmaceutical
industry in general, and developments in
regulatory arenas may have caused such
fluctuations. Stock markets have experienced
extreme price volatility in recent years.
This volatility has had a substantial effect
on the market prices of securities we issued
and other pharmaceutical and health care
companies, often for reasons unrelated to
the operating performance of the specific
companies. We anticipate that the market
price for our common stock may continue to
be volatile.                                                                                                                                             
|
| | - Issuance of
  Preferred Stock                                    | Our Board of Directors has the authority,
without any further vote by our 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 February 1, 2001, we issued 100,000 shares of our Series B Convertible Preferred
Stock related to the IST acquisition. As of
July 31, 2002, all of the shares of the
Series B Preferred Stock remained
outstanding.                                                                                                                                                                                   
|
| | - Environmental
  and Controlled
  Use of 
  Hazardous
  Materials | We are subject to federal, state and local
laws and regulations governing the use,
generation, manufacture, storage, discharge,
handling and disposal of certain materials
and wastes used in our operations, some of
which are classified as hazardous. We
could be required to incur significant costs
to comply with environmental laws and
regulations as our research activities are
increased, and current or future
environmental laws and regulations could
adversely affect our operations, business
and future profitability. Although we
believe that our 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, we could be held
liable for any damages that result and any
such liability could exceed our resources.
|
| | - Interest Rates                                                   | We are exposed to the risk of interest rate
fluctuations in connection with our
revolving line of credit and the Industrial
Development Authority (IDA) Bonds
outstanding. At July 31, 2002, the carrying
values of the revolving line of credit and
the IDA Bonds approximated fair value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

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| |                                               |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | 
| | --------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Sales of
  Palmettx®                        | Since the introduction of our Palmettx® line
of products, continued commodity pricing
pressures in the market have caused a
decline in the selling price of the product
while the cost to manufacture it has
remained the same. Due to the uncertainty
related to the weather and growing
conditions, the saw palmetto crop and
harvest is vulnerable. At July 31, 2002, we
had approximately $3.8 million of saw
palmetto inventory on hand. The ultimate
probable future economic benefit associated
with such inventory is contingent on our
ability to continue to sell our line of saw
palmetto products for a price greater than
the carrying value of the inventory. Our
current intention is to sell the remaining
inventory of saw palmetto products in the
normal course of business. However, we have
been contacted by several companies
interested in purchasing the saw palmetto
inventory in bulk. None of the terms
discussed were acceptable to us. While we
have not made a decision to pursue such a
sale, if all or a substantial portion of the
inventory is sold in bulk, the ultimate
sales price may be substantially less than
the current carrying value of the inventory.
Factors we will consider in our
determination of the appropriate disposition
of the inventory include, but are not
limited to: (i) the overall terms and
conditions of formal offers received, if
any; (ii) the expected future market for saw
palmetto products; (iii) our actual
operating performance in relation to our
fiscal 2003 plan; (iv) our internal cost of
capital; and (v) the extent and availability
of additional financing or investment to
support the clinical study related to the
OraTest products or other strategic
initiatives.
|
| | - Foreign
  Currency                          | We transact business in various foreign
countries. Foreign currency exposures are
primarily related to, but not limited to,
vendor and customer payments and
inter-company balances in currencies other
than the functional currency. Fluctuations
in foreign currencies are not expected to
have a material adverse effect on our
results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| | - Inspection of 
  Manufacturing
  Facilities | The FDA has recently inspected our
manufacturing facilities and certain
facilities of our suppliers. Such
inspections resulted in the identification
of certain deficiencies. We have developed
an action plan to remedy the deficiencies
and we are in the process of implementing
the plan. Should these deficiencies not be
remedied, product supply could be affected.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| | - Required
  Number of
  Employees            | Zila Nutraceuticals manufacturing facility
was financed through a transaction with The
Industrial Development Authority of the
County of Yavapai (the Authority) in which
the Authority issued $5.0 million in
Industrial Development Revenue Bonds (the
Bonds), the proceeds of which were loaned
to Inter-Cal for the construction of the
facility. In conjunction with the
Authority, an Economic Development Agreement
with the City of Prescott was entered into,
which requires that we maintain at least 50
employees and add additional employees.
There is no assurance we will be able to
maintain or add the required number of
employees.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

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Item 2.

PROPERTIES



| |                              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | 
| | ---------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| | - Corporate
  Headquarters   | On January 4, 1991, we purchased
a 16,000 square foot building
located at 5227 North Seventh
Street, Phoenix, Arizona
85014-2800 and moved our
corporate headquarters to this
location. The purchase price of
the building was approximately
$600,000. We paid 25% of the
purchase price in cash and
obtained a loan for the balance
of the purchase price. We
refinanced the mortgage with
Bank One, Arizona. The terms of
the refinancing included
interest to be payable monthly
on the unpaid balance at an
interest rate of 9.00%. The
refinanced mortgage loan had a
20-year term but was paid in
full on August 23, 2001.                          
|
| | - Manufacturing
  Facilities | We currently lease 13,400 square
feet for a manufacturing
facility and laboratory in
Phoenix, Arizona. This facility
produces Zila® Tolonium
Chloride, which is the active
ingredient in the OraTest®
products, provides technical
support and testing for the
Zilactin® line of products and
assembles ViziLite Test Kits.
The facility is leased under a
56-month agreement, which
expires December 31, 2005.
Monthly lease payments are
$9,245. Together with our
laboratory facilities, we
believe that our current
manufacturers are capable of
performing all necessary
production for us. See Item 1.
Business  Manufacturing and
Distribution.
|
| |                              | Oxycal owns 5 acres and occupies
a 65,000 square foot facility
located at 6735 Inter-Cal Way,
Prescott, Arizona 86301. The
building features production,
laboratory, packaging, storage
and shipping areas, as well as a
controlled environment, and was
mortgage financed from Yavapai
County Industrial Development
Authority Bond proceeds. The
construction and move to the
facility was completed in the
fall of 2000.                                                                                                                                                                                                                               
|
| |                              | IST leases 14,400 square feet
for a manufacturing facility in
Antioch, Illinois for the
manufacture and distribution of
dry handled swab products and
probe covers. The facility is
leased under a seven-year
agreement, which expires January
31, 2008. The lease has an
option to renew for an
additional three years. Monthly
lease payments are $5,667.                                                                                                                                                                                                                                                                                               
|
| | - Other                      | We are still responsible for
three building leases related to
the facilities of our discontinued dental supply operations as
follows: (1) 19,200
square feet of an
office/warehouse complex with a current
lease rate of $3,024 per month,
and lease expiration on
December 31, 2004, (2) 7,708
square feet of an office
building with a current lease rate of $9,603 per
month, and lease expiration on December
31, 2004, (3) 4,761
square feet of an office building with a
current lease rate of $4,047 per
month and lease expiration on November 19, 2004.                                                                                          




Item 3.LEGAL PROCEEDINGS

We and certain of our corporate officers were named as defendants in a
consolidated First Amended Class Action Complaint filed July 6, 1999 in the
United States District Court for the District of Arizona under the caption In
re Zila Securities Litigation, No. CIV 99 0115 PHX EHC. The First Amended
Class Action Complaint sought damages in an unspecified amount on behalf of a
class consisting of purchasers of our securities for alleged violations of the
federal securities laws. During the fourth quarter 2001, the parties settled
this matter without a material impact on our financial statements.

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On December 19, 2001, we and Joseph Hines, our former President, reached a
settlement with the Securities and Exchange Commission (the Commission)
relating to certain public statements made by us in January 1999 with respect
to the prospects for approval by the FDA of the OraTest® product.

Pursuant to the settlement, the Commission made findings related to an
unsigned draft report that had been prepared by the FDA staff and delivered to
us on or about December 28, 1998. The unsigned draft report recommended
against approval of the OraTest® product. The Commission found that, in public
statements made by us during the two-week period subsequent to its receipt of
the unsigned draft report and prior to an FDA advisory committee meeting that
was held on January 13, 1999, we and Mr. Hines should have disclosed the
receipt of the unsigned draft report. The Commission acknowledged our position
that, at the time, we were represented by experienced FDA counsel who had
advised us that our OraTest® NDA was approvable, but the Commission concluded
that the receipt of the unsigned draft report should have been disclosed in the
our public statements, and that the failure to do so constituted a violation of
Section 10(b) of the Securities Exchange Act of 1934 (the Act) and Rule 10b-5
thereunder.

In order to resolve the matter, we and Mr. Hines submitted Offers of
Settlement, which the Commission accepted. Without admitting or denying the
Commissions findings, we and Mr. Hines consented to the entry of an Order
Instituting Public Administrative Proceedings pursuant to Section 21C of the
Act and the issuance of a Cease-and-Desist Order prohibiting future violations
of such Section and Rule. Mr. Hines is a director, but is no longer an officer
of the Company.

In September 2000, counsel advised us that our obligation to pay royalties
to Tinnell under the 1980 agreement ceased as of August 25, 1998 when the
patents on the invention expired. In September 2000, we gave notice to Tinnell
that we would not continue paying such royalties and requested reimbursement of
royalties paid since August 1998. After attempts to settle the matter failed,
we filed suit in the Federal District Court for the District of Nevada (Zila,
Inc. v. James E. Tinnell, No. CV-S-00-1344), requesting a declaratory judgment
that we had no royalty obligations to Tinnell after August 1998 and judgment
for the overpaid royalties.

Tinnell asserted a counterclaim for royalties since the last payment in
August 2000 and several additional counterclaims based on transactions between
Tinnell and Zila in the 1980s. Counsel have advised us that, based on their
investigations and discovery to date, (i) the counterclaim for royalties is
without merit and (ii) the additional counterclaims are meritless and, in any
event, are time-barred by the applicable statutes of limitation. Both Tinnell
and us have filed motions for summary judgment which were denied.
The Company currently intends to complete pretrial proceedings and
proceed to trial.

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




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

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




PART II




Item 5.MARKET FOR THE COMPANYS COMMON STOCK AND RELATED STOCKHOLDER MATTERS

Information regarding the market for Zilas 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).

23



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##### Table of Contents



|                                |                |  |      |      |     |  |   |      | 
|------------------------------- | -------------- |  | ---- | ---- | --- |  | - | ---- | 
|                                |                |  | High |      | Low
|                                |                |  |      |      |    
|Fiscal Year Ended July 31, 2002 |                |  |      |      |     |  |   |     
|                               
|                               
|                               
|                               
|                                | First Quarter  |  | $    | 2.73 |     |  | $ | 1.60 | 
|                               
|                               
|                               
|                               
|                                | Second Quarter |  |      | 2.74 |     |  |   | 1.77 | 
|                               
|                               
|                               
|                               
|                                | Third Quarter  |  |      | 2.54 |     |  |   | 1.95 | 
|                               
|                               
|                               
|                               
|                                | Fourth Quarter |  |      | 2.26 |     |  |   | 0.69 | 
|                               
|                               
|                               
|                               
|Fiscal Year Ended July 31, 2001 |                |  |      |      |     |  |   |     
|                               
|                               
|                               
|                               
|                                | First Quarter  |  | $    | 4.00 |     |  | $ | 2.84 | 
|                               
|                               
|                               
|                               
|                                | Second Quarter |  |      | 3.63 |     |  |   | 1.88 | 
|                               
|                               
|                               
|                               
|                                | Third Quarter  |  |      | 3.13 |     |  |   | 2.00 | 
|                               
|                               
|                               
|                               
|                                | Fourth Quarter |  |      | 3.02 |     |  |   | 2.05 | 

The number of stockholders of record of the common stock as of July 31,
2002 and September 30, 2002 were approximately 3,154 and 3,163, respectively.
As of July 31, 2002, there are 100,000 shares of our Series B Preferred Stock
outstanding.

We have not paid dividends on our common stock. It is the policy of our
Board of Directors to retain future earnings to finance the growth and
development of our business. Any future dividends will be at the discretion of
our Board of Directors and will depend upon our financial condition, capital
requirements, earnings and liquidity, as well as other factors that the Board
of Directors may deem relevant.

On March 23, 2000, we issued a warrant to purchase 10,000 shares of our
common stock to a financial advisor. The warrant was issued pursuant to the
terms of an engagement agreement, and the exercise price is $4.906 per share.
The warrant was issued pursuant to the exemption set forth in Section 4(2) of
the Securities Act of 1933, as amended.

On December 21, 2000, we issued a warrant to purchase 15,000 shares of our
common stock to a financial advisor. The warrant was issued pursuant to the
terms of a consulting agreement and 7,500 of the shares underlying the warrant
have an exercise price of $4.00 per share and 7,500 of the shares have an
exercise price of $5.00 per share. The warrant was issued pursuant to the
exemption set forth in Section 4(2) of the Securities Act of 1933, as amended.

The
Company entered into an agreement with a financial advisor during
fiscal 2002 to perform consulting services. Under the agreement, the
Company is committed to issue warrants to purchase 30,000 shares
of its common stock for $4.00 per share. At July 31, 2002,
$28,000 is included in accrued liabilities representing the fair
value of the warrants expected to be issued.

On February 1, 2001, we issued 100,000 shares of Series B convertible
preferred stock to National Healthcare Manufacturing Corporation, U.S. as part
of the acquisition of the patent rights and the Antioch, Illinois manufacturing
operations for swab products. The preferred stock is convertible into shares
of our common stock at any time at a conversion ratio of one to one. The
holders of the preferred stock are entitled to receive cumulative quarterly
dividends at a rate of $0.0975 per share per fiscal quarter, payable in
arrears. Holders of the preferred shares have no voting rights except as
required by applicable law. We paid the holders of the preferred stock $29,000
in dividends during 2002 and we have accumulated accrued dividends of $29,500
as of July 31, 2002. No dividends were paid in 2001. The shares of preferred
stock were issued pursuant to the exemption set forth in Section 4(2) of the
Securities Act of 1933, as amended.

On December 4, 2001, we acquired the world marketing and distribution rights
(excluding the Pacific Rim) for the FDA approved ViziLite chemiluminescent
light technology from The Trylon Corporation of Torrance, California. The rights
acquired include the FDA-approved devices and methods of conducting endoscopic
examinations of body cavities using chemiluminescent light sources. Under the
transaction, we issued 2,000,000 shares of restricted common
stock, of which 1,625,000 shares were delivered to Trylon and
375,000 shares were placed into escrow. Of the
1,625,000 restricted shares, 750,000 shares are restricted within the meaning
of Rule 144 under the Securities Act of 1933, as amended, and may be eligible
for sale subject to the holding period and other requirements of that Rule. The
contractual restrictions on the remaining 875,000 shares will be removed at the
earlier of 10 years following the closing date or the achievement of certain
future sales and government approval milestones. The shares of common stock
were issued pursuant to the exemption set forth in Section 4(2) of the
Securities Act of 1933, as amended.

The information called for by S-K Section 201(d) relating to Securities
Authorized For Issuance Under Equity Compensation Plans is incorporated by
reference to the information contained in our definitive proxy statement for
the annual meeting of stockholders of Zila to be held on January 14, 2003,
which will be filed with the SEC not later than 120 days after July 31, 2002.

24



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##### Table of Contents






Item 6.SELECTED FINANCIAL DATA

The following tables summarize selected financial information derived from
our audited financial statements. The information set forth below is not
necessarily indicative of results of future operations and should be read in
conjunction with our 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.

|                                                                                  |  |                            |             |      |  |                |            |                |  |                |            |                |  |   |            |   |  |   |            |  
|--------------------------------------------------------------------------------- |  | -------------------------- | ----------- | ---- |  | -------------- | ---------- | -------------- |  | -------------- | ---------- | -------------- |  | - | ---------- | - |  | - | ---------- | -
|                                                                                  |  | Fiscal Year Ended July 31,
|                                                                                  |  |                           
|Statement of Operations Data:                                                     |  | 2002                       |             | 2001 |  | 2000           |            | 1999           |  | 1998          
|                                                                                  |  |                            |             |      |  |                |            |                |  |               
|                                                                                  |  |                            |             |      |  | (as restated)1 |            | (as restated)1 |  | (as restated)1 |            | (as restated)1
|Net Revenues                                                                      |  | $                          | 34,871,770  |      |  | $              | 30,710,761 |                |  | $              | 36,608,273 |                |  | $ | 38,727,634 |   |  | $ | 32,643,521 |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Net (Loss) Income                                                                 |  |                            | (12,010,284 | )    |  |                | (6,390,492 | )              |  |                | 3,343,900  |                |  |   | (2,194,671 | ) |  |   | 1,660,829  |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Net (Loss) Income Attributable to Common Shareholders                             |  |                            | (12,068,784 | )    |  |                | (6,390,492 | )              |  |                | 3,343,900  |                |  |   | (2,194,671 | ) |  |   | (5,653,771 | )
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Basic and Diluted Net (Loss) Income Per Share Attributable
To Common Shareholders |  |                            | (0.27       | )    |  |                | (0.15      | )              |  |                | 0.08       |                |  |   | (0.06      | ) |  |   | (0.17      | )

|                                                |  |             |            |      |  |                |            |                |  |                |            |                |  |   |            |  |  |   |            | 
|----------------------------------------------- |  | ----------- | ---------- | ---- |  | -------------- | ---------- | -------------- |  | -------------- | ---------- | -------------- |  | - | ---------- |  |  | - | ---------- | 
|                                                |  | At July 31,
|                                                |  |            
|Balance Sheet Data:                             |  | 2002        |            | 2001 |  | 2000           |            | 1999           |  | 1998          
|                                                |  |             |            |      |  |                |            |                |  |               
|                                                |  |             |            |      |  | (as restated)1 |            | (as restated)1 |  | (as restated)1 |            | (as restated)1
|Current Assets                                  |  | $           | 18,252,737 |      |  | $              | 31,961,201 |                |  | $              | 31,380,071 |                |  | $ | 30,750,624 |  |  | $ | 27,992,138 | 
|                                               
|                                               
|                                               
|                                               
|Total Assets                                    |  |             | 57,360,653 |      |  |                | 75,602,514 |                |  |                | 77,040,526 |                |  |   | 76,077,681 |  |  |   | 68,656,193 | 
|                                               
|                                               
|                                               
|                                               
|Current Liabilities                             |  |             | 7,427,221  |      |  |                | 15,803,043 |                |  |                | 11,377,470 |                |  |   | 9,636,116  |  |  |   | 9,485,322  | 
|                                               
|                                               
|                                               
|                                               
|Long-Term Debt                                  |  |             | 3,610,483  |      |  |                | 4,153,271  |                |  |                | 4,548,953  |                |  |   | 9,577,755  |  |  |   | 1,355,547  | 
|                                               
|                                               
|                                               
|                                               
|Total Liabilities                               |  |             | 11,037,704 |      |  |                | 19,956,314 |                |  |                | 15,926,423 |                |  |   | 19,214,681 |  |  |   | 10,840,869 | 
|                                               
|                                               
|                                               
|                                               
|Series A Convertible Redeemable Preferred Stock |  |             |            |      |  |                |            |                |  |                |            |                |  |   | 8,787,191  |  |  |   | 33,801,930 | 
|                                               
|                                               
|                                               
|                                               
|Series B Convertible Preferred Stock            |  |             | 462,500    |      |  |                | 462,500    |                |  |                |            |                |  |   |            |  |  |   |            | 
|                                               
|                                               
|                                               
|                                               
|Shareholders Equity                            |  |             | 46,322,949 |      |  |                | 55,646,200 |                |  |                | 61,114,103 |                |  |   | 48,076,619 |  |  |   | 24,013,394 | 



|1. |  | See Note 19 of Notes to Consolidated Financial Statements included at
Item 8.
|-- |  | -----------------------------------------------------------------------------




Item 7.MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The words believe, expect, anticipate, intend,
estimate and other expressions which are predictions of or indicate future
events and trends and which do not relate to historical matters, identify
forward-looking statements. These forward-looking statements are based largely
on our expectations or forecasts of future events, can be affected by
inaccurate assumptions and are subject to various business risks and known and
unknown uncertainties, a number of which are beyond our control. Therefore,
actual results could differ materially from the forward-looking statements
contained in this document, and readers are cautioned not to place undue
reliance on such forward-looking statements. Certain factors that might cause
such a difference are discussed in the section entitled Cautionary Factors
that May Affect Future Results on Page 16 of this Form 10-K and below. We
undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
There can be no assurance that the forward-looking statements contained in
this document will, in fact, transpire or prove to be accurate.

Factors that could cause or contribute to our actual results differing
materially from those discussed herein or for our stock price to be affected
adversely include, but are not limited to: (i) our failure to maintain
compliance with the covenants of our outstanding debt instruments; (ii)
industry trends, including a downturn or slowing of the growth of the dietary
supplement industry and the consumer oral care, OTC and prescription
industries; (iii) our ability to maintain the quality of the inventory and to
sell our line of saw palmetto products for a price greater than the carrying
value of the inventory; (iv) a decision to sell all or a portion of the saw
palmetto inventory in bulk rather than in the normal course at lower than our
cost; (v) increased competition from current competitors and new market
entrants; (vi) our reliance on single source manufacturing locations for
several of our products; (vii) adverse publicity regarding the industries in
which we market our products; (viii) our dependence upon our ability to develop
new products; (ix) our ability to gain or expand
distribution within new or existing channels of trade; (x) an increase in the
cost of obtaining and maintaining shelf space with major national retailers who
demand various forms of incentives from their suppliers such as slotting fees,
coop

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advertising, or rebates; (xi) adverse changes in government regulations;
(xii) our suppliers and our ability to continue to comply with current good
manufacturing practices (GMP) and other applicable regulatory requirements;
(xiii) exposure to product liability claims; (xiv) dependence on significant
customers; (xv) our ability to keep and attract key management employees; (xvi)
our inability to manage growth and execute our business plan; (xvii) sales and
earnings volatility; (xviii) volatility of the stock market; (xix) our reliance
on independent brokers to sell many of our products; (xx) our inability to
protect our intellectual property; and (xxi) a general downturn in the national
economy as a whole.

Included among the factors affecting the OraTest® product are (i)
successful completion of the clinical study; (ii) our ability to obtain
sufficient financing to fund the clinical study; (iii) the FDAs ultimate
decision regarding the OraTest® product; (iv) the length, size and expense of
our clinical study and the FDA review process; (v) the limitations on indicated
uses for which the OraTest® product may be marketed; and (vi) if approved, the
market reception to the OraTest® product and any post-marketing reports or
surveillance programs to monitor usage or side effects of the OraTest®product.
There can be no assurance that the forward-looking statements contained in this
document will, in fact, transpire or prove to be accurate.

Critical Accounting Policies

There are several accounting policies that we believe are significant to
the presentation of our consolidated financial statements. Note 1 to our
consolidated financial statements Nature of Business Activities and Summary of
Significant Accounting Policies summarizes each of our significant accounting
policies. The most critical policies include those related to revenue
recognition, use of estimates and intangible assets.

Revenue
Recognition - Revenue, from sales of products is recognized when
earned; that is, when the risks and rewards of ownership have transferred to
the customer, which is considered to have occurred upon shipment of the
finished product, as shipping terms is FOB shipping point. Cash discounts,
sales incentives, and returns are estimated and recognized at the date of
shipment based upon historical activity and current customer commitments. We
evaluate these estimates on a quarterly basis and revise them as necessary.

On occasion, we enter into arrangements to license our technology on
specifically approved products. For those arrangements where we have
continuing involvement with the licensee, nonrefundable, upfront license fees
are recognized systematically as they are earned over the life of the
agreement. Fees associated with substantive, at risk, performance milestones
are recognized as revenue upon their completion, as defined in the respective
agreements. For perpetual licenses or manufacturing rights agreements, where
(i) we have no further continuing involvement with the licensee; (ii) the fees
are nonrefundable; and (iii) the fees are not a prepayment of future royalties,
we recognize the fees as revenue at the time the arrangement becomes
effective. The assessment of existence or extent of continuing
involvement requires significant judgment and analysis of the
contractual requirements and other factors relating to the business
relationship between the parties.

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.
Significant estimates include the following:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Nutraceuticals Group entered the saw palmetto business with its
Palmettx line of products in fiscal year 2000. In order to take advantage
of bulk purchase discounts and to establish a reputation as a reliable
supplier, we purchased a large amount of inventory in fiscal year 2001 and
additional inventory in 2002. As of July 31, 2002, approximately $3.8
million of saw palmetto products remain in inventory, representing an
approximately 1.6 years supply based on fiscal year 2002 sales. Recent
sales of saw palmetto products have generated a nominal profit margin and
allowances have been recorded where appropriate to reduce the carrying value
of the inventory to its estimated market value. However, the ultimate
probable future economic benefit associated with the saw palmetto inventory
is contingent on our ability to maintain the quality of the inventory and to
sell our line of saw palmetto products for a price greater than the carrying
value of the inventory. The sale of our current inventory balance in
the normal course of business is likely to take an extended period
of time. The determination of appropriate reserves requires estimates
of future prices for Saw Palmetto products, spoilage rates and
consumer trends.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The cash flows used to measure long-lived assets related to the
OraTest® product are dependent upon obtaining Food and Drug Administration
(the FDA) approval and generating sufficient revenues from sales of the
OraTest® product.
The rigorous clinical testing and an extensive regulatory approval
process mandated by the FDA and equivalent foreign authorities before any
new drug can be marketed by us can take a number of years and require the
expenditure of

26



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##### Table of Contents





| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | substantial resources. We anticipate that we will require
significant additional financing to support these activities. 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. Net
long-lived assets related to the OraTest® product as of July 31, 2002 of
$6.1 million have been capitalized.



|                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|----------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Intangible
Assets - Following is a summary of the significant classes of
intangible assets and our impairment methodology for each.
|                                                                                                                                   
|                                                                                                                                    | Our policy is to review the carrying amounts of goodwill and other
intangibles whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Such events or
circumstances might include a significant decline in market share, a
significant decline in profits, rapid changes in technology, significant
litigation or other items. In evaluating the recoverability of goodwill and
other intangible assets, our policy is to compare the carrying amounts of
such assets with the estimated undiscounted future operating cash
flows. If we have changes in event or circumstances, including
reductions in anticipated cashflows generated by our operations or
determinations to divest of certain assets, certain assets could be
impaired which would result in a charge to earnings.                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                    | Ora
Test- The purchase of CTM
eliminated our obligation to pay royalties to CTM on future sales of the
OraTest® product. The recoverability of the $4.5 million net purchased
technology rights is dependent upon obtaining FDA approval and generating
sufficient revenues from future sales of the OraTest® products (see Note
13). Fixed assets of approximately $600,000 (primarily related to a
manufacturing facility), patents and patents pending of $1,023,000 and
inventory of $649,000 are also associated with the OraTest® products and are
grouped with the purchased technology rights for the purpose of testing
recoverability. We have prepared a probability-weighted analysis of
potential future cash flows under various possible outcomes. Significant
assumptions in the analysis include the expected date and overall likelihood
of FDA approval, cost of the remaining phase III clinical trials, cost of
the marketing roll out, future net cash flows associated with sales of the
products and the probabilities assigned to each possible outcome. The
assumptions included in the analysis are updated whenever events or changes
in circumstances indicate that the carrying amount may not be recoverable.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Peridex Goodwill- Goodwill totaling approximately $7.0 million (net
of accumulated amortization of $4.6 million) is related to the Peridex®
product which was acquired from Procter & Gamble in November
1997. While Peridex® sales have increased during fiscal year 2002 when
compared to fiscal year 2001, a significant future increase in sales is not
expected to occur. Assuming stabilized cash flows approximately 40% below
current actual net cash flows results in recovery of the total intangible
balance in approximately 8 years.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Zila Nutraceuticals- Goodwill and trademarks totaling approximately
$12.2 million (net of accumulated amortization of $3.1 million) are related
to the Ester-C® group of products. These assets were acquired by merger in
1997 and are combined for purposes of testing for impairment. Although we
forecast continuing increases in cash flows associated with the Ester-C®
products, the total intangible asset balance will be recovered in
approximately 4 years if net cash flows continue at current levels.



| |                                                                                                                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Other Goodwill- Other goodwill totaling approximately $1.3 million
(net of accumulated amortization of $80,000) is related to the IST
acquisition in February 2001 and the Pro-Ties acquisition in December 2000.
At July 31, 2002, an impairment charge of $8,000 was recognized to adjust
goodwill associated with the Pro-Ties acquisition to its estimated fair
value.

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 manufacturer and marketer of pharmaceutical, nutritional and
biotechnology products. In fiscal year 2002 we had the following Groups:
Consumer Pharmaceuticals, Professional Pharmaceuticals and Zila Nutraceuticals.
The Zila

27



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##### Table of Contents



Nutraceuticals Group is comprised of Oxycal Laboratories, Inc.
(Oxycal) and its Inter-Cal subsidiary (Inter-Cal), a manufacturer and
distributor of mineral and botanical products including a patented and unique
form of Vitamin C under the trademark Ester-C® and the Palmettx® botanical
line of products. The Consumer Pharmaceuticals Group consists of
over-the-counter products, including the Zilactin® family of over-the-counter
products. The Professional Pharmaceuticals Group includes Peridex®
prescription mouth rinse, OraTest®, an oral cancer detection system, the
ViziLite disposable light for illumination of oral mucosal abnormalities, and
the plastic molded products from Innovative Swab Technologies (IST).

On December 4, 2001, we acquired the world marketing and distribution
rights (excluding the Pacific Rim) for the Food and Drug Administration (FDA)
approved ViziLite chemiluminescent light device from The Trylon Corporation of
Torrance, CA (Trylon). The rights acquired include the FDA-approved devices
and methods of conducting endoscopic examinations of body cavities using
chemiluminescent light sources. We issued 2,000,000 shares of restricted
common stock for the rights and agreed to pay royalties to Trylon on sales of
the ViziLite product.

Effect of Restatement of Financial Statements

As discussed in Note 19 of the Notes to Consolidated Financial Statements,
we have restated our financial statements for the years ended
July 31, 2001 and 2000 and each of the
quarterly periods included in the fiscal year ended July 31, 2001 and the
first, second and third quarters of the fiscal year ended July 31, 2002. The
restatement reflects adjustments related to (i) expensing of certain deferred
licensing costs related to the OraTest® product that were previously
capitalized; (ii) reversal of certain license revenue; (iii) revision of the
amortization period related to the purchased technology rights; (iv) severance
payments made to several former employees when terminated; and (v) expensing
certain research and development costs associated with the Trylon transaction.
The following management discussion and analysis gives effect to the
restatement.

Operating Results

In
November 2001, we decided to sell the operations of the Zila Dental
Supply (ZDS) business. These operations were sold in two
separate transactions during the second fiscal quarter of 2002. The
accompanying consolidated financial statements have been prepared to
reflect the ZDS business including any gain (loss) on sale as
discontinued operations for all periods presented.

This
business segment was comprised of the full-service and mail order
business of Zila Dental Supply. We sold the ZDS full-service assets
on November 5, 2001 to Henry Schein, Inc. of Melville, NY
(Nasdaq: HSIC) for approximately $5.8 million in cash resulting
in a pre-tax gain from the disposal of approximately $823,000.
Proceeds from the sale were used to repay borrowings outstanding
under the revolving line of credit with Congress Financial
Corporation (Congress).

The
ZDS mail order operations (assets and liabilities) were sold on
December 4, 2001 to PracticeWares, Inc. of Sacramento, CA for
approximately $8.0 million in one short and two long-term notes.
Approximately $5.7 million of the $8.0 million purchase
price (net of post closing adjustments) was due and payable
January 11, 2002. We extended the maturity date of the
short-term note, upon payment of accrued and prepaid interest, to
February 15, 2002, and further extended the note to
March 1, 2002, with interest prepaid through the new maturity
date.

The
note was not paid on the due date and in March 2002, Zila and
PracticeWares agreed in principal to restructure the terms relating
to the sale. In June 2002, final agreement was reached such that
PracticeWares would pay Zila cash of approximately $4,130,000, plus a
19.0% ownership interest in PracticeWares (on a fully diluted basis)
in full satisfaction of the notes. On June 18, 2002 we received
$3.9 million from PracticeWares, Inc., which included
approximately $130,000 in accrued interest and $200,000 was held in
escrow for 60 days to offset certain indemnifications to
PracticeWares resulting in a pre-tax loss from the disposal of the
mail order assets of approximately $679,000. Proceeds from the sale
were used to repay borrowings outstanding under the revolving line of
credit with Congress.

As
a result of PracticeWares failure to pay the short-term notes,
the transaction to sell the mail order business did not qualify as a
sale for accounting purposes until June 18, 2002. Therefore, ZDS
had net losses of $550,000 for the period from December 4, 2001
to June 18, 2002, and they are reflected in the income statement
as (loss) income from operations of the discontinued Dental Supply
Segment.

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PracticeWorks,
Inc., another third party, acquired a minority interest in
PracticeWares in June 2002 for $1.0 million. Additionally,
PracticeWorks advanced $3.5 million in the form of a loan to
PracticeWares and has entered into a long-term distribution agreement
with PracticeWares under which PracticeWares will be able to offer
its dental supplies to PracticeWorks customers in exchange for
royalty payments to PracticeWorks on these sales. PracticeWares also
entered into a long-term license agreement with PracticeWorks for the
use of its e-commerce software. Prior to
March 5, 2001, PracticeWorks, Inc. operated as a division of
VitalWorks Inc. (VitalWorks), formerly InfoCure
Corporation. On March 5, 2001, VitalWorks completed the pro rata
distribution of all of the outstanding shares of PracticeWorks common
stock to VitalWorks stockholders.

The
financial statements have been prepared to reflect our historical
financial position and results of operations and cash flows as
adjusted for the reclassification of the ZDS business as discontinued
operations. The historical results of the operations of the ZDS
business up to November 2001 and the gain (loss) recognized on the
components of the sale are reported as discontinued operations in the
accompanying consolidated financial statements.

Fiscal year ended July 31, 2002

Total Company

Net revenues increased 13.5% to $34.9 million for fiscal year 2002
compared to revenues of $30.7 million for the 2001 fiscal year. The increase is
due primarily to sales increases in the Zila Nutraceutical and Professional
Pharmaceutical Groups offset by a decline in sales in the Consumer
Pharmaceutical Group.

For the year ended July 31, 2002 cost of products sold as a percentage of
net revenues increased slightly to 35.7% in fiscal year 2002 from 33.5% in the
prior fiscal year. An increase in cost of products sold occurred in all of our
Groups.

We incurred selling, general and administrative expenses of $21.8 million,
or 62.6% of net revenues, during fiscal year 2002 compared to $20.0 million, or
65.1% of net revenue in the same period in fiscal 2001. The increase in
selling, general and administrative expenses is attributable to (i) increased
marketing and selling expenses at the Nutraceuticals and Consumer
Pharmaceuticals Groups; (ii) the inclusion of IST costs for the entire current
year period; (iii) the addition of the ViziLite product costs during the
current period; and (iv) increased expenses at our manufacturing facility
related to production of the ViziLite product and increased testing of our
products.

Research and development expenses increased $919,000, or approximately
30.3%, from $3.0 million in fiscal year 2001 to $4.0 million for the same
period in fiscal year 2002. The increase is primarily due to expenses related
to the acquisition of ViziLite technology, the costs for a product currently
under development utilizing the ViziLite technology and the expensing of
several studies related to the OraTest® product in Europe and China.

During fiscal year 2002, we recorded an impairment charge of $224,000 to
write down the carrying value of several assets related to the Pro-Ties
bundling system because of the reduced sales activity and the Western European
marketing rights for the Peridex® product because we do not plan to enter this
market.

Depreciation and amortization expenses increased to $3.5 million in fiscal
year 2002 from $3.2 million for the same period in fiscal year 2001. The
increase is due primarily to the inclusion of the amortization related to the
ViziLite product and the full year of ISTs depreciation and amortization.

We recorded interest expense of $487,000 for the fiscal year 2002 compared
to $597,000 in the previous year. The decrease was attributable to decreased
bank borrowings and debt obligations, as well as lower interest rates during
the current year, compared to the previous year period.

We regularly review our deferred tax assets and related valuation
allowances in accordance with SFAS No. 109, Accounting for Income Taxes
SFAS 109 requires us to assess all available evidence, both positive and
negative, to determine whether a valuation allowance is needed based on the
weight of that evidence.

During fiscal year 2002, we incurred a loss from continuing operations of
$7,384,000. These losses exceeded our projected operating results and resulted
in a three-year cumulative loss position. Cumulative losses are a form of
evidence
under SFAS No. 109 that is among the most objectively verifiable and
carries more weight than other evidence that embodies some degree of
subjectivity such as projected future income. As a result of this negative
evidence, we determined that it is

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more likely than not that certain future tax
benefits will not be realized. For the year ended July 31, 2002, we recorded a
tax benefit based on the effective tax rate and offset the tax benefit with an
increase in the deferred tax asset valuation reserve. In addition, we recorded
income tax expense of $3,954,000 (net of a tax refund of $280,000 received
during the third quarter of fiscal 2002) during the period primarily due to an
increase in the valuation allowance related to our previously recorded deferred
tax assets. As of July 31, 2002, all of our deferred tax assets are offset by
a valuation allowance.

Zila Nutraceuticals Segment

Net revenues for the
Zila Nutraceuticals Group for the year ended July 31,
2002, were $19.6 million, a 27.2% increase, compared to $15.4 million for the
corresponding 2001 fiscal year. Sales of Ester-C® increased 22.9% over last
year. The increase is attributable to increased radio and television
advertising of the Ester-C® products in the first half of the current fiscal
year. Sales of saw palmetto products increased 69.4% in fiscal 2002 over the
prior year. International sales for the Nutraceutical Group during the year
increased 12.4% to $4.6 million compared to $4.1 million in the previous year.

Cost of products sold,
as a percentage of net revenues for the
Zila Nutraceuticals Group, was 36.8% for fiscal 2002 and 35.8% for fiscal 2001. The increase was
caused by the higher percentage of sales of the
PalmettxTM line of products, which had a lower profit margin than the Ester-C® line of products during the period.

As of July 31, 2002,
approximately $3.8 million of saw palmetto products
remain in inventory, representing approximately 1.6 years supply based on
fiscal 2002 sales. We do not intend to purchase additional saw palmetto
inventory in the foreseeable future. Recent sales of saw palmetto products
have generated a nominal profit margin and we have recorded reserves where
appropriate to reduce the carrying value of the inventory to its estimated
market value. During fiscal 2002, we reduced the carrying value of the saw
palmetto inventory by approximately $550,000 because the market value of the
product was less than its carrying value and due to spoilage.

In the last half of fiscal 2002, we increased the sales price of saw
palmetto oil products. Sales volume in the fiscal fourth quarter decreased as
a result of the price increase. However, sales in first quarter of fiscal 2003
have improved over the previous quarter, though not at the same volume as in
the quarters prior to the price increase. We continue to sell the products at
the higher sales prices. If future sales of saw palmetto products were to
continue at the same rate as those in the fiscal 2002 fourth quarter, it would
take us approximately 3.3 years to sell the remaining inventory. We have been
contacted by several companies interested in purchasing the saw palmetto
inventory in bulk. None of the terms discussed was acceptable to us. While we
have not made a decision to pursue such a sale, if all or a substantial portion
of the inventory is sold in bulk, the ultimate sales price may be substantially
less than the current carrying value of the inventory. The ultimate probable
future economic benefit associated with the saw palmetto inventory is
contingent on our ability to maintain the quality of the inventory and to sell
our line of saw palmetto products for a price greater than the carrying value
of the inventory.

Ascorbic acid is the major raw material in our Ester-C® products and is
subject to periodic price fluctuations. The price of ascorbic acid has
increased approximately 43% during the first quarter of fiscal year 2003. This
price increase will cause our material component of the cost of goods sold to
increase approximately 11% in fiscal 2003.

Consumer Pharmaceuticals Segment

Consumer Pharmaceuticals had net revenues of $9.6 million for the year
ended July 31, 2002, a 12% decrease over the $10.9 million recorded last year.
Sales of the three Zilactin® canker and cold sore medicines for fiscal 2002
decreased 10.2% from those in fiscal 2000. Sales of the Zilactin® Toothache
Swabs for fiscal 2002 decreased 20.3% over the previous year while sales of the
Zilactin® Baby declined 25% over the previous fiscal year. International sales
for fiscal 2002 were $596,000, an increase of 18.9% when compared to fiscal
year 2001. The overall decrease in sales was due primarily to several
new competitive product introductions during the year and the adverse effects
on consumer demand caused by the events of September 11, 2001. Several
initiatives were started during the second half of fiscal 2002 in an effort to
increase sales,

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including new package design for all Zilactin® products, a new
consumer and professional advertising campaign, increased level of public
relations activities and the release of the new Zilactin® Baby Teething Swab
products.

Cost of products sold as a percentage of net revenues for Consumer
Pharmaceuticals increased slightly to 28.8% during the year ended July 31, 2002
from 27.6% in the previous year. The increase is the result of a decrease in
the average selling price of most of the product lines sold during the current
year and additional manufacturing costs.

Professional Pharmaceuticals Segment

Net revenues for Professional Pharmaceuticals were $5.7 million, a 29.0%
increase from the $4.4 million recorded during the prior year. Net sales of the
Peridex® product increased 12.3% to $4.0 million in fiscal year 2002 due
primarily to increased purchases from Omnii Products related to their exclusive
supply agreement and lower product returns. Sales for the IST division were
$1.2 million compared to $521,000
last year. Sales in fiscal 2001
included only six months of shipments because IST was acquired in February
2001. In July 2002, IST received a contract to produce two new products for a
United States based healthcare company. The contract is expected to generate
over $2.5 million in revenue through October 2004.

Cost of products sold as a percentage of net product sales for
Professional Pharmaceuticals increased to 37.3% for the year ended July 31,
2002 from 35.5% for the year ended July 31, 2001. The increase for the current
year reflects the inclusion of IST costs of products for the entire
twelve-month period of the current fiscal year versus six months in the prior
year and the write off of expired inventory.

Fiscal year ended July 31, 2001

Total Company

Net revenues declined 16.1% to $30.7 million for fiscal year 2001,
compared to revenues of $36.6 million for the 2000 fiscal year.

Cost of products sold as a percentage of net revenues increased to 33.5%
in fiscal year 2001 from 28.6% in the corresponding 2000 period. The increase
for the period reflects increases in cost of sales for all of our Groups.

Selling, general and administrative expenses as a percentage of net sales
in fiscal 2001 increased to 65.1% from 57.4% in fiscal 2000 as a result of
lower net revenues. We incurred selling, general and administrative expenses
of $20.0 million in fiscal year 2001, a 4.9% decrease compared to $21.0 million
in fiscal year 2000. The decrease is primarily attributable to the elimination
of the costs related to the Cygnus and PracticeWorks businesses partially
offset by increased costs related to the increased marketing and advertising
expenses at the Nutraceuticals Group and the inclusion of the costs at IST.

Research and development expenses increased $1.4 million, or 86.4%, from
$1.6 million incurred in fiscal year 2000 to $3.0 million for fiscal year 2001.
The increase was primarily due to an increase in expenses related to research
and clinical activities associated with the OraTest® clinical study, partially
offset by a reduction of expenses related to seeking international approval of
OraTest® and a reduction of costs resulting from the sale of the Cygnus and
PracticeWorks businesses.

In October 2000, we recorded a non-cash impairment charge of $310,000 to
write down the carrying value of the land and buildings related to the former
Inter-Cal operation in Prescott, Arizona to an estimated fair value related to
its anticipated sale. The building was sold in March 2001.
Depreciation and amortization expenses increased $80,000 when compared to
fiscal year 2000. The increase was related primarily to the increase in
depreciation of assets associated with the Nutraceuticals Groups new
manufacturing facility that were placed in service during fiscal 2001.

We recorded interest expense of $597,000 for the year ended July 31, 2001
compared to $218,000 in the prior fiscal year, an increase of $379,000. The
increase was attributable to an increase in bank borrowings during fiscal year
2001 as
compared to the previous year period.

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During
fiscal year 2001, we recorded $1,808,000 in deferred tax assets
offset by an increase in the valuation allowance of $1,422,000, which resulted
in a net income tax benefit of $386,000 compared to an income tax expense of
$1.9 million in fiscal 2000.

Zila Nutraceuticals Segment

Net
revenues for the Zila Nutraceuticals Group for fiscal year 2001 were $15.4
million, a 19.4% decrease when compared to $19.0 million for fiscal year 2000.
The decrease was largely attributable to an overall slowdown in the domestic
and foreign vitamin and food supplement market during the first nine months of
the fiscal year and the effects of promotional discounting that occurred in
prior year periods. International sales for the Nutraceuticals Group for
fiscal year 2001 declined approximately 26.0% when compared to the previous
fiscal year.

Cost of products sold as a percentage of net revenues for the
Zila Nutraceuticals Group increased to 35.8% for fiscal year 2001 from 27.3% in
fiscal year 2000. The increase was caused by higher costs associated with the
manufacturing of the new Palmettx botanical line of products as well as the
duplicate overhead, moving and equipment validation costs related to the
relocation of the manufacturing equipment to the new facility during the 2001
fiscal year.

Consumer Pharmaceuticals Segment

The Consumer Pharmaceuticals Group had net revenues of $10.9 million for
fiscal year 2001, a slight increase from the $10.7 million recorded during the
corresponding period in 2000. Sales of the three Zilactin® canker and cold sore
medicines for fiscal 2001 were approximately equal to those in fiscal 2000.
Sales of the Zilactin® Toothache Swabs for fiscal 2001 increased 13.9% over the
previous year while sales of the Zilactin® Baby declined 25% over the 2000
fiscal year. International sales for fiscal 2001 increased 3.9% when compared
to fiscal year 2000.

Cost of products sold as a percentage of net revenues for Consumer
Pharmaceuticals increased to 27.6% in fiscal year 2001, compared to 25.9% for
the corresponding period in fiscal 2000. The increase for the period is a
result of a change in the mix of products sold as the toothache product has a
higher cost than the other Zilactin® products.

Professional Pharmaceuticals Segment

The Professional Pharmaceuticals Group had revenues of $4.4 million in
fiscal 2001, a 15.4% decrease from the $5.2 million recorded in 2000. The
decrease was due primarily to lower sales of the Peridex® product, which
declined 32.9% from $5.1 million in 2000 to $3.4 million in 2001 due to
increased pricing pressures and substitutions of generic equivalents. In
addition, the current year revenues include revenues for IST of $521,000 for
the partial year.

Cost of products sold as a percentage of net revenue for the Professional
Pharmaceuticals Group increased to 35.5% from 25.8% in the prior fiscal year
due primarily to the addition of IST to the Group during the year. IST had a
cost of products sold of 70.6% of net revenue for the current fiscal year.

Inflation and Seasonality

Inflation has had no material effect on the operations or financial
condition of our businesses. Our consolidated operations are not considered
seasonal in nature.

Liquidity and Capital Resources

At July 31, 2002, our primary sources of liquidity included cash and cash
equivalents of $1.6 million and the line of

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credit discussed below. We had
cash and cash equivalents of $1.3 million at July 31, 2001. Excess cash and
cash equivalents are invested primarily in money market accounts. Our working
capital was $11.1 million at July 31, 2002 compared to $16.2 million at July
31, 2001. The primary reason for the decrease in working capital is the
decrease in
accounts receivable and inventories associated with the sale of the ZDS segment
and the losses incurred during the period. Our current ratio was 2.5 at July
31, 2002, compared to 1.7 to 1 at July 31, 2001.

Net cash provided by operating activities was $1.2 million during year
ended July 31, 2002. Our net loss of $12.0 million was offset by non-cash items
of $8.7 million related primarily to depreciation, amortization and the
increase in the valuation allowance related to deferred tax assets and by a net
decrease in operating assets and liabilities of $4.5 million. Significant
changes in operating assets and liabilities were primarily comprised of (i) a
decrease in accounts receivable of $968,000 due to increased collection
efforts; (ii) a decrease in inventory of $2.2 million related primarily to the
increased sales of the Palmettx® and Ester-C® products and lower purchases of
inventory at Consumer Pharmaceuticals; and (iii) an increase in accounts
payable and accrued expenses of $1.6 million.

Net cash provided by investing activities was $6.0 million, related
primarily to the proceeds received from the sale of the ZDS assets of $9.7
million offset by the liabilities retained of the
discontinued operations of $2.1 million, capital asset purchases and patent
filings for Inter-Cal and the OraTest® product.

Net cash used in financing activities was $6.8 million. Significant
changes were: (i) the outstanding balance of the line of credit was reduced by
approximately $6.1 million; (ii) the building loan with Bank One, Arizona, NA
of approximately $277,000 was paid in full; and (iii) the outstanding principal
balance of the bonds related to the new Nutraceutical facility was reduced by
approximately $428,000.

At July 31, 2002, we had net operating loss carryforwards for federal tax
purposes of approximately $21 million, which expire in years 2007 through 2022.
Net operating loss carryforwards for state income tax purposes, totaling
approximately $6.7 million, must be utilized within five years of the date of
their origination, and expire from 2003 through 2007. Our ability to utilize
these net operating loss carryforwards will be impaired if we continue to incur
operating losses.

In December 2000, we renewed our $9 million line of credit with Bank One
for an additional 12 months under similar terms and conditions, including a
variable interest rate equal to the prime rate (Index), which was 6.75% at
July 31, 2001. Under the line of credit loan agreement, we were required to
comply with financial covenants based on certain financial ratios. As of April
30, 2001, we were in default of the debt service coverage ratio. On May 7,
2001, we entered into the First Loan Modification Agreement with Bank One
whereby (i) the line of credit was reduced to $7.25 million; (ii) the interest
rate was raised to 3.0% over the Index; (iii) we agreed to cross-defaulting and
cross-collateralizing of all Bank One loans and obligations; and (iv) Bank One
agreed to forebear in exercising any remedy with respect to the default through
May 31, 2001. On June 14, 2001, the Agreement was amended and the forbearance
period was extended to June 29, 2001.

On July 3, 2001, we entered into a Second Extension to the First Loan
Modification Agreement with Bank One. Under this Agreement, the line of credit
was reduced to $6.9 million and Bank One agreed to forebear in exercising any
remedy with respect to certain defaults under the line of credit through July
31, 2001 and agreed to extend the maturity date of the building loan for our
7th Street location until July 31, 2001.

We entered into a Third Extension to First Loan Modification Agreement
effective July 31, 2001. Under this Agreement, Bank One agreed to forebear in
exercising any remedy with respect to certain defaults under the line of credit
through August 31, 2001 and agreed to extend the maturity date of the building
loan until August 31, 2001.

On August 27, 2001, we entered into a Loan and Security Agreement (the
Congress Agreement) with Congress Financial Corporation (Congress) whereby
Congress would provide a $12 million revolving line of credit to us at an
interest rate equal to the prime rate plus 3/4 percent. The amount of funds
available to us from the line of credit is based upon a percentage of the value
of eligible receivables and inventory and was $4.8 million at July 31, 2002.
The obligations under the Congress Agreement are collateralized by various
assets, including, but not limited to our trade accounts receivable,
inventories, equipment and intangible assets and of certain of our operating
subsidiaries. Zila and all of its direct and indirect operating subsidiaries
guarantee the obligations under the Congress Agreement. The Congress Agreement
expires August 17, 2004; however any amounts due under the line of credit would
be classified as current because of certain provisions required by Congress.
The Congress Agreement contains a provision whereby Congress can call for
immediate repayment of all amounts due under the line upon its determination
that the Company has incurred a material adverse change. While we do not
believe that any events have occurred in fiscal 2002 that would constitute a
material adverse change, that determination is
33Table of Contentssolely the responsibility of
Congress. Under the Congress Agreement, we are also required to comply with a
financial covenant based on an adjusted tangible net worth calculation. At
July 31, 2002, our adjusted tangible net worth was $ 17.1 million compared to a
required amount of $16.0 million. If we continue to incur additional operating
losses, reduce the value
of our tangible assets, or incur additional debt, we may become out of
compliance with the covenant. A portion of the available funds from the new
line of credit were used to pay off in full the line of credit and building
loan due to Bank One, totaling approximately $6.4 million. The obligations of
Oxycal Laboratories, Incorporated, an operating subsidiary of Zila, Inc., to
Bank One with respect to the 1999 Industrial Revenue Development Bonds have not
changed.During October 2000, the Nutraceuticals Group moved into its new
manufacturing and laboratory facility in Prescott, Arizona. The facility was
financed through a transaction with The Industrial Development Authority of the
County of Yavapai (the Authority) in which the Authority issued $5.0 million
in Industrial Development Revenue Bonds (the Bonds), the proceeds of which
were loaned to Inter-Cal for the construction of the facility. The Bond
proceeds were held by the trustee, Bank One, Arizona, until such time as
invoices for building construction costs and new equipment were submitted for
payment. As of July 31, 2001, the trustee had released all the Bond proceeds.
As of July 31, 2002, the Bonds outstanding consisted of $3.9 million Series A
and $104,000 Taxable Series B which carried interest rates of 1.75% and 1.97%,
respectively. The Bonds were marketed and sold by Banc One Capital Markets and
carry a maturity of 20 years. In connection with the issuance of the Bonds,
the Authority required that Oxycal obtain, for the benefit of the Bondholders,
an irrevocable direct-pay letter of credit to secure payment of principal and
interest. The letter of credit was issued by Bank One and is guaranteed by
Zila.In March 2001, the Nutraceuticals Group sold the land and buildings
related to its former operation in Prescott, Arizona for approximately $1.0
million in cash and a promissory note for $310,000. The note carried interest
of 10% and was due and payable on May 31, 2002. The note was not paid on the
due date but was extended until May 31, 2003. The new note carries an interest
rate of 7.5% and requires the borrower to pay monthly payments of $2,874. The
payments are current.On November 10, 1999, we announced that our Board of Directors authorized
the repurchase of up to one million shares of Zila common stock. Purchases
will be made on the open market depending on market conditions and other
factors. As of July 31, 2002, 195,000 shares had been repurchased for $535,120.On February 5, 2001, we issued 100,000 shares of Series B Convertible
Preferred Stock as part of the IST acquisition. The holders of the Preferred
Stock are entitled to receive cumulative quarterly dividends at a rate of
$0.0975 per share per fiscal quarter, payable in arrears. We paid $29,000 in
dividends during 2002 and we have accumulated accrued dividends of $29,500 as
of July 31, 2002. No dividends were paid in 2001.The
table below summarizes our future cash contractual obligations by
fiscal year:

|           |  |                |           |                 |  |                   |        |           |  |       |           |       |  |   |         |  |  |   |         |  |  |   |           | 
|---------- |  | -------------- | --------- | --------------- |  | ----------------- | ------ | --------- |  | ----- | --------- | ----- |  | - | ------- |  |  | - | ------- |  |  | - | --------- | 
|           |  | Long-Term Debt |           | Short-Term Debt |  | Operations Leases |        | Severance |  | Other |           | Total
|           |  |                |           |                 |  |                   |        |           |  |       |           |      
|2003       |  | $              | 489,161   |                 |  | $                 | 99,783 |           |  | $     | 398,924   |       |  | $ | 622,868 |  |  |   |         |  |  | $ | 1,610,736 | 
|          
|          
|          
|          
|2004       |  |                | 458,497   |                 |  |                   |        |           |  |       | 398,312   |       |  |   | 71,588  |  |  |   | $57,600 |  |  |   | 985,797   | 
|          
|          
|          
|          
|2005       |  |                | 425,784   |                 |  |                   |        |           |  |       | 254,184   |       |  |   |         |  |  |   | 57,600  |  |  |   | 737,568   | 
|          
|          
|          
|          
|2006       |  |                | 425,784   |                 |  |                   |        |           |  |       | 111,926   |       |  |   |         |  |  |   |         |  |  |   | 537,710   | 
|          
|          
|          
|          
|2007       |  |                | 425,784   |                 |  |                   |        |           |  |       | 68,004    |       |  |   |         |  |  |   |         |  |  |   | 493,788   | 
|          
|          
|          
|          
|Thereafter |  |                | 1,874,634 |                 |  |                   |        |           |  |       | 34,002    |       |  |   |         |  |  |   |         |  |  |   | 1,908,636 | 
|           |  |                |           |                 |  |                   |        |           |  |       |           |       |  |   |         |  |  |   |         |  |  |   |           | 
|Total      |  | $              | 4,099,644 |                 |  | $                 | 99,783 |           |  | $     | 1,265,352 |       |  | $ | 694,456 |  |  | $ | 115,200 |  |  | $ | 6,274,405 | 
|           |  |                |           |                 |  |                   |        |           |  |       |           |       |  |   |         |  |  |   |         |  |  |   |           | 

Our current intention is to sell the remaining inventory of saw palmetto
products in the normal course of business. However, we have been contacted by
several companies interested in purchasing the saw palmetto inventory in bulk.
None of the terms discussed were acceptable to us. While we have not made
decision to pursue such a sale, if all or substantial portion of the inventory
is sold in bulk, the ultimate sales price may be substantially less than the
current carrying value of the inventory. Factors we will consider in our
determination of the appropriate disposition of the inventory include, but are
not limited to: (i) the overall terms and conditions of formal offers received,
if any; (ii) the expected future market for saw palmetto products; (iii) our
actual operating performance in relation to the fiscal 2003 plan; (iv) the
extent and availability of additional financing or investment to support the
clinical study related to the OraTest products; and (v) our internal cost of
capital.

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We also have approximately $446,000 of Zila® Tolonium Chloride powder, the
active ingredient in the OraTest® product, in inventory at our manufacturing
facility in Phoenix, AZ. We intend to realize the value of this
inventory through sales in the U.S., once final approval for the OraTest®
products are received from the FDA, and in Europe and Asia, after utilizing
approximately $148,000 of OraTest® finished product located in the U.K. prior
to the date we expect sales in the United States. The powder inventory
currently has expiration dates in 2003 and 2004, which is prior to the date we
expect sales in the United States. Previous testing indicates that the powder
product is stable and we expect to be able to extend the expiration dates of
the entire powder inventory through the date we expect sales in the United
States. However, no assurance can be given that such future testing efforts
will be successful. In addition, should FDA approval not be granted or be
significantly delayed, it may not be possible for us to recover the value of
this powder inventory.

During the third quarter of 2002, we determined that completion of the
OraTest® Phase III clinical trial will require a substantial number of
additional patients and have been evaluating the number of patients required to
complete the study. The requirement for the larger number of patients is
related to the tumor formation rate within the study population and not to the
efficacy of the OraTest® product Factors that affect the cost and timing of
completion of these milestone dates include but are not limited to: (i) patient
enrollment rates, (ii) tumor formation rate within the study population (iii)
compliance with the study protocol and related monitoring, (iv) level of
funding throughout the study, and (v) protocol modifications. .

We have decided to transition the trial from ILEX Oncology Services, Inc.
to a new global contract research organization (CRO). We requested
proposals from several of the largest, highest quality and most prominent CROs
with worldwide capabilities, and received fee quotations back from each. We
are currently in the process of finalizing our selection of the new global CRO.
Each CRO agreed that the current study could be transitioned successfully
without compromising any of our current study data.

In order to support the larger number of patients needed to complete the
study, we intend to increase the rate of funding for the study and the number
of clinical sites, with the aid of a larger, more experienced CRO with access
to clinical sites in high-density oral cancer regions around the world. This
effort is currently underway and we believe that we will have sufficient funds
for the clinical trial for the next fiscal year. We will, however, require
additional financing to support the OraTest® clinical trial, regulatory,
manufacturing and marketing costs extending beyond fiscal year 2003. We are
currently considering possible financing sources such as strategic partners and
are pursuing funding strategies that if completed would provide significant
funding for the clinical trial. We are also considering the possible
liquidation of certain Zila assets outside our areas of core competency as part
of Zilas new focus on core strengths and objectives. These assets could also
provide significant funding for the clinical trial. There is no assurance that
such funds will be available on terms acceptable to us.

We believe that cash generated from our operations, our investing
activities and the availability of cash under our line of credit are sufficient
to finance our level of operations, the OraTest® clinical trial, anticipated
capital expenditures and the stock repurchase program through the next 12
months. We will require additional financing to support the production and
future OraTest® clinical, regulatory, manufacturing and marketing costs or to
make any significant acquisitions. There can be no assurances that such funds
will be available on terms acceptable to us.

Related Party Transactions

In fiscal 2002, we paid $194,829 to Douglas, Curtis and Allyn, LLC,
(Douglas), a corporation owned by a member of our Board of Directors, Mr.
Curtis Rocca. The payment was related to consulting work performed in
connection with the sale of the ZDS businesses. In addition, Douglas was
paid an advisory retainer of $60,000 during fiscal 2002. The arrangements were
terminated in July 2002.

New Accounting Pronouncements

In May 2000, the Financial Accounting Standards Boards Emerging Issues
Task Force (EITF) reached a consensus on Issue No. 00-14, Accounting for
Certain Sales Incentives. The Issue addresses the recognition, measurement,
and income statement classification for certain sales incentives including
coupons, rebates and free products. We adopted EITF Issue No 00-14 on February
1, 2002. The implementation of this consensus required us to change the way we
classify certain sales incentives, which were previously recorded as selling,
general and administrative expenses. The cost of coupons

35



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##### Table of Contents



and rebates are now
recorded as a reduction of net sales. The cost of free products is now
recorded as an increase to cost of sales.

In April 2001, the EITF reached consensus on Issue No. 00-25, Vendor
Income Statement Characterization of Consideration from a Vendor to a
Retailer. The issue discusses accounting and income statement classification
of costs, other than those directly addressed in EITF Issue
No. 00-14 and 00-25, that are
incurred by a vendor (typically a manufacturer or distributor) to or on behalf
of a customer (typically a retailer) in connection with the customers purchase
or promotion of the vendors products. Such costs include consideration given
to retailers for space in their stores (slotting fees), consideration given to
obtain favorable display positions in the retailers stores and other
promotional activity such as cooperative advertising. The Issue addresses the
recognition and measurement of such costs and whether a vendor should classify
such costs in its income statement when incurred as a reduction of revenues or
as an expense item. The consensus on EITF Issue No. 00-25 was effective for us
on February 1, 2002. The effect of the adoption of EITF Issue No. 00-25 did
not have a material impact on our consolidated statements of operations.

The
table below shows the effect of the EITF Issue No. 00-14 and
00-25 adjustment to
revenues and selling, general and administrative expense for the years
previously presented ended July 31,

|                                                                     |  |      |            |      |  |   |            | 
|-------------------------------------------------------------------- |  | ---- | ---------- | ---- |  | - | ---------- | 
|                                                                     |  | 2001 |            | 2000
|                                                                     |  |      |            |     
|Pre-adoption net revenues                                            |  | $    | 31,686,392 |      |  | $ | 37,763,763 | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Reclassifications from selling, general and
administrative expenses: |  |      |            |      |  |   |            | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Sales incentives                                                     |  |      | 933,596    |      |  |   | 1,051,572  | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Co-op advertising                                                    |  |      | 42,035     |      |  |   | 103,918    | 
|                                                                     |  |      |            |      |  |   |            | 
|Total Adjustments                                                    |  |      | 975,631    |      |  |   | 1,155,490  | 
|                                                                     |  |      |            |      |  |   |            | 
|Net Revenues Reported                                                |  | $    | 30,710,761 |      |  | $ | 36,608,273 | 
|                                                                     |  |      |            |      |  |   |            | 

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and
Other Intangible Assets (which will be effective for Zila on August 1, 2002).
SFAS No. 142 specifies that goodwill and certain intangibles with indefinite
lives will no longer be amortized but instead will be subject to periodic
impairment testing. Had SFAS No. 142 been adopted on August 1, 2001, the
impact of ceasing goodwill amortization (based on our current levels of
goodwill) would have decreased net loss in fiscal 2002 by $1.2 million, or
$0.03 per diluted share. Intangible assets with finite lives will continue to
be amortized over their respective useful lives. We will be required to
measure goodwill for impairment as of August 1, 2002 as part of the transition
provisions and our impairment analyses must be completed no later than January
31, 2003. In addition, the Company will be required to measure intangible
assets with indefinite useful lives for impairment as of August 1, 2002 with
any resulting impairment reported within the first interim periods financial
statements. Any impairment resulting from these transition tests will be
recorded and recognized as the cumulative effect of a change in accounting
principle. We are in the process of evaluating the impact of SFAS No. 142 on
our intangible assets and have not yet determined if a cumulative effect
adjustment will be required upon completion.

Effective August 1, 2001, we adopted SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes
existing guidance on asset impairment under SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.
Among other provisions, SFAS No. 144 changes the criteria for classifying an
asset as held-for-sale. The standard also broadens the scope of businesses to
be

36



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##### Table of Contents



disposed of that qualify for reporting as discontinued operations, and
changes the timing of recognizing losses on such operations. The
adoption of SFAS No. 144 did not have a significant impact on our
financial position or results of operation.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities,which replaces Emerging Issues
Task Force Issue No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring).The new standard requires companies to
recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
The statement is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. We do not expect that the adoption of SFAS
No. 146 will have a significant impact on our financial position or results of
operations.

Item 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We
are exposed to market risk primarily from interest rates and from
changes in foreign currency exchange rates.

We
have a revolving line of credit with a variable interest rate equal
to three-quarters of one (0.75%) percent per annum in excess of the
prime rate announced by First Union Bank (4.75% at July 31, 2002). At
July 31, 2002, no borrowings were outstanding under this line of
credit. The impact of a 10% proportional increase in average interest
rates would not be expected to have a material effect on the Company
since average outstanding balances on the line are not expected to be
significant. We also have long-term debt associated with the
Industrial Development Revenue Bonds that carry a variable interest
rate. The rates are set weekly by Bank One Capital Markets and
fluctuate based on market conditions and were 1.75% and 1.97% at July
31, 2002. A 10% proportional increase in the average interest rate on
the bonds would increase annual interest expense by less than $10,000.




Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Consolidated financial statements, together with the related notes and the
report of Deloitte & Touche LLP, independent certified public accountants, are
set forth hereafter. Other required financial information and schedules are set
forth herein, as more fully described in Item 15 hereof.




Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.




PART III

The information called for by this Part III is, in accordance with General
Instruction G (3) to Form 10-K, incorporated herein by reference to the
information contained in our definitive proxy statement for the annual meeting
of stockholders of Zila to be held on January 14, 2003, which will be filed
with the SEC not later than 120 days after July 31, 2002.




PART IV




Item 15.EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES, AND REPORTS ON FORM 8-K

Method of Filing



|    |                                                          |                                                                                                                                                                                                                                                                                                                              |               
|--- | -------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------
|(a) | Financial Statements                                    
|    | (1)                                                      | Report of Deloitte & Touche
LLP                                                                                                                                                                                                                                                                                              | Filed herewith
|    | (2)                                                      | Consolidated Financial Statements and Notes thereto of the
Company including
Consolidated Balance Sheets as of July 31, 2002
and 2001 and relatedConsolidated Statements of Operations,
Comprehensive Income (Loss), Shareholders Equity, and Cash Flows
for each of the years in the three-year period ended July 31,
2002 | Filed herewith
|    | (3)                                                      | Financial Statement Schedule
Schedule II Valuation and Qualifying Accounts                                                                                                                                                                                                                                                   | Filed herewith
|(b) | Reports on Form 8-K for the quarter ended July 31, 2002.

37



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##### Table of Contents



During the quarter ended July 31, 2002, we filed a Current Report on Form
8-K dated June 18, 2002 containing information pursuant to Item 2
(Acquisition or Disposition of Assets) announcing the restructure and
finalization of the sale of the Zila Dental Supply mail order operations
(assets and liabilities) to PracticeWares, Inc. of Sacramento, CA.

(c)  Exhibits.

|        |      |             |                                                                                                                                                                               |                                                                                                                                                                                                          |                                                                                                                                                           |   |   |   | 
|------- | ---- | ----------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------- | - | - | - | 
|Exhibit |      |             |                                                                                                                                                                               |                                                                                                                                                                                                          |                                                                                                                                                           |   |  
|Number  |      | Description |                                                                                                                                                                               | Method of Filing                                                                                                                                                                                        
|        |      |             |                                                                                                                                                                               |                                                                                                                                                                                                         
|        | 3-A  |             |                                                                                                                                                                               | Certificate of Incorporation, as amended                                                                                                                                                                 |                                                                                                                                                           |   | A |  
|       
|       
|       
|       
|        | 3-B  |             |                                                                                                                                                                               | Amended and Restated Bylaws (as amended through September 26, 2002) *                                                                                                                                    |                                                                                                                                                           |   |   |  
|       
|       
|       
|       
|        | 3-C  |             |                                                                                                                                                                               | Certificate of Designations, Preferences and Rights of Series A
Convertible Preferred Stock                                                                                                              |                                                                                                                                                           |   | C |  
|       
|       
|       
|       
|        | 3-D  |             |                                                                                                                                                                               | Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock                                                                                                              |                                                                                                                                                           |   | L |  
|       
|       
|       
|       
|        | 4-A  |             |                                                                                                                                                                               | Specimen Stock Certificate                                                                                                                                                                               |                                                                                                                                                           |   | A |  
|       
|       
|       
|       
|        | 10-A |             |                                                                                                                                                                               | Revolving Line of Credit Loan Agreement dated February 1, 1999 between
Zila, Inc. and Bank One, Arizona                                                                                                  |                                                                                                                                                           |   | A |  
|       
|       
|       
|       
|        | 10-B |             |                                                                                                                                                                               | Stock Option Award Plan (as amended through April 10, 1991)                                                                                                                                              |                                                                                                                                                           |   | B |  
|       
|       
|       
|       
|        | 10-C |             |                                                                                                                                                                               | Non-Employee Directors Stock Option Plan (as amended through April 10, 1991)                                                                                                                             |                                                                                                                                                           |   | B |  
|       
|       
|       
|       
|        | 10-L |             |                                                                                                                                                                               | Asset Purchase Agreement dated October 28, 1999 between Zila, Inc., Cygnus
Imaging, Inc. and Procare Laboratories, Inc                                                                                   |                                                                                                                                                           |   | A |  
|       
|       
|       
|       
|        | 10-M |             |                                                                                                                                                                               | Secured Note dated October 28, 1999 between Zila, Inc. and Procare
Laboratories, Inc                                                                                                                     |                                                                                                                                                           |   | A |  
|       
|       
|       
|       
|        | 10-N |             |                                                                                                                                                                               | Asset Purchase agreement dated as of November 30, 1999 by and among Zila, Inc.,
Integrated Dental Technologies, Inc., InfoCure Systems, Inc., and
InfoCure Corporation                                   |                                                                                                                                                           |   | E |  
|       
|       
|       
|       
|        | 10-O |             |                                                                                                                                                                               | Revolving Line of Credit Loan Agreement dated December 1, 2000 between Zila, Inc.
and Bank One, Arizona, NA                                                                                              |                                                                                                                                                           |   | H |  
|       
|       
|       
|       
|        | 10-P |             |                                                                                                                                                                               | First Loan Modification Agreement dated May 7, 2001 between Zila, Inc.
and Bank One Arizona, NA                                                                                                          |                                                                                                                                                           |   | H |  
|       
|       
|       
|       
|        | 10-Q |             |                                                                                                                                                                               | Engagement Letter dated March 15, 2001 between Zila, Inc. and
Douglas, Curtis and Allyn, LLC                                                                                                             |                                                                                                                                                           |   | H |  
|       
|       
|       
|       
|        | 10-R |             |                                                                                                                                                                               | Extension to First Loan Modification Agreement dated effective May 31, 2001
between Zila, Inc. and Bank One Arizona, NA                                                                                  |                                                                                                                                                           |   | H |  
|       
|       
|       
|       
|        | 10-S |             |                                                                                                                                                                               | Second Extension to First Loan Modification Agreement dated effective June 29, 2001
between Zila, Inc. and Bank One Arizona, NA                                                                          |                                                                                                                                                           |   | I |  
|       
|       
|       
|       
|        | 10-T |             |                                                                                                                                                                               | Third Extension to First Loan Modification Agreement dated effective July 31, 2001
between Zila, Inc. and Bank One Arizona, NA                                                                           |                                                                                                                                                           |   | J |  
|       
|       
|       
|       
|        | 10-U |             |                                                                                                                                                                               | 1997 Stock Option Award Plan (as amended through September 13, 2001)                                                                                                                                     |                                                                                                                                                           |   | G |  
|       
|       
|       
|       
|        | 10-V |             |                                                                                                                                                                               | Employee Stock Purchase Plan                                                                                                                                                                             |                                                                                                                                                           |   | F |  
|       
|       
|       
|       
|        | 10-W |             |                                                                                                                                                                               | Loan and Security Agreement dated August 17, 2001 by and between Congress Financial
Corporation and Zila, Inc., Zila Pharmaceuticals, Inc. Ryker Dental of Kentucky, Inc. and
Inter-Cal Corporation, Inc |                                                                                                                                                           |   | K |  
|       
|       
|       
|       
|        | 10-X |             |                                                                                                                                                                               | Asset Purchase Agreement, dated as of November 1, 2001, by and between Ryker Dental
of Kentucky, Inc. and Henry Schein, Inc                                                                              |                                                                                                                                                           |   | M |  
|       
|       
|       
|       
|        | 10-Y |             |                                                                                                                                                                               |                                                                                                                                                                                                          | Amended and Restated Asset Purchase Agreement dated as of December 4, 2001 by
and among Zila, Inc., Ryker Dental of Kentucky, Inc. and PracticeWares, Inc |   |   | M | 
|       
|       
|       
|       
|        | 10-Z |             |                                                                                                                                                                               |                                                                                                                                                                                                          | First Amendment to Engagement Letter dated as of June 6, 2002 between Zila, Inc.
and Douglas, Curtis & Allyn, LLC                                         |   |   | N | 
|       
|       
|       
|       
|10-Aa   |      |             | Fourth Extension and Modification Agreement dated as of June 6, 2002 between Ryker Dental
of Kentucky, Inc., PracticeWares, Inc. and PracticeWorks, Inc. and Gregory A. Jones |                                                                                                                                                                                                          |                                                                                                                                                           | N |  
|       
|       
|       
|       
|10-Ab   |      |             | First Amendment to Amended and Restated Asset Purchase Agreement dated as of
June 18, 2002 between Ryker Dental of Kentucky, Inc., PracticeWares, Inc. and Zila, Inc          |                                                                                                                                                                                                          |                                                                                                                                                           | N |  
|       
|       
|       
|       
|10-Ac   |      |             | Stockholders Agreement dated as of June 18, 2002, among PracticeWorks, Inc.,
Gregory A. Jones, Ryker Dental of Kentucky, Inc. and PracticeWares, Inc                          |                                                                                                                                                                                                          |                                                                                                                                                           | N |  

38



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##### Table of Contents



|        |      |             |  |                  |                                                                                            |  |  |   | 
|------- | ---- | ----------- |  | ---------------- | ------------------------------------------------------------------------------------------ |  |  | - | 
|Exhibit |      |             |  |                  |                                                                                            |  | 
|Number  |      | Description |  | Method of Filing
|        |      |             |  |                 
|       
|       
|       
|       
|        | 21   |             |  |                  | Subsidiaries of Registrant                                                                 |  |  | D | 
|       
|       
|       
|       
|        | 23   |             |  |                  | Consent of Deloitte & Touche LLP (regarding Form S-8 and Form S-3
Registration Statements) |  |  | * | 
|       
|       
|       
|       
|        | 24-A |             |  |                  | Power of Attorney of Bradley C. Anderson                                                   |  |  | * | 
|       
|       
|       
|       
|        | 24-B |             |  |                  | Power of Attorney of Douglas D. Burkett                                                    |  |  | * | 
|       
|       
|       
|       
|        | 24-C |             |  |                  | Power of Attorney of H. Richard Grisham                                                    |  |  | * | 
|       
|       
|       
|       
|        | 24-D |             |  |                  | Power of Attorney of Joseph Hines                                                          |  |  | * | 
|       
|       
|       
|       
|        | 24-E |             |  |                  | Power of Attorney of Christopher D. Johnson                                                |  |  | * | 
|       
|       
|       
|       
|        | 24-F |             |  |                  | Power of Attorney of Michael S. Lesser                                                     |  |  | * | 
|       
|       
|       
|       
|        | 24-G |             |  |                  | Power of Attorney of Curtis M. Rocca                                                       |  |  | * | 
|       
|       
|       
|       
|        | 24-H |             |  |                  | Power of Attorney of Carl A. Schroeder                                                     |  |  | * | 
|       
|       
|       
|       
|        | 24-I |             |  |                  | Power of Attorney of Kevin J. Tourek                                                       |  |  | * | 
|       
|       
|       
|       
|        | 99.1 |             |  |                  | Sarbanes-Oxley Section 906 Certification of the Chief Executive Officer                    |  |  | * | 
|       
|       
|       
|       
|        | 99.2 |             |  |                  | Sarbanes-Oxley Section 906 Certification of the Chief Financial Officer                    |  |  | * | 



---

|* |  | Filed herewith
|- |  | --------------

|  |  |                                                                                                                                     
|- |  | ------------------------------------------------------------------------------------------------------------------------------------
|A |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 1999                           
| 
| 
| 
| 
|B |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the
quarterly period ended January 31, 1996, as amended
| 
| 
| 
| 
|C |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 1997                           
| 
| 
| 
| 
|D |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 1998                           
| 
| 
| 
| 
|E |  | Incorporated by reference to the Companys Current Report on Form 8-K dated January 3, 2000                                         
| 
| 
| 
| 
|F |  | Incorporated by reference to the Companys Form S-8 Registration Statement No. 333-54958
dated February 5, 2001                     
| 
| 
| 
| 
|G |  | Incorporated by reference to the Companys Form S-8 Registration Statement No. 333-54960
dated February 5, 2001                     
| 
| 
| 
| 
|H |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the
quarterly period ended April 30, 2001              
| 
| 
| 
| 
|I |  | Incorporated by reference to the Companys Current Report on Form 8-K dated June 29, 2001                                           
| 
| 
| 
| 
|J |  | Incorporated by reference to the Companys Current Report on Form 8-K dated July 31, 2001                                           
| 
| 
| 
| 
|K |  | Incorporated by reference to the Companys Current Report on Form 8-K dated August 17, 2001                                         
| 
| 
| 
| 
|L |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 2001.                          
| 
| 
| 
| 
|M |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the
quarterly period ended October 31, 2001            
| 
| 
| 
| 
|N |  | Incorporated by reference to the Companys Current Report on Form 8-K dated June 18, 2002                                           
| 
| 
| 
| 
|* |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 2002 located on signature page 

39



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##### Table of Contents






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
13th day of November 2002.

| |  |                                                                                                                                                                               
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  | 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:

|                                                      |  |                                                           |  |                  
|----------------------------------------------------- |  | --------------------------------------------------------- |  | -----------------
|Signature                                             |  | Title                                                     |  | Date             
|                                                      |  |                                                           |  |                  
|                                                      |  |                                                           |  |                  
|                                                      |  |                                                           | 
|/s/ DOUGLAS D. BURKETT, Ph.D.Douglas D. Burkett Ph.D. |  | Chairman of the Board,
President, Chief Executive
Officer |  | November 13, 2002
|                                                     
|*H. Richard Grisham                                   |  | Director                                                  |  | November 13, 2002
|                                                     
|*Joseph Hines                                         |  | Director                                                  |  | November 13, 2002
|                                                     
|*Christopher D. Johnson                               |  | Director                                                  |  | November 13, 2002
|                                                     
|*Michael S. Lesser                                    |  | Director                                                  |  | November 13, 2002
|                                                     
|*Curtis M. Rocca III                                  |  | Director                                                  |  | November 13, 2002
|                                                     
|*Carl A. Schroeder                                    |  | Director                                                  |  | November 13, 2002
|                                                     
|*Kevin J. Tourek                                      |  | Director                                                  |  | November 13, 2002
|                                                     
|* By /s/ Bradley C. AndersonBradley C. Anderson       |  |                                                           |  | November 13, 2002
|Attorney-in Fact                                      |  |                                                           |  |                  

40



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##### Table of Contents






CERTIFICATIONS

I, Douglas D. Burkett, certify that:

1.     I have reviewed this annual report on Form 10-K of Zila,
Incorporated;

2.     Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report; and

3.     Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in
all material respects the financial condition, results of operations
and cash flows of the registrant as of, and for, the periods presented
in this annual report.

|                                                                                |  | 
|------------------------------------------------------------------------------- |  | 
|Date: November 12, 2002                                                         |  | 
|                                                                               
|                                                                               
|                                                                               
|                                                                               
|                                                                                |  | 
|                                                                               
|                                                                               
|                                                                               
|                                                                               
|/s/ Douglas D. Burkett Ph. D.
Douglas D. Burkett Ph. D.
Chief Executive Officer |  | 
|                                                                               
|                                                                               
|                                                                               
|                                                                               
|                                                                                |  | 

I, Bradley C. Anderson, certify that:

1.     I have reviewed this annual report on Form 10-K of Zila,
Incorporated;

2.     Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report; and

3.     Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in
all material respects the financial condition, results of operations
and cash flows of the registrant as of, and for, the periods presented
in this annual report.

|                                                                    |  | 
|------------------------------------------------------------------- |  | 
|Date: November 12, 2002                                             |  | 
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|                                                                    |  | 
|                                                                   
|                                                                   
|                                                                   
|                                                                   
|/s/ Bradley C. Anderson
Bradley C. Anderson
Chief Financial Officer |  | 

41



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##### Table of Contents



INDEPENDENT AUDITORS REPORT

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

We have audited the accompanying consolidated balance sheets of Zila, Inc. and
subsidiaries as of July 31, 2002 and 2001, and the related consolidated
statements of operations, comprehensive income (loss), shareholders equity,
and cash flows for each of the three years in the period ended July 31, 2002.
Our audits also included the financial statement schedule listed in the Index
at Item 15(a)(3). These financial statements and financial statement schedule
are the responsibility of the Corporations management. Our responsibility is
to express an opinion on these financial statements and financial statement
schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. 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, such consolidated financial statements present fairly, in all
material respects, the financial position of Zila, Inc. and subsidiaries as of
July 31, 2002 and 2001, and the results of their operations and their cash
flows for each of the three years in the period ended July 31, 2002 in
conformity with accounting principles generally accepted in the United States
of America. Also, in our opinion, such financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as
a whole, presents fairly in all material respects the information set forth
therein.

As discussed in Note 19 of Notes to Consolidated Financial Statements, the
accompanying consolidated balance sheet as of July 31, 2001, and the related
consolidated statements of operations, comprehensive income (loss),
shareholders equity, and cash flows for the years ended July 31, 2001 and
2000, have been restated.

DELOITTE & TOUCHE LLP
Phoenix, Arizona
November 12, 2002

F-1



---



##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JULY 31, 2002 AND 2001

|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |             |            |              |            | 
|--------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------- | ----------------- | ---------- | ---------- | ---------- | ----------- | ---------- | ------------ | ---------- | 
|ASSETS                                        |                                                                                                                                              | 2002                       |                           | 2001             
|                                              |                                                                                                                                              |                            |                           |                  
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |             |            | (As Restated
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |             |            | See Note 19)
|CURRENT ASSETS:                               |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                             
|                                             
|                                             
|                                             
|                                              | Cash and cash equivalents                                                                                                                    |                            | $                         | 1,604,205         |            |            | $          | 1,263,935   |           
|                                             
|                                             
|                                             
|                                             
|                                              | Trade receivables, less allowance for doubtful accounts
of $132,619 (2002) and $268,571 (2001)                                               |                            |                           | 5,694,856         |            |            |            | 6,663,319   |           
|                                             
|                                             
|                                             
|                                             
|                                              | Inventories  net                                                                                                                            |                            |                           | 8,868,539         |            |            |            | 11,101,897  |           
|                                             
|                                             
|                                             
|                                             
|                                              | Current assets of discontinued operations                                                                                                    |                            |                           |                   |            |            |            | 11,108,838  |           
|                                             
|                                             
|                                             
|                                             
|                                              | Prepaid expenses and other current assets                                                                                                    |                            |                           | 2,085,137         |            |            |            | 1,823,212   |           
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                              |                                                                                                                                              |                            | Total current assets      |                   |            | 18,252,737 |            |             |            | 31,961,201   |           
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|PROPERTY AND EQUIPMENT  net                  |                                                                                                                                              |                            | 8,848,299                 |                   |            |            | 9,456,337  |            
|                                             
|                                             
|                                             
|                                             
|PURCHASED TECHNOLOGY RIGHTS  net             |                                                                                                                                              |                            | 4,467,579                 |                   |            |            | 4,946,261  |            
|                                             
|                                             
|                                             
|                                             
|GOODWILL  net                                |                                                                                                                                              |                            | 11,174,379                |                   |            |            | 12,383,291 |            
|                                             
|                                             
|                                             
|                                             
|TRADEMARKS AND OTHER INTANGIBLE ASSETS  net  |                                                                                                                                              |                            | 14,196,658                |                   |            |            | 11,684,830 |            
|                                             
|                                             
|                                             
|                                             
|NON-CURRENT ASSETS OF DISCONTINUED OPERATIONS |                                                                                                                                              |                            |                           |                   |            |            | 923,879    |            
|                                             
|                                             
|                                             
|                                             
|OTHER ASSETS                                  |                                                                                                                                              |                            | 421,001                   |                   |            |            | 4,246,715  |            
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|TOTAL                                         |                                                                                                                                              | $                          | 57,360,653                |                   |            | $          | 75,602,514 |            
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|LIABILITIES AND SHAREHOLDERS EQUITY          |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                             
|                                             
|                                             
|                                             
|CURRENT LIABILITIES:                          |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                             
|                                             
|                                             
|                                             
|                                              | Accounts payable                                                                                                                             |                            | $                         | 3,249,649         |            |            | $          | 2,809,203   |           
|                                             
|                                             
|                                             
|                                             
|                                              | Accrued liabilities                                                                                                                          |                            |                           | 3,588,627         |            |            |            | 2,437,107   |           
|                                             
|                                             
|                                             
|                                             
|                                              | Short-term borrowings                                                                                                                        |                            |                           | 99,784            |            |            |            | 6,160,947   |           
|                                             
|                                             
|                                             
|                                             
|                                              | Current liabilities of discontinued operations                                                                                               |                            |                           |                   |            |            |            | 3,648,138   |           
|                                             
|                                             
|                                             
|                                             
|                                              | Current portion of long-term debt                                                                                                            |                            |                           | 489,161           |            |            |            | 747,648     |           
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                              |                                                                                                                                              |                            | Total current liabilities |                   |            | 7,427,221  |            |             |            | 15,803,043   |           
|                                             
|                                             
|                                             
|                                             
|LONG-TERM DEBT OF DISCONTINUED OPERATIONS     |                                                                                                                                              |                            |                           |                   |            |            | 73,775     |            
|                                             
|                                             
|                                             
|                                             
|LONG-TERM DEBT  net of current portion       |                                                                                                                                              |                            | 3,610,483                 |                   |            |            | 4,079,496  |            
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                              |                                                                                                                                              |                            |                           | Total liabilities |            |            | 11,037,704 |             |            |              | 19,956,314 | 
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|COMMITMENTS AND CONTINGENCIES (Note 13)       |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                             
|                                             
|                                             
|                                             
|SHAREHOLDERS EQUITY:                         |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                             
|                                             
|                                             
|                                             
|                                              | Preferred stock  Series B, $.001 par value  authorized 2,500,000 shares,
issued 100,000 shares                                             |                            |                           | 462,500           |            |            |            | 462,500     |           
|                                             
|                                             
|                                             
|                                             
|                                              | Common stock, $.001 par value  authorized 65,000,000 shares, issued
45,666,160 shares (July 31, 2002) and 43,653,727 shares (July 31, 2001) |                            |                           | 45,666            |            |            |            | 43,654      |           
|                                             
|                                             
|                                             
|                                             
|                                              | Capital in excess of par value                                                                                                               |                            |                           | 82,899,967        |            |            |            | 79,930,094  |           
|                                             
|                                             
|                                             
|                                             
|                                              | Accumulated other comprehensive income (loss)                                                                                                |                            |                           | (75,376           | )          |            |            | 150,976     |           
|                                             
|                                             
|                                             
|                                             
|                                              | Accumulated deficit                                                                                                                          |                            |                           | (36,474,688       | )          |            |            | (24,405,904 | )         
|                                             
|                                             
|                                             
|                                             
|                                              | Common stock in treasury, at cost 195,000 shares                                                                                             |                            |                           | (535,120          | )          |            |            | (535,120    | )         
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|                                              |                                                                                                                                              | Total shareholders equity |                           |                   | 46,322,949 |            |            |             | 55,646,200 |             
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            
|TOTAL                                         |                                                                                                                                              | $                          | 57,360,653                |                   |            | $          | 75,602,514 |            
|                                              |                                                                                                                                              |                            |                           |                   |            |            |            |            

See notes to consolidated financial statements.

F-2



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED JULY 31, 2002, 2001 and 2000

|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |              |         |            |      | 
|------------------------------------------------------------ | ----------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----------------- | -------- | ---------- | ---------- | ---------- | -------- | ------------ | ---------- | ------------ | ------- | ---------- | ---- | 
|                                                             |                                     |                                                                                                                                         |                                            |                   |          | 2002       |            | 2001       |          | 2000        
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          | (As Restated |            | (As Restated
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          | See Note 19) |            | See Note 19)
|NET REVENUES                                                 |                                     | $                                                                                                                                       | 34,871,770                                 |                   |          | $          | 30,710,761 |            |          | $            | 36,608,273 |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|OPERATING COSTS AND EXPENSES:                                |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Cost of products sold               |                                                                                                                                         |                                            | 12,464,081        |          |            |            | 10,273,533 |          |              |            | 10,458,397   |        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Selling, general and administrative |                                                                                                                                         |                                            | 21,843,400        |          |            |            | 19,989,598 |          |              |            | 21,025,613   |        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Research and development            |                                                                                                                                         |                                            | 3,955,790         |          |            |            | 3,036,896  |          |              |            | 1,629,609    |        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Impairment of assets                |                                                                                                                                         |                                            | 224,347           |          |            |            | 310,000    |          |              |            |             |        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Depreciation and amortization       |                                                                                                                                         |                                            | 3,468,041         |          |            |            | 3,174,566  |          |              |            | 3,094,790    |        
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                             |                                     |                                                                                                                                         | 41,955,659                                 |                   |          |            | 36,784,593 |            |          |              | 36,208,409 |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|INCOME (LOSS) FROM OPERATIONS                                |                                     |                                                                                                                                         | (7,083,889                                 | )                 |          |            | (6,073,832 | )          |          |              | 399,864    |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|OTHER INCOME (EXPENSE):                                      |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Interest income                     |                                                                                                                                         |                                            | 68,959            |          |            |            | 181,669    |          |              |            | 325,985      |        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Interest expense                    |                                                                                                                                         |                                            | (486,939          | )        |            |            | (596,870   | )        |              |            | (218,234     | )      
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Other income (expense)              |                                                                                                                                         |                                            | 117,908           |          |            |            | (159,051   | )        |              |            | (96,929      | )      
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Gain on sale of assets              |                                                                                                                                         |                                            |                  |          |            |            |           |          |              |            | 4,677,860    |        
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                             |                                     |                                                                                                                                         | (300,072                                   | )                 |          |            | (574,252   | )          |          |              | 4,688,682  |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|INCOME (LOSS) FROM CONTINUING
OPERATIONS BEFORE INCOME TAXES |                                     |                                                                                                                                         | (7,383,961                                 | )                 |          |            | (6,648,084 | )          |          |              | 5,088,546  |             
|                                                            
|                                                            
|                                                            
|                                                            
|INCOME TAX (EXPENSE) BENEFIT                                 |                                     |                                                                                                                                         | (3,954,319                                 | )                 |          |            | 378,786    |            |          |              | (1,911,348 | )           
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|INCOME (LOSS) FROM CONTINUING OPERATIONS                     |                                     |                                                                                                                                         | (11,338,280                                | )                 |          |            | (6,269,298 | )          |          |              | 3,177,198  |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|DISCONTINUED OPERATIONS:                                     |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                     | Income (loss) from operations of discontinued Dental
Supply segment, net of income taxes of $0 (2002)
$7,326 (2001) and $122,904 (2000) |                                            |                   | (815,460 | )          |            |            | (121,194 | )            |            |              | 166,702 |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                     | Net gain from disposal of Dental Supply segment                                                                                         |                                            |                   | 143,456  |            |            |            |          |              |            |              |         |           
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|Total gain (loss) from discontinued operations               |                                     |                                                                                                                                         | (672,004                                   | )                 |          |            | (121,194   | )          |          |              | 166,702    |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|NET INCOME (LOSS)                                            |                                     |                                                                                                                                         | (12,010,284                                | )                 |          |            | (6,390,492 | )          |          |              | 3,343,900  |             
|                                                            
|                                                            
|                                                            
|                                                            
|Preferred stock dividends                                    |                                     |                                                                                                                                         | 58,500                                     |                   |          |            |            |            |          |              |            |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|Net income (loss) attributable to common shareholders        |                                     | $                                                                                                                                       | (12,068,784                                | )                 |          | $          | (6,390,492 | )          |          | $            | 3,343,900  |             
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|BASIC
AND DILUTED NET INCOME (LOSS) PER COMMON SHARE:        |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                     |                                                                                                                                         | Income (loss) from continuing operations   |                   | $        | (0.25      | )          |            | $        | (0.15        | )          |              | $       | 0.08       |     
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                     |                                                                                                                                         | Income (loss) from discontinued operations |                   |          | (0.02      | )          |            |          |             |            |              |         |           |     
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                             |                                     |                                                                                                                                         |                                            | NET INCOME (LOSS) |          | $          | (0.27      | )          |          | $            | (0.15      | )            |         | $          | 0.08 | 
|                                                             |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING:               |                                     |                                                                                                                                         |                                            |                   |          |            |            |            |          |              |            |             
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                     |                                                                                                                                         | BASIC                                      |                   |          | 44,592,932 |            |            |          | 43,412,786   |            |              |         | 42,180,236 |     
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                     |                                                                                                                                         | DILUTED                                    |                   |          | 44,592,932 |            |            |          | 43,412,786   |            |              |         | 43,576,180 |     

See notes to consolidated financial statements.

F-3



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
YEARS ENDED July 31, 2002, 2001 and 2000

|                                               |                                                                   |   |             |          |      |   |              |        |              |   |           |        |  
|---------------------------------------------- | ----------------------------------------------------------------- | - | ----------- | -------- | ---- | - | ------------ | ------ | ------------ | - | --------- | ------ | -
|                                               |                                                                   |   | 2002        |          | 2001 |   | 2000        
|                                               |                                                                   |   |             |          |      |   |             
|                                               |                                                                   |   |             |          |      |   | (As Restated |        | (As Restated
|                                               |                                                                   |   |             |          |      |   | See Note 19) |        | See Note 19)
|Net income (loss)                              |                                                                   | $ | (12,010,284 | )        |      | $ | (6,390,492   | )      |              | $ | 3,343,900 |       
|                                              
|                                              
|                                              
|                                              
|Other comprehensive income (loss), net of tax: |                                                                   |   |             |          |      |   |              |        |              |   |           |       
|                                              
|                                              
|                                              
|                                              
|                                               | Foreign currency translation adjustment                           |   |             | (226,352 | )    |   |              | 75,810 |              |   |           | 75,166 |  
|                                              
|                                              
|                                              
|                                              
|                                               | Unrealized holding losses on securities arising during
the period |   |             |          |      |   |              |        |              |   |           | (3,500 | )
|                                              
|                                              
|                                              
|                                              
|                                               | Reclassification of holding losses included in net loss           |   |             |          |      |   |              | 3,500  |              |   |           |        |  
|                                               |                                                                   |   |             |          |      |   |              |        |              |   |           |       
|Other comprehensive income (loss)              |                                                                   |   | (226,352    | )        |      |   | 79,310       |        |              |   | 71,666    |       
|                                               |                                                                   |   |             |          |      |   |              |        |              |   |           |       
|                                              
|                                              
|                                              
|                                              
|Comprehensive income (loss)                    |                                                                   | $ | (12,236,636 | )        |      | $ | (6,311,182   | )      |              | $ | 3,415,566 |       
|                                               |                                                                   |   |             |          |      |   |              |        |              |   |           |       

|                         |                            |   |                         |          |               |   |                    |       |  |   |         |          |  
|------------------------ | -------------------------- | - | ----------------------- | -------- | ------------- | - | ------------------ | ----- |  | - | ------- | -------- | -
|                         |                            |   |                         |          |               |   | Unrealized Holding |       |  |   |        
|                         |                            |   | Foreign Currency        |          | (Loss) Gains  |   | Accumulated Other 
|                         |                            |   | Translation Adjustments |          | on Securities |   | Comprehensive     
|                         |                            |   |                         |          |               |   |                   
|Balance at July 31, 2000 |                            | $ | 75,166                  |          |               | $ | (3,500             | )     |  |   | 71,666  |         
|                        
|                        
|                        
|                        
|                         | Other comprehensive income |   |                         | 75,810   |               |   |                    | 3,500 |  |   |         | 79,310   |  
|                         |                            |   |                         |          |               |   |                    |       |  |   |         |         
|Balance at July 31, 2001 |                            |   | 150,976                 |          |               |   |                   |       |  |   | 150,976 |         
|                         |                            |   |                         |          |               |   |                    |       |  |   |         |         
|                         | Other comprehensive loss   |   |                         | (226,352 | )             |   |                    |       |  |   |         | (226,352 | )
|                         |                            |   |                         |          |               |   |                    |       |  |   |         |         
|Balance at July 31, 2002 |                            | $ | (75,376                 | )        |               |   |                   |       |  | $ | (75,376 | )       
|                         |                            |   |                         |          |               |   |                    |       |  |   |         |         

F-4



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
YEARS ENDED JULY 31, 2002, 2001 and 2000

|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |             |  
|------------------------------------------------- | ---------------------------------------------------- |  | --------------- | ------- | ------------ | - | ---------- | ---------- | ----- |  | -------------------- | --------- | ----------- | - | -------- | ----- | ------------- | - | ------------- | --------- |  | - | ------------ | ----------- | - | - | -------- | -------- | - | - | ----------- | -------- | - | - | ---------- | ----------- | -
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  | Shareholders' Equity
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                     
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   | Accumulated |          |   |   |           
|                                                  |                                                      |  | Preferred Stock |         | Common Stock |   | Capital in |            |       |  |                      |           |             |   |          |       | Other         |   | Total        
|                                                  |                                                      |  |                 |         |              |   |            |            | Par   |  | Excess of            |           | Accumulated |   | Treasury |       | Comprehensive |   | Shareholders'
|                                                  |                                                      |  | Shares          |         | Amount       |   | Shares     |            | Value |  | Par Value            |           | Deficit     |   | Stock    |       | Income (Loss) |   | Equity       
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |              
|BALANCE, AUGUST 1, 1999, as previously reported   |                                                      |  | 7,482           |         |              | $ | 8,787,191  |            |       |  | 40,378,588           |           |             | $ | 40,379   |       |               | $ | 69,395,551    |           |  |   | ($19,949,703 | )           |   |   |         |          |   |   |            |          |   | $ | 49,486,227 |            
|                                                 
|                                                 
|                                                 
|                                                 
|Prior
period (adjustment see Note 19)             |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   | (1,409,609   | )           |   |   |          |          |   |   |             |          |   |   | (1,409,609 | )          
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |            
|BALANCE,
AUGUST 1, 1999, (as restated)            |                                                      |  | 7,482           |         |              |   | 8,787,191  |            |       |  | 40,378,588           |           |             |   | 40,379   |       |               |   | 69,395,551    |           |  |   | (21,359,312  | )           |   |   |          |          |   |   |             |          |   |   | 48,076,618 |            
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Conversion of preferred stock into common stock      |  |                 | (7,482  | )            |   |            | (8,787,191 | )     |  |                      | 2,904,472 |             |   |          | 2,904 |               |   |               | 8,784,287 |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 8,787,191   |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Warrants issued for services provided                |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               | 30,000    |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 30,000      |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Purchase of common stock for treasury                |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   | $        | (409,750 | ) |   |             |          |   |   |            | (409,750    | )
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Exercise of common stock warrants                    |  |                 |         |              |   |            |            |       |  |                      | 49,074    |             |   |          | 49    |               |   |               | 76,280    |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 76,329      |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Exercise of common stock options                     |  |                 |         |              |   |            |            |       |  |                      | 30,524    |             |   |          | 31    |               |   |               | 148,117   |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 148,148     |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Income tax benefit  stock options                   |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               | 990,000   |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 990,000     |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Foreign currency translation                         |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   | $           | 75,166   |   |   |            | 75,166      |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Net unrealized loss on available-for-sale securities |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             | (3,500   | ) |   |            | (3,500      | )
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Net
income, as (restated see Note 19)                |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              | 3,343,900   |   |   |          |          |   |   |             |          |   |   |            | 3,343,900   |  
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |            
|BALANCE,
JULY 31, 2000, as (restated see Note 19) |                                                      |  |                |         |              |   |           |            |       |  | 43,362,658           |           |             |   | 43,363   |       |               |   | 79,424,235    |           |  |   | (18,015,412  | )           |   |   | (409,750 | )        |   |   | 71,666      |          |   |   | 61,114,102 |            
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Warrants issued for services provided                |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               | 30,000    |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 30,000      |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Purchase of common stock for treasury                |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          | (125,370 | ) |   |             |          |   |   |            | (125,370    | )
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Exercise of common stock warrants                    |  |                 |         |              |   |            |            |       |  |                      | 149,870   |             |   |          | 150   |               |   |               | 449,460   |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 449,610     |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Exercise of common stock options                     |  |                 |         |              |   |            |            |       |  |                      | 128,622   |             |   |          | 129   |               |   |               | 2,871     |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 3,000       |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Issuance of common stock                             |  |                 |         |              |   |            |            |       |  |                      | 12,577    |             |   |          | 12    |               |   |               | 23,528    |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 23,540      |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Issuance of preferred stock                          |  |                 | 100,000 |              |   |            | 462,500    |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 462,500     |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Foreign currency translation                         |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             | 75,810   |   |   |            | 75,810      |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Net unrealized gain on available-for-sale securities |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             | 3,500    |   |   |            | 3,500       |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Net
loss, as (restated see Note 19)                  |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              | (6,390,492  | ) |   |          |          |   |   |             |          |   |   |            | (6,390,492  | )
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |            
|BALANCE, JULY 31, 2001, (as restated see Note 19) |                                                      |  | 100,000         |         |              | $ | 462,500    |            |       |  | 43,653,727           |           |             | $ | 43,654   |       |               | $ | 79,930,094    |           |  | $ | (24,405,904  | )           |   | $ | (535,120 | )        |   | $ | 150,976     |          |   | $ | 55,646,200 |            
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |            
|                                                  | Dividends on preferred stock                         |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              | (58,500     | ) |   |          |          |   |   |             |          |   |   |            | (58,500     | )
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Issuance of common stock                             |  |                 |         |              |   |            |            |       |  |                      | 2,012,433 |             |   |          | 2,012 |               |   |               | 2,969,873 |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            | 2,971,885   |  
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Foreign currency translation                         |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             | (226,352 | ) |   |            | (226,352    | )
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Net loss                                             |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              | (12,010,284 | ) |   |          |          |   |   |             |          |   |   |            | (12,010,284 | )
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |            
|BALANCE, JULY 31, 2002                            |                                                      |  | 100,000         |         |              | $ | 462,500    |            |       |  | 45,666,160           |           |             | $ | 45,666   |       |               | $ | 82,899,967    |           |  | $ | (36,474,688  | )           |   | $ | (535,120 | )        |   | $ | (75,376     | )        |   | $ | 46,322,949 |            
|                                                  |                                                      |  |                 |         |              |   |            |            |       |  |                      |           |             |   |          |       |               |   |               |           |  |   |              |             |   |   |          |          |   |   |             |          |   |   |            |            

See notes to consolidated financial statements.

F-5



---



##### Table of Contents



ZILA, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JULY 31, 2002, 2001, 2000

|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |            |            |            |  
|------------------------------------------------------------------------ | -------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------- | --------------------------------------------------- | ----------- | --------- | ---------- | ---------- | ---------- | ------------ | ---------- | ------------ | ---------- | ---------- | ---------- | -
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             | 2002      |            | 2001       |            | 2000        
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |             
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            | (As Restated |            | (As Restated
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            | See Note 19) |            | See Note 19)
|OPERATING ACTIVITIES:                                                    |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net income (loss)                                                                                  |                                                                                                    | $                                                   | (12,010,284 | )         |            | $          | (6,390,492 | )            |            | $            | 3,343,900  |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities: |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |            |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Depreciation and amortization                                                                      |                                                     |             | 3,468,041 |            |            |            | 3,174,566    |            |              |            | 3,094,790  |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Gain on sale of assets                                                                             |                                                     |             |           |            |            |            | (17,116      | )          |              |            | (4,677,860 | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Loss (gain) from discontinued operations                                                           |                                                     |             | 672,004   |            |            |            | 121,194      |            |              |            | (166,702   | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Impairment of assets                                                                               |                                                     |             | 224,347   |            |            |            | 310,000      |            |              |            |            |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Warrants issued for services                                                                       |                                                     |             |           |            |            |            | 30,000       |            |              |            | 30,000     |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Deferred income taxes and other                                                                    |                                                     |             | 4,303,550 |            |            |            | (253,851     | )          |              |            | 1,605,027  |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Change in assets and liabilities:                                                                  |                                                     |             |           |            |            |            |             |            |              |            |            |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    |                                                                                                    | Receivables-net                                     |             |           | 968,464    |            |            |              | (229,144   | )            |            |            | (1,185,529 | )
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    |                                                                                                    | Inventories                                         |             |           | 2,233,358  |            |            |              | (4,243,438 | )            |            |            | (1,681,897 | )
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    |                                                                                                    | Prepaid expenses and other assets                   |             |           | (261,925   | )          |            |              | 153,370    |              |            |            | (1,225,650 | )
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    |                                                                                                    | Accounts payable and accrued liabilities            |             |           | 1,562,465  |            |            |              | (1,276,370 | )            |            |            | 2,072,814  |  
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                         |                                                                                                    |                                                                                                    | Net cash provided by (used in) operating activities |             |           | 1,160,020  |            |            |              | (8,621,281 | )            |            |            | 1,208,893  |  
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|INVESTING ACTIVITIES:                                                    |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Purchases of property and equipment                                                                |                                                                                                    |                                                     | (619,168    | )         |            |            | (2,323,601 | )            |            |              | (4,960,944 | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net proceeds from sale of assets                                                                   |                                                                                                    |                                                     |             |           |            |            | 1,030,662  |              |            |              | 7,749,927  |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Retained
liabilities of discontinued operations                                                    |                                                                                                    |                                                     | (2,080,325  | )         |            |            | (231,846   | )            |            |              | (657,787   | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net cash paid for acquisition                                                                      |                                                                                                    |                                                     |             |           |            |            | (1,849,418 | )            |            |              |            |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net proceeds from disposition of discontinued operations                                           |                                                                                                    |                                                     | 9,719,125   |           |            |            |            |              |            |              |            |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Purchases of intangible assets                                                                     |                                                                                                    |                                                     | (1,047,082  | )         |            |            | (833,843   | )            |            |              | (159,210   | )         
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                         |                                                                                                    |                                                                                                    | Net cash provided by (used in) investing activities |             |           | 5,972,550  |            |            |              | (4,208,046 | )            |            |            | 1,971,986  |  
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|FINANCING ACTIVITIES:                                                    |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net (repayments) proceeds from short-term borrowings                                               |                                                                                                    |                                                     | (6,061,163  | )         |            |            | 6,109,177  |              |            |              | (65,180    | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net proceeds from issuance of common stock                                                         |                                                                                                    |                                                     | 25,363      |           |            |            | 476,150    |              |            |              | 224,477    |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Aquisition of treasury stock                                                                       |                                                                                                    |                                                     |             |           |            |            | (125,370   | )            |            |              | (409,750   | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Dividends paid to preferred stockholders                                                           |                                                                                                    |                                                     | (29,000     | )         |            |            |            |              |            |              |            |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Cash released by trustee                                                                           |                                                                                                    |                                                     |             |           |            |            | 2,928,001  |              |            |              | 1,906,754  |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Principal payments on long-term debt                                                               |                                                                                                    |                                                     | (727,500    | )         |            |            | (486,947   | )            |            |              | (5,409,676 | )         
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                         |                                                                                                    |                                                                                                    | Net
cash provided by (used in) financing activities |             |           | (6,792,300 | )          |            |              | 8,901,011  |              |            |            | (3,753,375 | )
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                     |                                                                                                    |                                                                                                    | 340,270                                             |             |           |            | (3,928,316 | )          |              |            | (572,496     | )         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|CASH
AND CASH EQUIVALENTS, BEGINNING OF YEAR                             |                                                                                                    |                                                                                                    | 1,263,935                                           |             |           |            | 5,192,251  |            |              |            | 5,764,747    |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|CASH
AND CASH EQUIVALENTS, END OF YEAR                                   |                                                                                                    | $                                                                                                  | 1,604,205                                           |             |           | $          | 1,263,935  |            |              | $          | 5,192,251    |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|CASH PAID FOR INTEREST                                                   |                                                                                                    | $                                                                                                  | 415,832                                             |             |           | $          | 498,556    |            |              | $          | 169,573      |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|CASH PAID FOR INCOME TAXES                                               |                                                                                                    | $                                                                                                  | 17,051                                              |             |           | $          | 94,521     |            |              | $          | 128,074      |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND
FINANCING ACTIVITIES: |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                                                    | Issuance of common stock related to Vizilite in exchange
for license and research and development |                                                     | $           | 2,946,522 |            |            |            |              |            |              |            |            |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                         |                                                                                                    | Issuance of Series B Convertible Preferred Stock for acquisition                                   |                                                     |             |           |            |            | $          | 462,500      |            |              |            |            |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           
|                                                                         |                                                                                                    | Conversion of Series A Convertible Redeemable Preferred stock
to common stock                      |                                                     |             |           |            |            |            |              |            |              | $          | 8,787,191  |           
|                                                                         |                                                                                                    |                                                                                                    |                                                     |             |           |            |            |            |              |            |              |           

See notes to consolidated financial statements.

F-6



---



##### Table of Contents



ZILA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended July 31, 2002, 2001 and 2000



|1. |  | Nature of Business Activities and Summary of Significant Accounting Policies
|-- |  | ----------------------------------------------------------------------------

Nature of Business Activities Zila, Inc. and subsidiaries (Zila or the
Company), a Delaware corporation, is a manufacturer and marketer of
pharmaceutical, nutritional and biotechnology products. In fiscal year 2002,
the Companys business was organized into the following Groups: Consumer
Pharmaceuticals, Professional Pharmaceuticals and Zila Nutraceuticals. The
Consumer Pharmaceuticals Group consists of over-the-counter products, including
the Zilactin® family of products. The Professional Pharmaceuticals Group
includes Peridex® prescription mouth rinse and OraTest®, an oral cancer
diagnostic system, the ViziLite disposable light for illumination of oral
mucosal abnormalities and the plastic molded products from Innovative Swab
Technologies (IST). Zila Nutraceuticals Group is presently comprised of
Oxycal Laboratories, Inc. (Oxycal) and its Inter-Cal subsidiary, a
manufacturer and distributor of mineral and botanical products including a
patented and unique form of Vitamin C under the trademark Ester-C® and the
Palmettx botanical line of products.

The accompanying consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
of America.

Significant accounting policies are as follows:

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), Zila Technologies, Inc, Zila Swab
Technologies, Inc. and Oxycal Laboratories, Inc. Zila International Inc. has no
operations. All significant intercompany balances and transactions are
eliminated in consolidation.

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.
Significant estimates include the following:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Nutraceuticals Group entered the saw palmetto business with its
Palmettx line of products in fiscal year 2000. In order to take advantage
of bulk purchase discounts and to establish a reputation as a reliable
supplier, the Company purchased a large amount of inventory in fiscal year
2001 and additional inventory in 2002. As of July 31, 2002, approximately
$3.8 million of saw palmetto products remain in inventory, representing an
approximately 1.6 years supply based on fiscal year 2002 sales. Recent
sales of saw palmetto products have generated a nominal profit margin and
allowances have been recorded where appropriate to reduce the carrying value
of the inventory to its estimated market value. However, the ultimate
probable future economic benefit associated with the saw palmetto inventory
is contingent on the Companys ability to maintain the quality of the
inventory and to sell its line of saw palmetto products for a price greater
than the carrying value of the inventory.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The cash flows used to measure long-lived assets related to the
OraTest® product are dependent upon obtaining Food and Drug Administration
(the FDA) approval and generating sufficient revenues from sales of the
OraTest® product. The rigorous clinical testing and an extensive regulatory
approval process mandated by the FDA and equivalent foreign authorities
before any new drug can be marketed by the Company can take a number of
years and require the expenditure of substantial resources. The Company
anticipates that it will require significant additional financing to support
these activities. 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. Net long-lived assets related to the OraTest® product
as of July 31, 2002 of $6.1 million have been capitalized.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys policy is to review the carrying amounts of goodwill and
other long-lived assets whenever events or changes in circumstances indicate that
the carrying amount of an asset may not be recoverable. Such events or
circumstances might include a significant decline in market share, a
significant decline in profits, rapid changes in technology, significant
litigation or other items. In evaluating the recoverability of goodwill and
other intangible assets, managements policy is to compare the carrying
amounts of such assets with the estimated undiscounted future operating cash
flows. In the event impairment

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| |                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | exists, an impairment charge would be
determined by comparing the carrying amounts of the asset to the applicable
estimated future cash flows, discounted at a risk-adjusted rate. In addition, the remaining
amortization period for the impaired asset would be reassessed and revised
if necessary.



| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | For goodwill and intangible assets, the Company continuously evaluates
the reasonableness of the useful lives of these assets.

Revenue Recognition  Revenue from sales of products is recognized when
earned; that is, when the risks and rewards of ownership have transferred to
the customer, which is considered to have occurred upon shipment of the
finished product, as shipping terms is FOB shipping point. Cash discounts,
sales incentives, and returns are estimated and recognized at the date of
shipment based upon historical activity and current customer commitments. The
Company evaluates these estimates on a quarterly basis and revises them as
necessary.

On occasion, the Company enters into arrangements to license its
technology on specifically approved products. For those arrangements where the
Company has continuing involvement with the licensee, nonrefundable, upfront
license fees are recognized systematically as they are earned over the life of
the agreement. Fees associated with substantive, at risk, performance
milestones are recognized as revenue as the milestones are achieved, as defined
in the respective agreements. For perpetual licenses or manufacturing rights
agreements, where (i) the Company has no further continuing involvement with
the licensee; (ii) the fees are nonrefundable; and (iii) the fees are not a
prepayment of future royalties, the fees are recognized as revenue at the time
the arrangement becomes effective.

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, work in process and raw
materials, are stated at the lower of cost (first-in, first-out method) or
market.

Property and Equipmentare 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. Listed below are
the ranges of useful lives by property and equipment category:

|                                   |  |            
|---------------------------------- |  | -----------
|Buildings                          |  | 20-40 years
|                                  
|                                  
|                                  
|                                  
|Building improvements              |  | 10 years   
|                                  
|                                  
|                                  
|                                  
|Furniture and equipment            |  | 5 years    
|                                  
|                                  
|                                  
|                                  
|Production and warehouse equipment |  | 7-10 years 

Intangible Assets

Purchased Technology Rights  In 1996, the Company acquired CTM Associates,
Inc. (CTM). The purchase of CTM perfected the Companys interest in the
OraTest® technology and eliminated its obligation to pay royalties to CTM on
future sales of the OraTest® product. The purchased technology rights are
amortized on a straight-line basis over the expected period of benefit, which
was based on the estimated remaining life of the related patents, which will
expire in 2011.

Goodwill, which represents the excess of purchase price over fair value of
net assets acquired, is amortized on a straight-line basis over the expected
period to be benefited with estimated useful lives ranging from 15 to 40 years.

Trademarks and Other Intangible Assets Trademarks are amortized on a
straight-line basis over the lesser of their legal or expected lives, which
range from 17 to 25 years. Other intangible assets include deferred patent
costs, which represent legal costs associated with filing patent applications
and licensing costs related to the ViziLite product, are amortized on a
straight-line basis over the lesser of their legal or expected lives, which
range from 10 to 17 years.

Research and Development  The costs associated with research and
development programs for new products and significant product improvements are
expensed as incurred. Research and development costs totaled $3,956,000,
$3,037,000 and $1,630,000 in 2002, 2001 and 2000, respectively.

Net Income (Loss) Per Common Share Basic net income (loss) per common
share is computed by dividing net income (loss) available to common
shareholders by the weighted average number of common shares outstanding during
the year before giving

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effect to stock options and warrants considered to be
dilutive common stock equivalents. Diluted net income (loss) per common share is
computed by dividing net income (loss) available to common shareholders by the
weighted average number of common and potentially dilutive shares outstanding
during the year after giving effect to convertible preferred stock, stock
options and warrants. For the years ended July 31,
2002 and 2001, the effect of 335,000 and 531,710 shares respectively of
convertible preferred stock, options and warrants were excluded because their
inclusion would have the effect of decreasing the loss per share.

For
the year ended July 31, 2000, the following is a reconciliation of the
numerators and denominators of diluted and basic per share computations for
income from continuing operations:

|                                                           |                             |   |            |           | 
|---------------------------------------------------------- | --------------------------- | - | ---------- | --------- | 
|Income available to common shareholders, as restated       |                             | $ | 3,343,900  |          
|                                                           |                             |   |            |          
|Average outstanding common shares                          |                             |   | 42,180,236 |          
|                                                          
|                                                          
|                                                          
|                                                          
|Effect of dilutive securities:                             |                             |   |            |          
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Options                     |   |            | 268,919   | 
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Warrants                    |   |            | 54,962    | 
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Convertible preferred stock |   |            | 1,072,063 | 
|                                                           |                             |   |            |          
|Average outstanding and potentially dilutive common shares |                             |   | 43,576,180 |          
|                                                           |                             |   |            |          
|Basic income per share from continuing operations          |                             | $ | 0.08       |          
|                                                           |                             |   |            |          
|Diluted income per share from continuing operations        |                             | $ | 0.08       |          
|                                                           |                             |   |            |          

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. Ongoing
credit evaluations are preformed of customers to determine an appropriate
allowance for credit losses.

Comprehensive Incomeconsists of net income (loss) and other gains and
losses affecting shareholders equity that, under accounting principles
generally accepted in the United States of America are excluded from net income
(loss). Such items consist primarily of unrealized gains and losses on
marketable equity investments and foreign currency translation gains and
losses.

Shipping Costs  Costs of shipping products to customers are included in the
cost of products sold.

New Accounting Pronouncements In May 2000, the Financial Accounting
Standards Boards Emerging Issues Task Force (EITF) reached consensus on
Issue No. 00-14, Accounting for Certain Sales Incentives. The Issue
addresses the recognition, measurement, and income statement classification for
certain sales incentives including coupons, rebates and free products. The
consensus in Issue No. 00-14 was effective for the Company on February 1, 2002.
The consensus requires certain sales incentives that were previously classified
as selling, general and administrative expenses to be classified as a reduction
in sales. The cost of free products is now recorded as a reduction of revenues
from products sold.

In April 2001, the EITF reached consensus on Issue No. 00-25, Vendor
Income Statement Characterization of Consideration from a Vendor to a
Retailer. The Issue discusses accounting and income statement classification
of costs, other than those directly addressed in Issue 00-14, that are incurred
by a vendor (typically a manufacturer or distributor) to or on behalf of a
customer

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##### Table of Contents



(typically a retailer) in connection with the customers purchase or
promotion of the vendors products. Such costs include consideration given to
retailers for space in their stores (slotting fees), consideration given to
obtain favorable display positions in the retailers stores and other
promotional activity such as cooperative advertising. The Issue addresses the
recognition and measurement of such costs and whether a vendor should classify
such costs in its income statement when incurred as a reduction of revenues or
as an expense item. The consensus on EITF No. 00-25 was effective for the Company on February
1, 2002. The effect of the adoption of EITF No. 00-25 did not have a material
impact on the Companys consolidated statement of operations.

The table below shows the effect of the Issue No. 00-14 and Issue No.
00-25 adjustment to revenues and selling, general and administrative expense
for the years ended July 31,

|                                                                     |                   |   |            |         |      |   |            |           | 
|-------------------------------------------------------------------- | ----------------- | - | ---------- | ------- | ---- | - | ---------- | --------- | 
|                                                                     |                   |   | 2001       |         | 2000
|                                                                     |                   |   |            |         |     
|Pre-adoption net revenues                                            |                   | $ | 31,686,392 |         |      | $ | 37,763,763 |          
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Reclassifications from selling, general and
administrative expenses: |                   |   |            |         |      |   |            |          
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|                                                                     | Sales incentives  |   |            | 933,596 |      |   |            | 1,051,572 | 
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|                                                                     | Co-op advertising |   |            | 42,035  |      |   |            | 103,918   | 
|                                                                     |                   |   |            |         |      |   |            |          
|Total Adjustments                                                    |                   |   | 975,631    |         |      |   | 1,155,490  |          
|                                                                    
|                                                                    
|                                                                    
|                                                                    
|Net Revenues Reported                                                |                   | $ | 30,710,761 |         |      | $ | 36,608,273 |          
|                                                                     |                   |   |            |         |      |   |            |          

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and
Other Intangible Assets, which will be effective for Zila on August 1, 2002.
SFAS No. 142 specifies that goodwill and certain intangibles with indefinite
lives will no longer be amortized but instead will be subject to periodic
impairment testing. Intangible assets with finite lives will continue to be
amortized over their respective useful lives. The Company will be required to
measure goodwill for impairment as of August 1, 2002 as part of the transition
provisions and the Companys impairment analyses must be completed no later
than January 31, 2003. In addition, the Company will be required to measure
intangible assets with indefinite useful lives for impairment as of August 1,
2002 with any resulting impairment reported within the first interim periods
financial statements. Any impairment resulting from these transition tests
will be recorded and recognized as the cumulative effect of a change in
accounting principle. The Company is in the process of evaluating the impact
of SFAS No. 142 on the Companys intangible assets and has not yet determined
if a cumulative effect adjustment will be required.

Effective August 1, 2001, the Company adopted SFAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes
existing guidance on asset impairment under SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.
Among other provisions, SFAS No. 144 changes the criteria for classifying an
asset as held-for-sale. The standard also broadens the scope of businesses to
be disposed of that qualify for reporting as discontinued operations, and
changes the timing of recognizing losses on such operations. The
adoption of SFAS No. 144 did not have a significant impact on
our financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities,which replaces EITF Issue No.
94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring).The new standard requires companies to recognize costs
associated with exit or disposal activities when they are incurred rather than
at the date of a commitment to an exit or disposal plan. The statement is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. The Company does not expect that the adoption will have a significant
impact on the Companys financial position or results of operations.



|2. |  | Acquisitions
|-- |  | ------------

On December 4, 2001, the Company acquired the world marketing and
distribution rights (excluding the Pacific Rim) for the FDA approved ViziLite
chemiluminescent light technology from The Trylon Corporation (Trylon) of
Torrance, California. The rights acquired include the FDA-approved devices
and methods of conducting endoscopic examinations of body cavities using
chemiluminescent light sources.

F-10



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##### Table of Contents



In payment of the purchase price for the transaction, 2,000,000 shares of
restricted common stock were issued, of which 1,625,000 shares were delivered
to Trylon and 375,000 shares were placed into escrow. The shares of common
stock are restricted in accordance with the following provisions: (i) all
2,000,000 shares are restricted within the meaning of Rule 144 under the
Securities Act of 1933, as amended, (ii) 500,000 of the shares delivered to
Trylon have an additional contractual restriction upon sale or transfer that
will be removed at the earlier of ten years following the closing date or the
achievement of certain future sales milestones of the ViziLite product, (iii)
375,000 of the other shares delivered to Trylon have an additional contractual
restriction that will be removed at the earlier of ten years following the
closing date or in the event of the submission of a new drug 510(k) application
with the FDA for a new product line extension of the ViziLite product
currently under development. The 375,000 shares in escrow are to remain in
escrow until the date upon which FDA marketing clearance is received on the new
product line extension of the ViziLite product described in item (iii) above.
If such clearance is not received on or before the second anniversary of the
closing date, then subject to certain exceptions, the stock in escrow is to be
returned to the Company and cancelled.

The 1,625,000 shares of restricted common stock that were delivered were
valued at $2,945,000 as follows: (i) the fair value of the 750,000 shares
restricted within the meaning of Rule 144 but not otherwise restricted, were
valued at $1,853,000 which was based upon the common stock share market price
of $2.47 on December 4, 2001; (ii) the 500,000 shares of restricted common
stock subject to additional contractual restrictions relating to sales
milestones were valued at $619,000 and were discounted from the December 4,
2001 share price based upon the length of time and probability of achieving the
requisite sales milestones; and (iii) the 375,000 restricted shares of common
stock subject to additional contractual restrictions tied to FDA submissions
were valued at $473,000 and were discounted based upon the length of time and
probability of submitting an acceptable new drug 510(k) application to the FDA.
The $2,472,000 of value referenced in items (i) and (ii) above was recorded as
an intangible asset as a license. The $473,000 in value referenced in item
(iii) above was recorded as research and development and expensed.

The release of the 375,000 shares in escrow is contingent upon Trylon
obtaining regulatory approval of the new product line extension of the ViziLite
product currently under development. The shares will be recorded as research
and development expense (and included in diluted earnings per share) when and if such regulatory approval is obtained.

In December 2001, the Company entered into a distributorship agreement
with Patterson Dental Company to supply certain products for the dental
industry, including the ViziLite product, in the United States and Canada. In
February 2002, Zila, Trylon and the World Medical Trade Organization Inc.
(WMTO), entered into a Memorandum of Understanding whereby the Company will
supply products including the ViziLite product to the WMTO for distribution in
various countries in the Pacific Rim. Foreign sales to date have not been
significant.

On February 1, 2001, the Company acquired the patent rights and the
Antioch, Illinois manufacturing operations for swab products from National
Healthcare Manufacturing Corporation, headquartered in Winnipeg, Canada for
approximately $2.3 million in a combination of cash and preferred stock. (See
Note 11). Intellectual property, inventory, plus molding, labeling, filling and
sealing equipment were included in the acquisition. The business unit is known
as Innovative Swab Technologies.

3. Sale of Assets

On October 28, 1999, the Company completed the sale of substantially all
of its assets and certain liabilities of its wholly-owned subsidiary, Cygnus
Technologies, Inc. (Cygnus) to ProCare Laboratories, Inc. of Scottsdale,
Arizona for approximately $4.0 million. On December 20, 1999, the Company
completed the sale of substantially all of its assets and liabilities of its
wholly-owned subsidiary Integrated Dental Technologies, Inc. (IDT) related to
IDTs PracticeWorks division located in Gold River, California to InfoCure
Corporation, of Atlanta, Georgia for approximately $4.65 million.

The following unaudited pro forma condensed statement of operations data
for the year ended July 31, 2000, present the historical statement of
operations data for Zila, Cygnus and IDT as if the Cygnus and IDT transactions
had occurred as of August 1, 1999. The pro forma data are not necessarily
indicative of the results of operations that would actually have been reported
had the transactions been consummated at the date mentioned above or which may
be reported in the future.

|                                     |  |              |        |            |  |         |       |                 |  |           |         |           |  |  |  |  |  |   |        | 
|------------------------------------ |  | ------------ | ------ | ---------- |  | ------- | ----- | --------------- |  | --------- | ------- | --------- |  |  |  |  |  | - | ------ | 
|Year ended July 31, 2000             |  | Historical   |        |            |  |         |       |                 |  |          
|(in thousands except per share data) |  |              |        |            |  |         |       |                 |  |          
|                                     |  | Zila         |        |            |  |         |       |                 |  |           |         | Pro forma |  |  |  | 
|                                     |  | Consolidated |        | Cygnus (a) |  | IDT (a) |       | Adjustments (b) |  | Pro Forma
|                                     |  |              |        |            |  |         |       |                 |  |          
|Net revenues                         |  | $            | 36,608 |            |  |         | ($193 | )               |  |           | ($1,515 | )         |  |  |  |  |  | $ | 34,900 | 
|                                    
|                                    
|                                    
|                                    
|Cost of products sold                |  |              | 10,458 |            |  |         | (110  | )               |  |           | (69     | )         |  |  |  |  |  |   | 10,279 | 

F-11



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##### Table of Contents



|                                               |  |              |        |            |  |         |      |                 |  |           |        |           |  |  |        |   |  |   |        | 
|---------------------------------------------- |  | ------------ | ------ | ---------- |  | ------- | ---- | --------------- |  | --------- | ------ | --------- |  |  | ------ | - |  | - | ------ | 
|Year ended July 31, 2000                       |  | Historical   |        |            |  |         |      |                 |  |          
|(in thousands except per share data)           |  |              |        |            |  |         |      |                 |  |          
|                                               |  | Zila         |        |            |  |         |      |                 |  |           |        | Pro forma |  |  |        |  
|                                               |  | Consolidated |        | Cygnus (a) |  | IDT (a) |      | Adjustments (b) |  | Pro Forma
|                                               |  |              |        |            |  |         |      |                 |  |          
|                                              
|                                              
|                                              
|                                              
|Selling, general and administrative expenses   |  |              | 21,026 |            |  |         | (491 | )               |  |           | (1,188 | )         |  |  |        |   |  |   | 19,347 | 
|                                              
|                                              
|                                              
|                                              
|Research and development expenses              |  |              | 1,629  |            |  |         | (155 | )               |  |           | (120   | )         |  |  |        |   |  |   | 1,354  | 
|                                              
|                                              
|                                              
|                                              
|Depreciation and amortization                  |  |              | 3,095  |            |  |         | (110 | )               |  |           | (35    | )         |  |  |        |   |  |   | 2,950  | 
|                                              
|                                              
|                                              
|                                              
|Income (loss) from operations                  |  |              | 400    |            |  |         | 673  |                 |  |           | (103   | )         |  |  |        |   |  |   | 970    | 
|                                              
|                                              
|                                              
|                                              
|Other income (expense)                         |  |              | 4,689  |            |  |         |      |                 |  |           |        |           |  |  | (4,678 | ) |  |   | 11     | 
|                                              
|                                              
|                                              
|                                              
|Income tax (expense) benefit                   |  |              | (2,020 | )          |  |         |      |                 |  |           |        |           |  |  | (2,761 | ) |  |   | 741    | 
|                                              
|                                              
|                                              
|                                              
|Income (loss) from continuing operations       |  |              | 3,069  |            |  |         | 673  |                 |  |           | (103   | )         |  |  | (1,917 | ) |  |   | 1,722  | 
|                                              
|                                              
|                                              
|                                              
|Per share from continuing operations (basic)   |  | $            | 0.07   |            |  |         |      |                 |  |           |        |           |  |  |        |   |  | $ | 0.04   | 
|                                              
|                                              
|                                              
|                                              
|Basic shares outstanding                       |  |              | 42,180 |            |  |         |      |                 |  |           |        |           |  |  |        |   |  |   | 42,180 | 
|                                              
|                                              
|                                              
|                                              
|Per share from continuing operations
(diluted) |  | $            | 0.07   |            |  |         |      |                 |  |           |        |           |  |  |        |   |  | $ | 0.04   | 
|                                              
|                                              
|                                              
|                                              
|Diluted shares outstanding                     |  |              | 43,576 |            |  |         |      |                 |  |           |        |           |  |  |        |   |  |   | 43,576 | 



---

|(a) |  | Represents Cygnus and IDT balances for the year ended July 31,
2000. These amounts are removed to reflect the sale of assets and
the corresponding revenue and expenses thereby reducing the
consolidated balances for pro forma purposes.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(b) |  | The pro forma adjustments represent the elimination of the gain
on the sale of the assets and the resulting income tax effect
recorded.                                                                                                   

In the year ended July 31, 2001, the Company recorded a non-cash charge of
$310,000 in the Nutraceuticals segment to write down the carrying amount of the
land and buildings of its former location in Prescott, Arizona to an estimated
fair value related to its anticipated sale. The building was sold in February
2001. In the year ended July 31, 2002, an asset impairment charge of
approximately $224,000 was recorded related to the write down of a mold and
certain intangible assets related to the Pro-Ties product line and the
Peridex® product distribution rights for Western Europe. The net present value
of expected future cashflows for each of these assets was used to determine the
amount of impairment. The charges are included in the Professional
Pharmaceuticals reporting segment.

4. Discontinued Operation

In November 2001, the Company decided to sell the operations of its Zila
Dental Supply (ZDS) business. These operations were sold in two separate
transactions during the second fiscal quarter of 2002. The accompanying
consolidated financial statements have been prepared to reflect the ZDS
business including any gain (loss) on sale as discontinued operations for all
periods presented.

This business segment was comprised of the full-service and mail order
businesses of Zila Dental Supply. ZDSs full-service assets were sold on
November 5, 2001 to Henry Schein, Inc. of Melville, NY (Nasdaq: HSIC) for
approximately $5.8 million in cash resulting in a pre-tax gain of approximately
$823,000. Proceeds from the sale were used to repay borrowings outstanding
under the revolving line of credit with Congress Financial Corporation
(Congress).

The ZDS mail order operations (assets and liabilities) were sold on
December 4, 2001 to PracticeWares, Inc. of Sacramento, CA for approximately
$8.0 million in one short and two long-term notes. Approximately $5.7 million
of the $8.0 million purchase price (net of post closing adjustments) was due
and payable January 11, 2002. The Company extended the maturity date of the
short-term note, upon payment of accrued and prepaid interest, to February 15,
2002, and further extended the note to March 1, 2002, with interest prepaid
through the new maturity date.

The note was not paid on the due date and in March 2002, Zila and
PracticeWares agreed in principle to restructure the terms relating to the
sale. In June 2002, final agreement was reached such that PracticeWares would
pay Zila cash of approximately $4,130,000, plus a 19.0% ownership interest in
PracticeWares (on a fully diluted basis) in full satisfaction of the notes. On
June 18, 2002, the Company received $3.9 million from PracticeWares, Inc.,
which included approximately $130,000 in accrued interest. $200,000 was held in
escrow for 60 days to offset certain indemnifications of Zila to PracticeWares,
resulting in a pre-tax loss from the disposal of the mail order
assets and liabilities of
approximately $679,000. Proceeds from the sale were used to repay borrowings
outstanding under the revolving line of credit with Congress.

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##### Table of Contents



As a result of PracticeWares failure to pay the short-term notes when
due, the transaction to sell the mail order business did not qualify as a sale
for accounting purposes until June 18, 2002. ZDSs net loss of $550,000 for
the period from December 4, 2001 to June 18, 2002 is
reflected in the statement of operations as income (loss) from operations of the discontinued Dental Supply
Segment. In connection with the sale, the Company retained three operating
leases and recorded a reserve for future minimum lease payments in excess of
expected sublease income of $430,000. The reserve is included in the loss on
disposal of the mail order assets.

The results of the discontinued ZDS business are as follows, in thousands:

|                  |  |      |        |      |  |      |        |   |  |   |        | 
|----------------- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | 
|                  |  | 2002 |        | 2001 |  | 2000
|                  |  |      |        |      |  |     
|Net sales         |  | $    | 23,426 |      |  | $    | 41,630 |   |  | $ | 39,817 | 
|                 
|                 
|                 
|                 
|Net income (loss) |  | $    | (815   | )    |  | $    | (121   | ) |  | $ | 167    | 

5. Inventories

Inventories consist of the following at July 31:

|                   |  |      |           |      |  |   |            |  
|------------------ |  | ---- | --------- | ---- |  | - | ---------- | -
|                   |  | 2002 |           | 2001
|                   |  |      |           |     
|Finished goods     |  | $    | 2,455,080 |      |  | $ | 4,128,119  |  
|                  
|                  
|                  
|                  
|Work in process    |  |      | 1,806,783 |      |  |   | 71,872     |  
|                  
|                  
|                  
|                  
|Raw materials      |  |      | 4,899,401 |      |  |   | 6,981,109  |  
|                  
|                  
|                  
|                  
|Inventory reserves |  |      | (292,725  | )    |  |   | (79,203    | )
|                   |  |      |           |      |  |   |            |  
|Total inventories  |  | $    | 8,868,539 |      |  | $ | 11,101,897 |  
|                   |  |      |           |      |  |   |            |  

During fiscal years 2002 and 2001, the Company recorded charges and
reserves of $550,000 and $7,000 respectively, to reduce the carrying value of
its Saw Palmetto inventory due to spoilage costs and costs in excess of current
market prices.

6. Property and Equipment

Property and equipment consists of the following at July 31:

|                                               |  |      |            |      |  |   |            | 
|---------------------------------------------- |  | ---- | ---------- | ---- |  | - | ---------- | 
|                                               |  | 2002 |            | 2001
|                                               |  |      |            |     
|Land                                           |  | $    | 619,917    |      |  | $ | 619,917    | 
|                                              
|                                              
|                                              
|                                              
|Building and improvements                      |  |      | 5,641,896  |      |  |   | 5,789,948  | 
|                                              
|                                              
|                                              
|                                              
|Furniture and equipment                        |  |      | 2,013,720  |      |  |   | 1,765,858  | 
|                                              
|                                              
|                                              
|                                              
|Leasehold improvements and other assets        |  |      | 377,117    |      |  |   | 358,466    | 
|                                              
|                                              
|                                              
|                                              
|Production and warehouse equipment             |  |      | 4,812,293  |      |  |   | 4,567,883  | 
|                                               |  |      |            |      |  |   |            | 
|Total property and equipment                   |  |      | 13,458,795 |      |  |   | 13,102,072 | 
|                                              
|                                              
|                                              
|                                              
|Less accumulated depreciation and amortization |  |      | 4,616,645  |      |  |   | 3,645,735  | 
|                                               |  |      |            |      |  |   |            | 
|Property and equipment  net                   |  | $    | 8,848,299  |      |  | $ | 9,456,337  | 
|                                               |  |      |            |      |  |   |            | 

Depreciation expense related to property and equipment for 2002, 2001 and
2000 was $1,083,000, $952,000 and $843,000, respectively.

7. Intangible Assets

Intangible assets consist of the following at July 31:

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##### Table of Contents



|                                                                                                         |                                              |   |            |            |      |   |            |            | 
|-------------------------------------------------------------------------------------------------------- | -------------------------------------------- | - | ---------- | ---------- | ---- | - | ---------- | ---------- | 
|                                                                                                         |                                              |   | 2002       |            | 2001
|                                                                                                         |                                              |   |            |            |     
|Purchased technology rights  net of accumulated
amortization of $2,951,894 (2002) and
$2,473,212 (2001) |                                              | $ | 4,467,579  |            |      | $ | 4,946,261  |           
|                                                                                                         |                                              |   |            |            |      |   |            |           
|Goodwill  net of accumulated amortization of
$5,550,292 (2002) and $4,349,848 (2001)                    |                                              | $ | 11,174,379 |            |      | $ | 12,383,291 |           
|                                                                                                         |                                              |   |            |            |      |   |            |           
|Trademarks and other intangible assets:                                                                  |                                              |   |            |            |      |   |            |           
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                         | Trademarks                                   |   | $          | 11,487,214 |      |   | $          | 11,520,889 | 
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                         | Patents                                      |   |            | 2,735,623  |      |   |            | 2,188,507  | 
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                         | Licensing costs                              |   |            | 2,711,616  |      |   |            | 87,860     | 
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                         | Other                                        |   |            | 544,896    |      |   |            | 477,638    | 
|                                                                                                         |                                              |   |            |            |      |   |            |           
|                                                                                                         | Total trademarks and other intangible assets |   |            | 17,479,349 |      |   |            | 14,274,894 | 
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                        
|                                                                                                         | Less accumulated amortization                |   |            | 3,282,691  |      |   |            | 2,590,064  | 
|                                                                                                         |                                              |   |            |            |      |   |            |           
|                                                                                                         | Trademarks and other intangible assets  net |   | $          | 14,196,658 |      |   | $          | 11,684,830 | 
|                                                                                                         |                                              |   |            |            |      |   |            |           

In
accordance with SFAS No. 144 Accounting for the Impairment or Disposal of
Long-Lived Assets, the Company evaluates its intangible and other assets for
recoverability whenever events or changes in circumstances indicate that its
carrying amount may not be recoverable.

The Company evaluates goodwill for impairment pursuant to SFAS No. 121
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of. In instances where goodwill and other intangible assets
relate to the same asset group such that separately identifiable cash flows do
not exist, goodwill and other intangibles are combined for purposes of testing
impairment.

Following is a summary of the significant classes of intangible assets:

Purchased
Technology Rights  Purchased technology rights relate to the
acquisition of CTM, Inc. in fiscal year 1996. The purchase of CTM eliminated
the Companys obligation to pay royalties to CTM on future sales of the
OraTest® product. The recoverability of the $4.5 million net purchased
technology rights is dependent upon obtaining FDA approval and generating
sufficient revenues from future sales of the OraTest® products (see Note 13).
Fixed assets of approximately $600,000 (primarily related to a manufacturing
facility), patents and patents pending of $1,023,000 and inventory of $649,000
are also associated with the OraTest® products and are grouped with the
purchased technology rights for the purpose of testing recoverability.

Peridex
Goodwill Goodwill totaling approximately $7.0 million (net of
accumulated amortization of $4.6 million) is related to the Peridex® product
which was acquired from The Procter & Gamble Company in November 1997.

Zila Nutraceuticals Goodwill and trademarks totaling approximately $12.2
million (net of accumulated amortization of $3.1 million) are related to the
Ester-C®group of products. These assets were acquired by merger in 1997 and
are combined for purposes of testing for impairment.

Other Goodwill Other goodwill totaling approximately $1.3 million (net
of accumulated amortization of $80,000) is related to the IST acquisition in
February 2001 and the Pro-Ties acquisition in December 2000. At July 31, 2002,
an impairment charge of $8,000 was recognized to adjust goodwill associated
with the Pro-Ties acquisition to its estimated fair value.

Licensing Costs Licensing costs primarily represent the value of the
restricted common stock issued in the Trylon transaction discussed in Note 2.

Patents
 Patents totaling $2.1 million (net of accumulated amortization of
$670,000) are related to several of the Companys product lines, including
Zilactin®, OraTest®, IST Products and Ester-C®.

Other
Intangible Assets The most significant component of other
intangible assets are $279,000 (net of accumulated amortization of $28,000) in
deferred financing costs associated with the bond financing related to the Zila
Nutraceuticals building in Prescott, AZ. Such costs are amortized over 20
years and are charged to interest expense using the effective interest method.

F-14



---



##### Table of Contents



In
the year ended July 31, 2002, an asset impairment charge of
approximately $224,000 was recorded related to the write down of a
mold and certain intangible assets related to the
Pro-TiesTM product line and the Peridex® product
distribution rights for Western Europe. The net present value of
expected future cashflows for each of these assets was used to
determine the amount of impairment. The charges are included in the
Professional Pharmaceuticals reporting segment.

Amortization of intangible assets during fiscal 2002, 2001 and 2000 was
$2,385,000, $2,223,000, and $2,252,000, respectively.

8. Short-term Borrowings and Long-Term Debt

At July 31, 2002, the Company had (i) a short-term note payable of $92,000
at 7.88% for installments due on its various insurance policies; (ii) the
short-term portion of an equipment lease for $8,000; and (iii) no short-term
borrowings outstanding against its line of credit with Congress. On July 31,
2001, short-term borrowings consisted of $6.1 million on a revolving line of
credit with Bank One, Arizona, NA (Bank One) and $61,000 at 6.99% for
installments due on various insurance policies.

In December 2000, the Company renewed its $9 million line of credit with
Bank One for an additional 12 months under similar terms and conditions,
including a variable interest rate equal to the prime rate (Index), which was
6.75% at July 31, 2001. Under the line of credit loan agreement, the Company
was required to comply with financial covenants based on certain financial
ratios and as of April 30, 2001, the Company was in default of the debt service
coverage ratio. On May 7, 2001, Zila and Bank One entered into the First Loan
Modification Agreement whereby the line of credit was reduced to $7.25 million,
the interest rate was raised to 3.0% over the Index, the Company agreed to
cross-defaulting and cross-collateralizing of all Bank One loans and
obligations and Bank One agreed to forebear in exercising any remedy with
respect to the default through May 31, 2001. On June 14, 2001, the Agreement
was amended and the forbearance period was extended to June 29, 2001.

On July 3, 2001, Zila and Bank One entered into a Second Extension to
First Loan Modification Agreement. Under this agreement, the line of credit
was reduced to $6.9 million and Bank One agreed to forebear in exercising any
remedy with respect to certain defaults under the line of credit through July
31, 2001 and also agreed to extend the maturity date of the building loan for
the 7th Street location until July 31, 2001.

The Company entered into a Third Extension to First Loan Modification
Agreement effective July 31, 2001. Under this agreement, Bank One agreed to
forebear in exercising any remedy with respect to certain defaults under the
line of credit through August 31, 2001 and agreed to extend the maturity date
of the building loan until August 31, 2001.

On August 27, 2001, Zila and Congress entered into a Loan and Security
Agreement (the Agreement) whereby Congress would provide a $12 million
revolving line of credit at an interest rate equal to the prime rate plus 3/4
percent. The amount of funds available from the line of credit is based upon a
percentage of the value of eligible receivables and inventory and was $4.8
million at July 31, 2002. The obligations under the Agreement are
collateralized by various assets, including, but not limited to trade accounts
receivable, inventories, equipment and intangible assets. Zila and all of its
direct and indirect operating subsidiaries guarantee the obligations under the
Agreement. The Agreement expires August 17, 2004; however any amounts due
under the line of credit would be classified as current because of certain
provisions required by Congress. Under the Agreement, the Company is required
to comply with a financial covenant based on an adjusted tangible net worth
calculation. At July 31, 2002, the Companys adjusted tangible net worth, as
defined in the Agreement, was $17.1 million compared to the required amount of
$16.0 million. A portion of the available funds from the new line of credit
were used to pay off in full the line of credit and building loan due to Bank
One, totaling approximately $6.4 million.

|                                                                                                      |  |      |           |      |  |   |           | 
|----------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- |  | - | --------- | 
|Long-term debt consisted of the following at July 31:                                                 |  | 2002 |           | 2001
|                                                                                                      |  |      |           |     
|IDA bond payable, Series A, (1)                                                                       |  | $    | 3,900,000 |      |  | $ | 3,900,000 | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|IDA bond payable, Series B, (1)                                                                       |  |      | 103,553   |      |  |   | 532,288   | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Mortgage note payable, interest at 9%,
monthly payments of $2,315 with a balloon
due August 31, 2001  |  |      |           |      |  |   | 277,821   | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Notes payable for equipment with interest
rates between 6.34% and 12.25% with
maturities through 2004 |  |      | 96,091    |      |  |   | 117,035   | 
|                                                                                                      |  |      |           |      |  |   |           | 
|                                                                                                      |  |      | 4,099,644 |      |  |   | 4,827,144 | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Less current portion                                                                                  |  |      | 489,161   |      |  |   | 747,648   | 
|                                                                                                      |  |      |           |      |  |   |           | 
|Long-term portion                                                                                     |  | $    | 3,610,483 |      |  | $ | 4,079,496 | 
|                                                                                                      |  |      |           |      |  |   |           | 



---

|(1) |  | In April 1999, Oxycal entered into a transaction with The Industrial
Development Authority of the County of Yavapai (the Authority) in which the
Authority issued $5.0 million in Industrial Development Revenue Bonds (the
Bonds), the proceeds of which
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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---



##### Table of Contents



| |  | were loaned to Oxycal for the construction of a new manufacturing and
laboratory facility. The Bond proceeds were held by the trustee, Bank One,
Arizona until such time as invoices for building construction and new equipment
were submitted for payment. As of July 31, 2001, the trustee had released all
the Bond proceeds. The Bonds consist of $3.9 million Series A and $104,000
Taxable Series B, which, as of July 31, 2002, bear interest at rates of 1.75 %
and 1.97 %, respectively. The Bonds were marketed and sold by Banc One Capital
Markets and mature in 20 years. In connection with the issuance of the Bonds,
the Authority required that Oxycal obtain, for the benefit of the Bondholders,
an irrevocable direct-pay letter of credit to secure payment of principal and
interest. Zila, Inc. guaranteed the letter of credit.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Aggregate annual maturities of long-term debt for the fiscal years ending
July 31 are as follows:

|                     |  |   |           | 
|-------------------- |  | - | --------- | 
|2003                 |  | $ | 489,161   | 
|                    
|                    
|                    
|                    
|2004                 |  |   | 458,497   | 
|                    
|                    
|                    
|                    
|2005                 |  |   | 425,784   | 
|                    
|                    
|                    
|                    
|2006                 |  |   | 425,784   | 
|                    
|                    
|                    
|                    
|2007                 |  |   | 425,784   | 
|                    
|                    
|                    
|                    
|2008 and thereafter  |  |   | 1,874,634 | 
|                     |  |   |           | 
|Total                |  |   | 4,099,644 | 
|                    
|                    
|                    
|                    
|Less current portion |  |   | 489,161   | 
|                     |  |   |           | 
|Long-term portion    |  | $ | 3,610,483 | 
|                     |  |   |           | 

9. Stock Options and Warrants

a.     Stock 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 common stock. On December 7, 2000, the plan
was amended to increase the authorized number of shares to 3,000,000. The
options are issuable at an exercise price no less than market value at the date
of grant. Options may be exercised up to ten years from the date of grant. In
fiscal 2002, 2001 and 2000, the Company granted options to purchase 513,000,
354,800 and 285,000 shares of common stock, respectively, to employees. At
July 31, 2002, 1,329,000 shares were available for grant under this plan.

On September 1, 1988, the Company adopted a Stock Option Award Plan,
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 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 ten years from the date of grant. At July 31, 2002, no shares were
available for grant under this plan.

The Company adopted a Non-Employee Directors Stock Option Plan that became
effective October 20, 1989, authorizing the Board of Directors to grant options
of 100,000 shares to non-employee members of the Board of Directors in
increments of 2,500 shares per director each year. Grants under the plan are
for services provided to the Company as a director. The plan was amended
December 8, 1995 to increase the authorized number of shares to 200,000. The
options are issuable at an 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, 2002, 125,000 shares were available for grant under
this plan.

A summary of the status of the option plans as of July 31, 2002, 2001 and
2000 and changes during the years then ended is presented below:

|                                 |  |        |           |       |  |          |      |       |  |        |           |          |  |   |      |  |  |          |           |   |  |   |      | 
|-------------------------------- |  | ------ | --------- | ----- |  | -------- | ---- | ----- |  | ------ | --------- | -------- |  | - | ---- |  |  | -------- | --------- | - |  | - | ---- | 
|                                 |  | 2002   |           | 2001  |  | 2000    
|                                 |  |        |           |       |  |         
|                                 |  |        |           |       |  | Weighted |      |       |  |        |           | Weighted |  |   |      |  |  | Weighted
|                                 |  |        |           |       |  | Average  |      |       |  |        |           | Average  |  |   |      |  |  | Average 
|                                 |  |        |           |       |  | Exercise |      |       |  |        |           | Exercise |  |   |      |  |  | Exercise
|                                 |  | Shares |           | Price |  | Shares   |      | Price |  | Shares |           | Price   
|                                 |  |        |           |       |  |          |      |       |  |        |           |         
|Outstanding at beginning of year |  |        | 2,097,943 |       |  | $        | 5.07 |       |  |        | 2,576,354 |          |  | $ | 5.07 |  |  |          | 2,306,678 |   |  | $ | 5.41 | 
|                                
|                                
|                                
|                                
|Granted                          |  |        | 550,500   |       |  |          | 1.71 |       |  |        | 354,800   |          |  |   | 2.64 |  |  |          | 513,000   |   |  |   | 3.25 | 
|                                
|                                
|                                
|                                
|Exercised                        |  |        | 0         |       |  |          |      |       |  |        | (249,752  | )        |  |   | 1.19 |  |  |          | (30,524   | ) |  |   | 4.85 | 
|                                
|                                
|                                
|                                
|Forfeited/expired                |  |        | (452,025  | )     |  |          | 4.38 |       |  |        | (583,459  | )        |  |   | 5.27 |  |  |          | (212,800  | ) |  |   | 4.37 | 
|                                 |  |        |           |       |  |          |      |       |  |        |           |          |  |   |      |  |  |          |           |   |  |   |      | 

F-16



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##### Table of Contents



|                                |  |        |           |       |  |          |      |       |  |        |           |          |  |  |      |  |  |          |           |  |  |  |      | 
|------------------------------- |  | ------ | --------- | ----- |  | -------- | ---- | ----- |  | ------ | --------- | -------- |  |  | ---- |  |  | -------- | --------- |  |  |  | ---- | 
|                                |  | 2002   |           | 2001  |  | 2000    
|                                |  |        |           |       |  |         
|                                |  |        |           |       |  | Weighted |      |       |  |        |           | Weighted |  |  |      |  |  | Weighted
|                                |  |        |           |       |  | Average  |      |       |  |        |           | Average  |  |  |      |  |  | Average 
|                                |  |        |           |       |  | Exercise |      |       |  |        |           | Exercise |  |  |      |  |  | Exercise
|                                |  | Shares |           | Price |  | Shares   |      | Price |  | Shares |           | Price   
|                                |  |        |           |       |  |          |      |       |  |        |           |         
|Outstanding at end of year      |  |        | 2,196,418 |       |  |          | 4.42 |       |  |        | 2,097,943 |          |  |  | 5.07 |  |  |          | 2,576,354 |  |  |  | 5.07 | 
|                                |  |        |           |       |  |          |      |       |  |        |           |          |  |  |      |  |  |          |           |  |  |  |      | 
|Options exercisable at year-end |  |        | 1,496,763 |       |  |          | 5.51 |       |  |        | 1,386,321 |          |  |  | 5.94 |  |  |          | 1,877,559 |  |  |  | 5.25 | 
|                                |  |        |           |       |  |          |      |       |  |        |           |          |  |  |      |  |  |          |           |  |  |  |      | 

The weighted-average grant-date fair value of options granted during the
years ended July 31, 2002, 2001 and 2000 was $375,000, $606,000
and $722,000,
respectively

The following table summarizes information regarding stock options
outstanding as of July 31, 2002:

|                    |             |                     |             |                  |          |          |          |               |             |          |          |      |  |  |         |           |  |   |      |      | 
|------------------- | ----------- | ------------------- | ----------- | ---------------- | -------- | -------- | -------- | ------------- | ----------- | -------- | -------- | ---- |  |  | ------- | --------- |  | - | ---- | ---- | 
|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, 2002       |             | Contractual Life |          | Price    |          | July 31, 2002 |             | Price   
|                    |             |                     |             |                  |          |          |          |               |             |         
|$0.76  3.00        |             |                     | 713,378     |                  |          |          | 8.4      |               |             | $        | 2.00     |      |  |  | 141,720 |           |  | $ | 2.54 |     
|                   
|                   
|                   
|                   
|                    | 3.01  4.50 |                     |             | 544,954          |          |          |          | 5.3           |             |          |          | 3.17 |  |  |         | 416,957   |  |   |      | 3.20 | 
|                   
|                   
|                   
|                   
|                    | 4.51  6.00 |                     |             | 388,877          |          |          |          | 3.5           |             |          |          | 5.57 |  |  |         | 388,877   |  |   |      | 5.57 | 
|                   
|                   
|                   
|                   
|                    | 6.01  8.00 |                     |             | 354,209          |          |          |          | 4.2           |             |          |          | 6.95 |  |  |         | 354,209   |  |   |      | 6.95 | 
|                   
|                   
|                   
|                   
|                    | 8.01  9.92 |                     |             | 195,000          |          |          |          | 5.1           |             |          |          | 9.88 |  |  |         | 195,000   |  |   |      | 9.88 | 
|                    |             |                     |             |                  |          |          |          |               |             |          |          |      |  |  |         |           |  |   |      |     
|                    | Total       |                     |             | 2,196,418        |          |          |          | 5.8           |             |          |          | 4.42 |  |  |         | 1,496,763 |  |   |      | 5.51 | 
|                    |             |                     |             |                  |          |          |          |               |             |          |          |      |  |  |         |           |  |   |      |     

The Company applies APB Opinion No. 25 and related interpretations in
accounting for its stock-based employee compensation plans and the directors
stock option plan. Accordingly, no compensation cost has been recognized for
stock-based employee and director 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 income (loss) attributable to common
shareholders and income (loss) per share attributable to common shareholders
for the years ended July 31, 2002, 2001 and 2000 would have been increased
or reduced to the pro forma amounts indicated below, followed by the model
assumptions used:

|                                                                                     |                          |  |          |             |      |  |      |            |   |  |   |           |  
|------------------------------------------------------------------------------------ | ------------------------ |  | -------- | ----------- | ---- |  | ---- | ---------- | - |  | - | --------- | -
|                                                                                     |                          |  | July 31,
|                                                                                     |                          |  |         
|                                                                                     |                          |  | 2002     |             | 2001 |  | 2000
|                                                                                     |                          |  |          |             |      |  |     
|Net income (loss) attributable
to common shareholders:                               |                          |  |          |             |      |  |      |            |   |  |   |          
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | As reported              |  | $        | (12,069,000 | )    |  | $    | (6,390,000 | ) |  | $ | 3,344,000 |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Pro forma                |  | $        | (12,444,000 | )    |  | $    | (6,996,000 | ) |  | $ | 2,622,000 |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Net income (loss) attributable
to common shareholders per
basic share outstanding:   |                          |  |          |             |      |  |      |            |   |  |   |          
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | As reported              |  | $        | (.27        | )    |  | $    | (.15       | ) |  | $ | .08       |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Pro forma                |  | $        | (.28        | )    |  | $    | (.16       | ) |  | $ | .06       |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Net income (loss) attributable
to common shareholders per
diluted share outstanding: |                          |  |          |             |      |  |      |            |   |  |   |          
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | As reported              |  | $        | (.27        | )    |  | $    | (.15       | ) |  | $ | .08       |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Pro forma                |  | $        | (.28        | )    |  | $    | (.16       | ) |  | $ | .06       |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Black-Scholes model assumptions:                                                     |                          |  |          |             |      |  |      |            |   |  |   |          
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Risk-free interest rate  |  |          | 2.62        | %    |  |      | 4.8        | % |  |   | 5.3       | %
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Expected volatility      |  |          | 72          | %    |  |      | 74         | % |  |   | 78        | %
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Expected term (in years) |  |          | 7.10        |      |  |      | 9.3        |   |  |   | 8.5       |  
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                     | Dividend yield           |  |          | 0           | %    |  |      | 0          | % |  |   | 0         | %

F-17



---



##### Table of Contents



b.     Warrants The Company has issued warrants to various investors,
shareholders and other third parties in connection with services provided. If and when warrants are issued, they will be valued
using a Black Scholes model and charged to expense. Warrants issued in
exchange for goods or services are expensed at the fair value of the
consideration received. During the years ended July 31, 2002, 2001, and 2000
warrants were issued for goods or services valued at $0, $30,000 and $30,000
respectively and are included as a component of selling, general and
administrative expenses. Activity related to such warrants, which expire at
various dates through September 2005, is summarized as follows:

|                           |           |  |           |          |               |   |            |            | 
|-------------------------- | --------- |  | --------- | -------- | ------------- | - | ---------- | ---------- | 
|                           |           |  | Number of |          | Warrant Price
|                           |           |  | Shares    |          | Per Share    
|                           |           |  |           |          |              
|Outstanding, July 31, 1999 |           |  | 1,107,431 |          |               | $ | 3.00-9.915 |           
|                          
|                          
|                          
|                          
|                           | Exercised |  |           | (49,074  | )             |   |            | 3.00       | 
|                          
|                          
|                          
|                          
|                           | Issued    |  |           | 10,000   |               |   |            | 4.90       | 
|                           |           |  |           |          |               |   |            |           
|Outstanding, July 31, 2000 |           |  | 1,068,357 |          |               | $ | 3.00-9.915 |           
|                          
|                          
|                          
|                          
|                           | Issued    |  |           | 15,000   |               |   |            | 4.00-5.00  | 
|                          
|                          
|                          
|                          
|                           | Exercised |  |           | (149,870 | )             |   |            | 3.00       | 
|                          
|                          
|                          
|                          
|                           | Expired   |  |           | (908,487 | )             |   |            | 3.00-9.915 | 
|                           |           |  |           |          |               |   |            |           
|Outstanding, July 31, 2001 |           |  | 25,000    |          |               | $ | 4.00-5.00  |           
|                          
|                          
|                          
|                          
|No activity                |           |  |           |          |               |   |            |           
|                          
|                          
|                          
|                          
|Outstanding July 31, 2002  |           |  | 25,000    |          |               | $ | 4.00-5.00  |           
|                           |           |  |           |          |               |   |            |           

The
Company entered into an agreement with a financial advisor during
fiscal 2002 to perform consulting services. Under the agreement, the
Company is committed to issue warrants to purchase 30,000 shares of
its common stock for $4.00 per share. At July 31, 2002, $28,000
is included in accrued liabilities representing the fair value of the
warrants expected to be issued.

c.     Stock Purchase Plan During fiscal year 2001, the Company established
the Zila, Inc. Employee Stock Purchase Plan whereby the Company is authorized,
as of July 31, 2001, to issue up to 2 million shares of common stock to its
employees, nearly all of whom are eligible to participate. Eligible employees
may have up to 15% of eligible compensation deducted from their pay and applied
to the purchase of shares of common stock. The price the employee must pay for
each share of stock will be 85% of the lower of the fair market value of the
common stock at the beginning or the end of the purchase term. As of July 31,
2002, 25,010 shares were sold to employees. The plan is considered
non-compensatory under APB Opinion No. 25.

10. Income Taxes

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

|                                                  |         |   |           |           |      |   |          |          |   |   |           |           | 
|------------------------------------------------- | ------- | - | --------- | --------- | ---- | - | -------- | -------- | - | - | --------- | --------- | 
|                                                  |         |   | 2002      |           | 2001 |   | 2000    
|                                                  |         |   |           |           |      |   |         
|Current:                                          |         |   |           |           |      |   |          |          |   |   |           |          
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Federal |   | $         | (280,000  | )    |   |          |          |   |   | $         | 154,000   | 
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | State   |   |           | 17,000    |      |   |          |          |   |   |           | 60,000    | 
|                                                  |         |   |           |           |      |   |          |          |   |   |           |          
|Total current                                     |         |   | (263,000  | )         |      |   |          |          |   |   | 214,000   |          
|                                                  |         |   |           |           |      |   |          |          |   |   |           |          
|Deferred:                                         |         |   |           |           |      |   |          |          |   |   |           |          
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Federal |   |           | 3,648,000 |      |   | $        | (314,000 | ) |   |           | 1,479,000 | 
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | State   |   |           | 569,000   |      |   |          | (65,000  | ) |   |           | 218,000   | 
|                                                  |         |   |           |           |      |   |          |          |   |   |           |          
|Total deferred                                    |         |   | 4,217,000 |           |      |   | (379,000 | )        |   |   | 1,697,000 |          
|                                                  |         |   |           |           |      |   |          |          |   |   |           |          
|Total consolidated income
tax (benefit) provision |         | $ | 3,954,000 |           |      | $ | (379,000 | )        |   | $ | 1,911,000 |          
|                                                  |         |   |           |           |      |   |          |          |   |   |           |          

F-18



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##### Table of Contents



A reconciliation of the federal statutory rate to the effective income tax
rate for the years ended July 31 is as follows:

|                       |                                                   |  |      |    |      |  |      |    |    |  |    |     |  
|---------------------- | ------------------------------------------------- |  | ---- | -- | ---- |  | ---- | -- | -- |  | -- | --- | -
|                       |                                                   |  | 2002 |    | 2001 |  | 2000
|                       |                                                   |  |      |    |      |  |     
|Federal statutory rate |                                                   |  | (34  | %) |      |  | (34  | )% |    |  | 34 | %  
|                      
|                      
|                      
|                      
|Adjustments:           |                                                   |  |      |    |      |  |      |    |    |  |    |    
|                      
|                      
|                      
|                      
|                       | State income taxes  net of federal tax effects   |  |      | (5 | )    |  |      | (1 | )  |  |    | 9   |  
|                      
|                      
|                      
|                      
|                       | Effect of foreign tax rates                       |  |      |    |      |  |      | 1  |    |  |    | 2   |  
|                      
|                      
|                      
|                      
|                       | Non-deductible meal and entertainment expenses    |  |      | 1  |      |  |      | 1  |    |  |    | 1   |  
|                      
|                      
|                      
|                      
|                       | Non-deductible intangible amortization            |  |      | 6  |      |  |      | 7  |    |  |    | 8   |  
|                      
|                      
|                      
|                      
|                       | Non-deductible goodwill related to sale of assets |  |      |    |      |  |      |    |    |  |    | 13  |  
|                      
|                      
|                      
|                      
|                       | Increase (decrease) in valuation allowance        |  |      | 86 |      |  |      | 20 |    |  |    | (29 | )
|                       |                                                   |  |      |    |      |  |      |    |    |  |    |    
|                       | Effective tax rate                                |  |      | 54 | %    |  |      | (6 | %) |  |    | 38  | %
|                       |                                                   |  |      |    |      |  |      |    |    |  |    |    

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

|                                 |                                                  |   |            |           |      |   |            |           |  |   |           |           |  
|-------------------------------- | ------------------------------------------------ | - | ---------- | --------- | ---- | - | ---------- | --------- |  | - | --------- | --------- | -
|                                 |                                                  |   | 2002       |           | 2001 |   | 2000      
|                                 |                                                  |   |            |           |      |   |           
|Deferred income tax assets:      |                                                  |   |            |           |      |   |            |           |  |   |           |          
|                                
|                                
|                                
|                                
|                                 | Net operating loss carry forwards                |   | $          | 8,257,000 |      |   | $          | 5,563,000 |  |   | $         | 3,767,000 |  
|                                
|                                
|                                
|                                
|                                 | Allowance for obsolete or discontinued
inventory |   |            | 112,000   |      |   |            | 74,000    |  |   |           | 59,000    |  
|                                
|                                
|                                
|                                
|                                 | Alternative minimum tax credit                   |   |            | 154,000   |      |   |            | 154,000   |  |   |           | 154,000   |  
|                                
|                                
|                                
|                                
|                                 | Book
basis versus tax basis differences          |   |            | 447,000   |      |   |            | 274,000   |  |   |           | (12,000   | )
|                                
|                                
|                                
|                                
|                                 | Reserve for litigation                           |   |            |           |      |   |            | 40,000    |  |   |           | 16,000    |  
|                                
|                                
|                                
|                                
|                                 | Allowance for doubtful accounts                  |   |            | 104,000   |      |   |            | 123,000   |  |   |           | 136,000   |  
|                                
|                                
|                                
|                                
|                                 | Accrued vacation                                 |   |            | 20,000    |      |   |            | 143,000   |  |   |           | 93,000    |  
|                                
|                                
|                                
|                                
|                                 | Deferred revenue                                 |   |            | 8,000     |      |   |            | 3,000     |  |   |           |           |  
|                                
|                                
|                                
|                                
|                                 | Severance cost                                   |   |            |           |      |   |            | 48,000    |  |   |           | 131,000   |  
|                                
|                                
|                                
|                                
|                                 | Accrued bonus                                    |   |            |           |      |   |            |           |  |   |           | 264,000   |  
|                                
|                                
|                                
|                                
|                                 | Other                                            |   |            |           |      |   |            | 165,000   |  |   |           | 171,000   |  
|                                 |                                                  |   |            |           |      |   |            |           |  |   |           |          
|Total deferred income tax assets |                                                  |   | 9,102,000  |           |      |   | 6,587,000  |           |  |   | 4,779,000 |          
|                                
|                                
|                                
|                                
|Valuation allowance              |                                                  |   | (9,102,000 | )         |      |   | (2,370,000 | )         |  |   | (948,000  | )        
|                                 |                                                  |   |            |           |      |   |            |           |  |   |           |          
|Net deferred income tax assets   |                                                  | $ | 0          |           |      | $ | 4,217,000  |           |  | $ | 3,831,000 |          
|                                 |                                                  |   |            |           |      |   |            |           |  |   |           |          

Deferred income taxes reflect the tax effect of temporary differences
between the amounts of assets and liabilities recognized for financial
reporting and tax purposes. The Company has offset its net deferred tax assets
with a valuation allowance due to a lack of earnings history.

The Company regularly reviews its deferred tax assets and related
valuation reserves in accordance with SFAS No. 109, Accounting for Income
Taxes (SFAS No. 109). SFAS No. 109 requires an assessment of all available
evidence, both positive and negative, to determine whether a valuation
allowance is needed. During fiscal year 2000, the Company sold two of its
under performing operating units that had historically created much of the
annual taxable losses. The taxable gain generated by the transactions allowed
the Company to utilize a large portion of previously existing net operating
loss carryforwards. This evidence, resulted in the reversal of $2,912,000 in
valuation allowance during the fiscal year ended July 31, 2000, because it was
determined more likely than not the majority of the remaining deferred tax
assets would be utilized.

During fiscal year 2001, after consideration of available positive and
negative evidence, the Company recorded $1,808,000 in deferred tax assets
offset by an increase in the deferred valuation allowance of $1,422,000, which
resulted in a net income tax benefit of $386,000. The increase in the
valuation allowance was primarily due to the operating losses, which had
occurred during the year.

F-19



---



##### Table of Contents



During fiscal year 2002, the Company lost $7,384,000 from continuing
operations, which significantly exceeded amounts and resulted in a three-year
cumulative loss position. As a result of this negative evidence, the Company
determined that it was more likely than not that certain future tax benefits
will not be realized. Accordingly, the valuation allowance was increased to an
amount, which reduced the net deferred tax assets to $0 as of July 31, 2002.
During fiscal 2002, the Company recorded a tax benefit of $280,000 related to
the filing of amended federal income tax returns during the third quarter of
fiscal 2002. The amended returns were filed pursuant to section 102 of the Job
Creation and Worker Assistance Act of 2002, which extended the use of NOL
carrybacks over five years instead of three.

At July 31, 2002, federal net operating loss carryforwards totaled
approximately $21,225,000 and expire, if not utilized, from 2007 through 2022.
Net operating loss carryforwards for state income tax purposes, totaling
approximately $6,788,000, must be utilized within five years of the date of
their origination, and expire from 2003 through 2007.

The comprehensive losses in fiscal years 2002, and the comprehensive income for fiscal year 2001 of
$79,000 and fiscal year 2000 of $72,000, respectively, were recorded net of $0 income tax benefit or expense due to the
recording of valuation allowances by the Company.

11. Convertible Preferred Stock

On February 1, 2001, the Company issued 100,000 shares of Series B
convertible preferred stock to National Healthcare Manufacturing Corporation,
U.S. as part of the acquisition discussed in Note 2. The preferred stock is
convertible into shares of common stock at any time at a conversion ratio of
one to one. The holders of the preferred stock are entitled to receive
cumulative quarterly dividends at a rate of $0.0975 per share per fiscal
quarter, payable in arrears. Holders of the preferred shares have no voting
rights except as required by applicable law. The Company paid dividends of
$29,000 during 2002. Accumulated accrued dividends are $29,500 as of July 31,
2002. No dividends were paid in 2001.

12. Treasury Stock

During the quarter ended January 31, 2000, the Company began acquiring
shares of its common stock in conjunction with a stock repurchase program
announced in November 1999. The program authorized the repurchase of up to one
million shares of Zila common stock from time to time on the open market
depending on market conditions and other factors. As of July 31, 2002, the
Company had purchased 195,000 shares of common stock at an aggregate cost of
$535,120.

13. Commitments and Contingencies

FDA approval of the OraTest® product

The Company is pursuing FDA approval of a New Drug Application (NDA) for
its OraTest® products. The initiation of the marketing of the OraTest® products
in the United States is dependent upon the approval of the NDA by the FDA.
During 1994, the FDA approved its 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. In
November 1998, the FDA notified the Company that the OraTest® NDA was being
given priority review, which targeted agency review within six months from
September 3, 1998, the date when the Company provided additional data to the
FDA. On January 13, 1999, the FDAs Oncologic Drugs Advisory Committee (the
Committee) met to review the OraTest® NDA and recommended, among other
things, that the FDA not approve the NDA as submitted. Subsequent to the
Committee meeting, the Companys representatives engaged in a dialog with the
FDA, culminating in meetings at the agency in 1999 and 2000.

On March 3, 1999, the Company received an action letter from the FDA
outlining certain deficiencies in the OraTest® NDA that prevented the FDA from
approving the product at that time. The FDAs letter detailed a procedure for
amending the NDA to rectify those matters. In November 1999, the Company
contracted with ILEX Oncology Services, Inc. (ILEX), a wholly-owned
subsidiary of ILEX Oncology, Inc. of San Antonio, Texas, for management of
clinical research and liaison with the FDA related to the Companys pursuit of
regulatory approval for the OraTest® oral cancer detection product. In March
2000, the Company paid approximately $792,000 to ILEX as a deposit on estimated
expenses related to an FDA-required Phase III clinical

F-20



---



##### Table of Contents



study associated with the Companys ongoing efforts to obtain FDA approval of
OraTest®. Current commitments under the ILEX agreement include a monthly
installment payment of $76,000 plus reimbursement for out of pocket expenses as
they occur during the course of the study.

During the third quarter of 2002, the Company determined that completion
of the OraTest® Phase III clinical trial will require a substantial number of
additional patients and has been evaluating the number of patients required to
complete the study. The requirement for the larger number of patients is
related to the tumor formation rate within the study population and not to the
efficacy of the OraTest® product. Factors that affect the cost and timing of
completion of these milestone dates include but are not limited to: (i) patient
enrollment rates, (ii) tumor formation rate within the study population (iii)
compliance with the study protocol and related monitoring, (iv) level of
funding throughout the study, and (v) protocol modifications.

The Company has decided to transition the clinical trial from ILEX to a
new global contract research organization (CRO). The Company requested
proposals from several of the largest, highest quality and most prominent CROs
with worldwide capabilities, and received fee quotations back from each. The
Company is currently in the process of finalizing its selection of the new
global CRO. Each CRO agreed that the current study could be transitioned
successfully without compromising any of the current study data.

In order to support the larger number of patients needed to complete the
study, the Company intends to increase the rate of funding for the study and
the number of clinical sites, with the aid of a larger, more experienced CRO
with access to clinical sites in high-density oral cancer regions around the
world. This effort is currently underway and the Company believes that it will
have sufficient funds for the clinical trial for the next fiscal year. The
Company will, however, require additional financing to support the OraTest®
clinical trial, regulatory, manufacturing and marketing costs extending beyond
fiscal year 2003. The Company is currently considering possible financing
sources such as strategic partners and are pursuing funding strategies that, if
completed, would provide significant funding for the clinical trial. The
Company is also considering the possible liquidation of certain Zila assets
outside the Companys areas of core competency strength as part of Zilas new
focus on core strengths and objectives. These assets could also provide
significant funding for the clinical trial. There is no assurance that such
funds will be available on terms acceptable to the Company.

Litigation

Zila and certain of its officers were named as defendants in a
consolidated First Amended Class Action Complaint filed July 6, 1999 in the
United States District Court for the District of Arizona under the caption In
re Zila Securities Litigation, No. CIV 99 0115 PHX EHC. The First Amended Class
Action Complaint sought damages in an unspecified amount on behalf of a class
consisting of purchasers of its securities for alleged violations of the
federal securities laws. During the fourth quarter 2001, the parties settled
this matter without a material impact on the Companys financial statements.

On December 19, 2001, Zila and Joseph Hines, its former President, reached
a settlement with the Securities and Exchange Commission (the Commission)
relating to certain public statements made by the Company in January 1999 with
respect to the prospects for approval by the FDA of the OraTest® product.

Pursuant to the settlement, the Commission made findings related to an
unsigned draft report that had been prepared by the FDA staff and delivered to
the Company on or about December 28, 1998. The unsigned draft report
recommended against approval of the OraTest® product. The Commission found
that, in public statements made by the Company during the two-week period
subsequent to its receipt of the unsigned draft report and prior to an FDA
advisory committee meeting that was held on January 13, 1999, the Company and
Mr. Hines should have disclosed the receipt of the unsigned draft report. The
Commission acknowledged the Companys position that, at the time, it was
represented by experienced FDA counsel who had advised the Company that its
OraTest® NDA was approvable, but the Commission concluded that the receipt of
the unsigned draft report should have been disclosed in the Companys public
statements, and that the failure to do so constituted a violation of Section
10(b) of the Securities Exchange Act of 1934 (the Act) and Rule 10b-5
thereunder.

In order to resolve the matter, the Company and Mr. Hines submitted Offers
of Settlement, which the Commission accepted. Without admitting or denying the
Commissions findings, the Company and Mr. Hines consented to the entry of an
Order Instituting Public Administrative Proceedings pursuant to Section 21C of
the Act and the issuance of a Cease-and-Desist Order prohibiting future
violations of such Section and Rule. Mr. Hines is a director, but is no longer
an officer of Zila.

In connection with the acquisition of patent rights in 1980, the Company
agreed to pay to Dr. James E. Tinnell (Tinnell), the inventor of one of the
Companys treatment compositions, a royalty of 5% of gross sales of the
invention disclosed

F-21



---



##### Table of Contents



in his then pending patent application. Royalty expense to Tinnell for the
years ended July 31, 2002, 2001 and 2000 was $0, $38,000 and $449,916,
respectively.

In September 2000, counsel advised the Company that its obligation to pay
royalties to Tinnell under the 1980 agreement ceased as of August 25, 1998 when
the patents on the invention expired. In September 2000, the Company gave
notice to Tinnell that the Company would not continue paying such royalties and
requested reimbursement of royalties paid since August 1998. After attempts to
settle the matter failed, the Company filed suit in the Federal District Court
for the District of Nevada (Zila, Inc. v. James E. Tinnell, No. CV-S-00-1344),
requesting a declaratory judgment that it had no royalty obligations to Tinnell
after August 1998 and judgment for the overpaid royalties.

Tinnell asserted a counterclaim for royalties since the last payment in
August 2000 and several additional counterclaims based on transactions between
Tinnell and Zila in the 1980s. Counsel has advised the Company that, based on
their investigations and discovery to date, (i) the counterclaim for royalties
is without merit and (ii) the additional counterclaims are meritless and, in
any event, are time-barred by the applicable statutes of limitation. Both Zila
and Tinnell have filed motions for summary judgment which have been
denied. The Company currently intends to complete pretrial procedures
and proceed to trial.

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
Companys financial position or results of operations.

Saw Palmetto

The Company was obligated to process additional saw palmetto berries into
oil. As of July 31, 2002, all obligations under the processing agreement have
been met and there are no further obligations to purchase berries or process
berries into oil. The Companys current intention is to sell the remaining
inventory of saw palmetto products in the normal course of business. However,
the Company has been contacted by several companies interested in purchasing
saw palmetto inventory in bulk. None of the terms discused were acceptable to
the Company. While the Company has not made such a decision, if all or a
substantial portion of the inventory is sold in bulk rather than in the normal
course, the ultimate sales price may be substantially less than the current
carrying value of the inventory.

OraTest® Inventory

The Company has approximately $446,000 of Zila® Tolonium Chloride powder,
the active ingredient in the OraTest® product, in inventory at its
manufacturing facility in Phoenix, AZ. The Company intends to realize the
value of this inventory through sales in the United States, once final approval
for the OraTest® products is received from the FDA, and in Europe and Asia,
after utilizing approximately $148,000 of OraTest® finished product located in
the United Kingdom, prior to the date we expect sales in the United States. The
powder inventory currently has expiration dates in 2003 and 2004, which is
prior to the date we expect sales in the United States. Previous testing
indicates that the powder product is stable and the Company expects to be able
to extend the expiration dates of the entire powder inventory through the date
of expected sales in the United States. However, no assurance can be given
that such future testing efforts will be successful. In addition, should FDA
approval not be granted or be significantly delayed, it may not be possible to
recover the value of this powder inventory.

Daleco Capital Corporation

In June 1992, Daleco Capital
Corporation formed a limited partnership known as Daleco Zila Partners II,
L.P. (the Partnership). Zila 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 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, 2002, 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 products, until such time
as three times the amount of funds expended on the marketing program by the
Partnership has been paid to the Partnership. The Company has paid commissions
to the Partnership of approximately $11,000, $15,000 and $16,000 for the years
ended July 31, 2002, 2001 and 2000, respectively.

F-22



---



##### Table of Contents



Operating Leases

The Company lease offices, warehouse facilities and certain equipment,
under operating leases that expire through 2008. Future minimum lease payments
under these non-cancelable leases are as follows:

|                |  |   |           | 
|--------------- |  | - | --------- | 
|2003            |  | $ | 398,924   | 
|               
|               
|               
|               
|2004            |  |   | 398,312   | 
|               
|               
|               
|               
|2005            |  |   | 254,184   | 
|               
|               
|               
|               
|2006            |  |   | 111,926   | 
|               
|               
|               
|               
|2007            |  |   | 68,004    | 
|               
|               
|               
|               
|2008 and beyond |  |   | 34,002    | 
|                |  |   |           | 
|Total           |  | $ | 1,265,352 | 
|                |  |   |           | 

Rent expense for the years ended July 31, 2002, 2001 and 2000 totaled
$407,000, $475,000 and $353,000, respectively.

Contingent Warrants

In fiscal year 2002, the Company entered into a distribution agreement
with WMTO, an international distributor of healthcare products, to obtain
regulatory approval and to distribute the Vizilite and OraTest® products in
certain Asian countries and in other Pacific Rim countries. Pursuant to the
agreement, if WMTO meets certain purchasing milestones within defined time
periods, then the Company is obligated to issue warrants to WMTO to purchase up
to 600,000 shares of Zila common stock at $2.50 per share.

14. Related Party Transactions

In fiscal 2002, the Company paid $194,829 to Douglas, Curtis and Allyn,
LLC, (Douglas), a corporation owned by a member of the Companys Board of
Directors, Mr. Curtis Rocca. The payment was related to consulting work
performed in connection with the sale of the ZDS businesses and pursuant to an
engagement letter dated March 15, 2001 between Douglas and the Company. In
addition, Douglas was paid an advisory retainer of $60,000 during fiscal 2002.
The agreements were terminated in July 2002.

15. Employee Benefit Plan

The
Company makes available to all eligible
employees, the Zila, Inc. 401(k) Savings and Retirement Plan (the Zila Plan).
Participants may contribute, through payroll deductions, up to 15% of their
basic compensation not to exceed Internal Revenue Code limitations. The
Company may make matching or profit sharing contributions to the Zila Plan.
During 2002, 2001 and 2000, the Company contributed approximately $140,000,
$150,000 and $152,000, respectively, to the Zila Plan. Prior to fiscal year
2000, eligible Oxycal employees participated in a different 401(k) defined
contribution plan (the Oxycal Plan) whereby an employee could contribute up
to a certain maximum amount each year. Effective July 1, 1999, the Oxycal Plan
was merged into the Zila Plan.

16. Segment Information

The Company is organized into three major groups, all of which have
distinct product lines, brand names and are managed as autonomous business
units. The following reporting segments have been identified for purposes of
applying SFAS No. 131 Disclosures about Segments of an Enterprise and Related
Information":Consumerwhich includes Zila Pharmaceuticals, Inc. and the
Zilactin® line of products; Professionalwhich includes Peridex®, Pro-Ties,
OraTest®,and the IST line of products; and Nutraceuticals,which includes
Oxycal Laboratories, Inc. and its wholly-owned subsidiary, Inter-Cal, Inc. The
Company evaluates performance and allocates resources to segments based on
operating results. Expenses related to the manufacturing facility for Zila
Tolonium Chloride and ongoing OraTest® capital expenditures and clinical study
have been combined with the Corporate segment. The Dental Imaging and Dental
Software businesses, sold in fiscal year 2000, are combined into the Other
segment. Prior to August 1, 2000, the Consumer and Professional segment were
combined and shown as the Pharmaceutical segment. The

F-23



---



##### Table of Contents



Professional segment was removed from the Pharmaceutical segment as a result of
a change in management reporting structure. Previous segment disclosures have
been restated to reflect this presentation. The accounting policies
of the operating segments are the same as those described in
Note 1. Nature of Business Activities and Summary of Significant
Accounting Policies.



| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | The table below presents information about reported segments for each of
the three years ended July 31
(in thousands):

|                                                              |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |        |  
|------------------------------------------------------------- | ---- | -------- | - | ------------ |  | -------------- | - | --------- | - | ----- | - | ------ |  |  |  | ------ | - |  | - | ----- |  |  | - | ------ | -
|Net revenues from                                             |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |       
|continuing                                                    |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |       
|operations:                                                   |      | Consumer |   | Professional |  | Nutraceuticals |   | Corporate |   | Other |   | Total 
|                                                              |      |          |   |              |  |                |   |           |   |       |   |       
|                                                              | 2002 |          | $ | 9,603        |  |                | $ | 5,710     |   |       | $ | 19,559 |  |  |  |        |   |  |   |       |  |  | $ | 34,872 |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2001 |          |   | 10,898       |  |                |   | 4,439     |   |       |   | 15,374 |  |  |  |        |   |  |   |       |  |  |   | 30,711 |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2000 |          |   | 10,673       |  |                |   | 5,194     |   |       |   | 19,033 |  |  |  |        |   |  | $ | 1,708 |  |  |   | 36,608 |  
|                                                             
|                                                             
|                                                             
|                                                             
|Income (loss) from
continuing
operations before
income taxes: |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |       
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2002 |          |   | 2,181        |  |                |   | (3,558    | ) |       |   | 2,808  |  |  |  | (8,813 | ) |  |   |       |  |  |   | (7,384 | )
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2001 |          |   | 3,950        |  |                |   | (3,094    | ) |       |   | 1,173  |  |  |  | (8,677 | ) |  |   |       |  |  |   | (6,648 | )
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2000 |          |   | 4,047        |  |                |   | (2,839    | ) |       |   | 5,848  |  |  |  | (6,088 | ) |  |   | 4,121 |  |  |   | 5,089  |  
|                                                             
|                                                             
|                                                             
|                                                             
|Identifiable
assets from continuing operations:               |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |       
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2002 |          |   | 2,820        |  |                |   | 15,945    |   |       |   | 28,958 |  |  |  | 9,638  |   |  |   |       |  |  |   | 57,361 |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2001 |          |   | 3,197        |  |                |   | 13,209    |   |       |   | 33,769 |  |  |  | 13,395 |   |  |   |       |  |  |   | 63,570 |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2000 |          |   | 3,265        |  |                |   | 9,493     |   |       |   | 32,644 |  |  |  | 18,869 |   |  |   | 478   |  |  |   | 64,749 |  
|                                                             
|                                                             
|                                                             
|                                                             
|Capital expenditures:                                         |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |       
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2002 |          |   | 2            |  |                |   | 56        |   |       |   | 315    |  |  |  | 246    |   |  |   |       |  |  |   | 619    |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2001 |          |   | 42           |  |                |   | 101       |   |       |   | 2,108  |  |  |  | 73     |   |  |   |       |  |  |   | 2,324  |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2000 |          |   | 195          |  |                |   | 441       |   |       |   | 4,200  |  |  |  |        |   |  |   | 125   |  |  |   | 4,961  |  
|                                                             
|                                                             
|                                                             
|                                                             
|Depreciation and
amortization:                                |      |          |   |              |  |                |   |           |   |       |   |        |  |  |  |        |   |  |   |       |  |  |   |       
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2002 |          |   | 72           |  |                |   | 1,316     |   |       |   | 1,235  |  |  |  | 845    |   |  |   |       |  |  |   | 3,468  |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2001 |          |   | 78           |  |                |   | 1,063     |   |       |   | 1,160  |  |  |  | 874    |   |  |   |       |  |  |   | 3,175  |  
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | 2000 |          |   | 46           |  |                |   | 896       |   |       |   | 1,021  |  |  |  | 987    |   |  |   | 145   |  |  |   | 3,095  |  

Revenues from customers attributed to all foreign countries from which the
Company derives revenue were $6,039,000, $5,646,000, and $5,681,000 for the
years ended July 31, 2002, 2001 and 2000, respectively.

17. Quarterly Financial Data (unaudited)

Quarterly financial information is presented in the following summary:

|                                         |                                   |   |                |       |             |   |             |       |         |   |            |       |   |   |            |       |  
|---------------------------------------- | --------------------------------- | - | -------------- | ----- | ----------- | - | ----------- | ----- | ------- | - | ---------- | ----- | - | - | ---------- | ----- | -
|                                         |                                   |   | 2002          
|                                         |                                   |   |               
|                                         |                                   |   | Quarters Ended
|                                         |                                   |   |               
|                                         |                                   |   | October 31     |       | January 31  |   | April 30    |       | July 31
|                                         |                                   |   |                |       |             |   |             |       |        
|                                         |                                   |   | As restated    |       | As restated |   | As restated |       |         |   |           
|                                         |                                   |   | (Note 19)      |       | (Note 19)   |   | (Note 19)   |       |         |   |           
|Net revenues                             |                                   | $ | 8,889,874      |       |             | $ | 8,826,561   |       |         | $ | 8,352,520  |       |   | $ | 8,802,815  |      
|                                        
|                                        
|                                        
|                                        
|Gross profit                             |                                   |   | 5,775,295      |       |             |   | 5,619,701   |       |         |   | 5,304,600  |       |   |   | 5,708,092  |      
|                                        
|                                        
|                                        
|                                        
|Loss from continuing operations          |                                   |   | (919,980       | )     |             |   | (7,163,450  | )     |         |   | (1,834,518 | )     |   |   | (1,420,332 | )    
|                                        
|                                        
|                                        
|                                        
|(Loss) gain from discontinued operations |                                   |   | (7,248         | )     |             |   | 123,707     |       |         |   | (287,712   | )     |   |   | (500,751   | )    
|                                        
|                                        
|                                        
|                                        
|Net loss                                 |                                   | $ | (927,228       | )     |             | $ | (7,039,743  | )     |         | $ | (2,122,230 | )     |   | $ | (1,921,083 | )    
|                                        
|                                        
|                                        
|                                        
|Basic and diluted net loss per share:    |                                   |   |                |       |             |   |             |       |         |   |            |       |   |   |            |      
|                                        
|                                        
|                                        
|                                        
|                                         | Loss from continuing operations   |   | $              | (0.02 | )           |   | $           | (0.16 | )       |   | $          | (0.04 | ) |   | $          | (0.03 | )
|                                        
|                                        
|                                        
|                                        
|                                         | Loss from discontinued operations |   |                | (0.00 | )           |   |             | (0.00 | )       |   |            | (0.01 | ) |   |            | (0.01 | )
|                                         |                                   |   |                |       |             |   |             |       |         |   |            |       |   |   |            |      
|                                         | Net loss                          |   | $              | (0.02 | )           |   | $           | (0.16 | )       |   | $          | (0.05 | ) |   | $          | (0.04 | )
|                                         |                                   |   |                |       |             |   |             |       |         |   |            |       |   |   |            |      

F-24



---



##### Table of Contents



|                                               |                                            |   |                             |       |            |   |            |       |         |   |            |       |   |   |           |      | 
|---------------------------------------------- | ------------------------------------------ | - | --------------------------- | ----- | ---------- | - | ---------- | ----- | ------- | - | ---------- | ----- | - | - | --------- | ---- | 
|                                               |                                            |   | 2001 (as restated (Note 19)
|                                               |                                            |   |                            
|                                               |                                            |   | Quarters Ended             
|                                               |                                            |   |                            
|                                               |                                            |   | October 31                  |       | January 31 |   | April 30   |       | July 31
|                                               |                                            |   |                             |       |            |   |            |       |        
|Net revenues                                   |                                            | $ | 8,560,168                   |       |            | $ | 7,774,963  |       |         | $ | 5,477,893  |       |   | $ | 8,897,737 |     
|                                              
|                                              
|                                              
|                                              
|Gross profit                                   |                                            |   | 5,959,684                   |       |            |   | 5,131,512  |       |         |   | 3,487,529  |       |   |   | 5,858,503 |     
|                                              
|                                              
|                                              
|                                              
|Loss from continuing operations                |                                            |   | (102,973                    | )     |            |   | (1,955,469 | )     |         |   | (4,826,385 | )     |   |   | 622,855   |     
|                                              
|                                              
|                                              
|                                              
|Gain (loss) from discontinued operations       |                                            |   | 41,229                      |       |            |   | (6,656     | )     |         |   | (212,989   | )     |   |   | 49,895    |     
|                                              
|                                              
|                                              
|                                              
|Net (loss) income                              |                                            | $ | (61,744                     | )     |            | $ | (1,962,125 | )     |         | $ | (5,039,373 | )     |   | $ | 672,750   |     
|                                              
|                                              
|                                              
|                                              
|Basic and diluted net income (loss) per share: |                                            |   |                             |       |            |   |            |       |         |   |            |       |   |   |           |     
|                                              
|                                              
|                                              
|                                              
|                                               | Income (loss) from continuing operations   |   | $                           | (0.00 | )          |   | $          | (0.05 | )       |   | $          | (0.12 | ) |   | $         | 0.02 | 
|                                              
|                                              
|                                              
|                                              
|                                               | Income (loss) from discontinued operations |   |                             | (0.00 | )          |   |            | (0.00 | )       |   |            | (0.00 | ) |   |           | 0.00 | 
|                                               |                                            |   |                             |       |            |   |            |       |         |   |            |       |   |   |           |     
|                                               | Net income (loss)                          |   | $                           | (0.00 | )          |   | $          | (0.05 | )       |   | $          | (0.12 | ) |   | $         | 0.02 | 
|                                               |                                            |   |                             |       |            |   |            |       |         |   |            |       |   |   |           |     

18. Subsequent Events

Subsequent to July 31, 2002, the Company has incurred termination costs of
$695,000. These costs were not incurred pursuant to a restructuring plan.
Termination costs are accrued on the actual date of termination where the
employee does not have significant continuing employment obligations. These
costs will be recorded in the Companys first fiscal quarter ended October 31,
2002.

19. Restatement of Financial Statements

Subsequent
to the issuance of the Companys consolidated financial
statements for the year ended July 31, 2001 and each of the
quarterly periods ended July 31, 2002, management of the Company
determined that certain of its historical accounting practices were
not appropriate under accounting principles generally accepted in the
United States of America (GAAP), as discussed below.

| |   |  |                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |  | Since 1992, the Company had been capitalizing deferred
licensing costs related to the OraTest product, and amortizing these
costs over the life the OraTest patent. The Company has determined
that these costs should have expensed as incurred.                                                                                                                                                                            
|
| |  |  | During December 2002, The Company issued 375,000 shares of
restricted common stock with the value of $367,000 to Trylon in
payment for future research and development services, which was
capitalized. The Company has determined that because the shares would
not be returned to the Company under any circumstance, the amount
should have been recorded as research and development expense when
the shares were issued.
|
| |  |  | In January 2001, the Company entered in a perpetual licensing
agreement and recognized revenue of $483,000. The Company has
determined that because of its continuing involvement in the
generation of revenues under the licensing agreement, the revenue
should have been deferred and recognized recorded over the expected
economic life of the licensed agreement, approximately eight years.                           
|
| |  |  | The Company has determined that it had incorrectly amortized
acquired purchased technology rights over the incorrect estimated
useful lives.                                                                                                                                                                                                                                                                                 
|
| |  |  | During 1998 and 1999, the Company incurred severance
obligations of $1,626,000 related to the termination of various
employees, which were being expensed when paid. The Company has
determined that because the individuals involved did not have
substantive future performance obligation the costs should have been
expensed when incurred.                                                                              

As
a result, the accompanying financial statements for the fiscal years ended
July 31, 2001 and 2000 and the quarterly periods for the year
ended July 31, 2001 and the first, second and third quarters of
the year ended July 31, 2002 have been restated from the amounts
previously reported to correct the accounting for these transactions.

A summary of the effects of the restatement is as follows:

|                                                                 |  |                |            |               |  |           |            |                |  |   |            |  |  |   |            | 
|---------------------------------------------------------------- |  | -------------- | ---------- | ------------- |  | --------- | ---------- | -------------- |  | - | ---------- |  |  | - | ---------- | 
|For the years ended July 31,                                     |  | 2001           |            | 2000         
|                                                                 |  |                |            |              
|                                                                 |  | (As Previously |            |               |  |           |            | (As Previously |  |   |            | 
|                                                                 |  | Reported)      |            | (As Restated) |  | Reported) |            | (As Restated) 
|                                                                 |  |                |            |               |  |           |            |               
|Net revenues                                                     |  | $              | 31,118,971 |               |  | $         | 30,710,761 |                |  | $ | 36,608,273 |  |  | $ | 36,608,273 | 
|                                                                
|                                                                
|                                                                
|                                                                
|Selling, general and administrative                              |  |                | 20,196,611 |               |  |           | 19,989,598 |                |  |   | 21,630,166 |  |  |   | 21,025,613 | 
|                                                                
|                                                                
|                                                                
|                                                                
|Research and development                                         |  |                | 3,036,896  |               |  |           | 3,036,896  |                |  |   | 1,628,580  |  |  |   | 1,629,609  | 
|                                                                
|                                                                
|                                                                
|                                                                
|Depreciation and amortization                                    |  |                | 3,256,331  |               |  |           | 3,174,566  |                |  |   | 3,177,722  |  |  |   | 3,094,790  | 
|                                                                
|                                                                
|                                                                
|                                                                
|Interest income                                                  |  |                | 190,018    |               |  |           | 181,669    |                |  |   |            |  |  |   |            | 
|                                                                
|                                                                
|                                                                
|                                                                
|Net income (loss) from continuing
operations before income taxes |  |                | (6,520,303 | )             |  |           | (6,648,084 | )              |  |   | 4,402,091  |  |  |   | 5,088,546  | 

F-25



---



##### Table of Contents



|                                                      |  |                |            |               |  |           |            |                |  |   |            |   |  |   |            |  
|----------------------------------------------------- |  | -------------- | ---------- | ------------- |  | --------- | ---------- | -------------- |  | - | ---------- | - |  | - | ---------- | -
|For the years ended July 31,                          |  | 2001           |            | 2000         
|                                                      |  |                |            |              
|                                                      |  | (As Previously |            |               |  |           |            | (As Previously |  |   |            |  
|                                                      |  | Reported)      |            | (As Restated) |  | Reported) |            | (As Restated) 
|                                                      |  |                |            |               |  |           |            |               
|                                                     
|                                                     
|                                                     
|                                                     
|Income tax (expense) benefit                          |  |                | 335,000    |               |  |           | 386,112    |                |  |   | (1,745,605 | ) |  |   | (2,020,187 | )
|                                                     
|                                                     
|                                                     
|                                                     
|Net loss from continuing operations                   |  |                | (6,185,303 | )             |  |           | (6,261,972 | )              |  |   | 2,656,486  |   |  |   | 3,068,359  |  
|                                                     
|                                                     
|                                                     
|                                                     
|Net income (loss)                                     |  | $              | (6,313,823 | )             |  | $         | (6,390,492 | )              |  | $ | 2,932,027  |   |  | $ | 3,343,900  |  
|                                                     
|                                                     
|                                                     
|                                                     
|Basic and diluted net income (loss)
per common share: |  |                |            |               |  |           |            |                |  |   |            |   |  |   |            |  
|                                                     
|                                                     
|                                                     
|                                                     
|Income (loss) from continuing operations              |  | $              | (0.15      | )             |  | $         | (0.15      | )              |  | $ | 0.06       |   |  | $ | 0.07       |  
|                                                     
|                                                     
|                                                     
|                                                     
|Income (loss) from discontinued operations            |  |                | (0.00      | )             |  |           | (0.00      | )              |  |   | 0.01       |   |  |   | 0.01       |  
|                                                      |  |                |            |               |  |           |            |                |  |   |            |   |  |   |            |  
|Net income (loss)                                     |  | $              | (0.15      | )             |  | $         | (0.15      | )              |  | $ | 0.07       |   |  | $ | 0.08       |  
|                                                      |  |                |            |               |  |           |            |                |  |   |            |   |  |   |            |  

A summary of the effects of the restatement on Zilas Consolidated Balance
Sheets at July 31 is as follows:

|                                       |  |                |            |               |  |           |            |                |  |   |            |  |  |   |            | 
|-------------------------------------- |  | -------------- | ---------- | ------------- |  | --------- | ---------- | -------------- |  | - | ---------- |  |  | - | ---------- | 
|                                       |  | 2001           |            | 2000         
|                                       |  |                |            |              
|                                       |  | (As Previously |            |               |  |           |            | (As Previously |  |   |            | 
|                                       |  | Reported)      |            | (As Restated) |  | Reported) |            | (As Restated) 
|                                       |  |                |            |               |  |           |            |               
|Trade receivables                      |  | $              | 6,771,668  |               |  | $         | 6,663,319  |                |  | $ | 6,124,176  |  |  | $ | 6,124,176  | 
|                                      
|                                      
|                                      
|                                      
|Purchased technology rights-net        |  |                | 5,164,535  |               |  |           | 4,946,261  |                |  |   | 5,600,975  |  |  |   | 5,424,941  | 
|                                      
|                                      
|                                      
|                                      
|Trademarks and other intangible assets |  |                | 12,721,567 |               |  |           | 11,684,830 |                |  |   | 12,423,632 |  |  |   | 11,262,890 | 
|                                      
|                                      
|                                      
|                                      
|Other assets                           |  |                | 3,837,970  |               |  |           | 4,246,715  |                |  |   | 6,138,525  |  |  |   | 6,804,369  | 
|                                      
|                                      
|                                      
|                                      
|Accrued liabilities                    |  |                | 2,317,317  |               |  |           | 2,437,107  |                |  |   | 2,620,882  |  |  |   | 2,947,685  | 
|                                      
|                                      
|                                      
|                                      
|Accumulated deficit                    |  |                | 23,331,499 |               |  |           | 24,405,904 |                |  |   | 17,017,675 |  |  |   | 18,015,411 | 
|                                      
|                                      
|                                      
|                                      
|Total assets                           |  |                | 76,557,129 |               |  |           | 75,602,514 |                |  |   | 77,711,459 |  |  |   | 77,040,526 | 
|                                      
|                                      
|                                      
|                                      
|Total shareholders equity             |  |                | 56,720,605 |               |  |           | 55,646,200 |                |  |   | 62,111,838 |  |  |   | 61,114,103 | 

A summary of the effects of the restatement on Zilas Quarterly financial
information is as follows:

|                                         |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |       |  
|---------------------------------------- | --------------------------------- | - | ------------------------------ | ----- | ------------------------------ | - | --------- | ----- | -------------- | - | ---------- | ----- | - | - | ---------- | ----- | -
|                                         |                                   |   | Quarter ended October 31, 2001 |       | Quarter ended January 31, 2002
|                                         |                                   |   |                                |       |                               
|                                         |                                   |   | (As Previously                 |       |                                |   |           |       | (As Previously |   |            |       |  
|                                         |                                   |   | Reported)                      |       | (As Restated)                  |   | Reported) |       | (As Restated) 
|                                         |                                   |   |                                |       |                                |   |           |       |               
|Net revenues                             |                                   | $ | 8,889,874                      |       |                                | $ | 8,889,874 |       |                | $ | 8,764,062  |       |   | $ | 8,826,561  |      
|                                        
|                                        
|                                        
|                                        
|Gross profit                             |                                   |   | 5,775,295                      |       |                                |   | 5,775,295 |       |                |   | 5,710,514  |       |   |   | 5,619,701  |      
|                                        
|                                        
|                                        
|                                        
|Loss from continuing operations          |                                   |   | (998,616                       | )     |                                |   | (919,980  | )     |                |   | (6,097,555 | )     |   |   | (7,163,450 | )    
|                                        
|                                        
|                                        
|                                        
|(Loss) gain from discontinued operations |                                   |   | (7,248                         | )     |                                |   | (7,248    | )     |                |   | 123,707    |       |   |   | 123,707    |      
|                                        
|                                        
|                                        
|                                        
|Net loss                                 |                                   | $ | (991,368                       | )     |                                | $ | (927,228  | )     |                | $ | (5,973,848 | )     |   | $ | (7,039,743 | )    
|                                        
|                                        
|                                        
|                                        
|Basic and diluted net loss per share:    |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |      
|                                        
|                                        
|                                        
|                                        
|                                         | Loss from continuing operations   |   | $                              | (0.02 | )                              |   | $         | (0.02 | )              |   | $          | (0.13 | ) |   | $          | (0.16 | )
|                                        
|                                        
|                                        
|                                        
|                                         | Loss from discontinued operations |   |                                | 0.00  |                                |   |           | (0.00 | )              |   |            | 0.00  |   |   |            | 0.00  |  
|                                         |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |       |  
|                                         | Net loss                          |   | $                              | (0.02 | )                              |   | $         | (0.02 | )              |   | $          | (0.13 | ) |   | $          | (0.16 | )
|                                         |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |       |  

In addition accumulated deficit as of August 1, 1999 was
increased by $1,409,609.

F-26



---



##### Table of Contents



|                                      |                                   |   |                              |       |               |   |            |       |  
|------------------------------------- | --------------------------------- | - | ---------------------------- | ----- | ------------- | - | ---------- | ----- | -
|                                      |                                   |   | Quarter ended April 30, 2002
|                                      |                                   |   |                             
|                                      |                                   |   | (As Previously               |       |               |   |           
|                                      |                                   |   | Reported)                    |       | (As Restated)
|                                      |                                   |   |                              |       |              
|Loss from continuing operations       |                                   | $ | (1,952,467                   | )     |               | $ | (1,834,518 | )    
|                                     
|                                     
|                                     
|                                     
|(Loss) from discontinued operations   |                                   |   | (287,712                     | )     |               |   | (287,712   | )    
|                                     
|                                     
|                                     
|                                     
|Net loss                              |                                   | $ | (2,240,179                   | )     |               | $ | (2,122,230 | )    
|                                     
|                                     
|                                     
|                                     
|Basic and diluted net loss per share: |                                   |   |                              |       |               |   |            |      
|                                     
|                                     
|                                     
|                                     
|                                      | Loss from continuing operations   |   | $                            | (0.04 | )             |   | $          | (0.04 | )
|                                     
|                                     
|                                     
|                                     
|                                      | Loss from discontinued operations |   |                              | (0.01 | )             |   |            | (0.01 | )
|                                      |                                   |   |                              |       |               |   |            |       |  
|                                     
|                                     
|                                     
|                                     
|                                      | Net loss                          |   | $                            | (0.05 | )             |   | $          | (0.05 | )
|                                      |                                   |   |                              |       |               |   |            |       |  

|                                         |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |       |  
|---------------------------------------- | --------------------------------- | - | ------------------------------ | ----- | ------------------------------ | - | --------- | ----- | -------------- | - | ---------- | ----- | - | - | ---------- | ----- | -
|                                         |                                   |   | Quarter ended October 31, 2000 |       | Quarter ended January 31, 2001
|                                         |                                   |   |                                |       |                               
|                                         |                                   |   | (As Previously                 |       |                                |   |           |       | (As Previously |   |            |       |  
|                                         |                                   |   | Reported)                      |       | (As Restated)                  |   | Reported) |       | (As Restated) 
|                                         |                                   |   |                                |       |                                |   |           |       |               
|Net revenues                             |                                   | $ | 8,560,168                      |       |                                | $ | 8,560,168 |       |                | $ | 8,183,173  |       |   | $ | 7,774,963  |      
|                                        
|                                        
|                                        
|                                        
|Gross profit                             |                                   |   | 5,959,684                      |       |                                |   | 5,959,684 |       |                |   | 5,539,723  |       |   |   | 5,131,512  |      
|                                        
|                                        
|                                        
|                                        
|Loss from continuing operations          |                                   |   | (203,784                       | )     |                                |   | (102,973  | )     |                |   | (1,619,775 | )     |   |   | (1,955,469 | )    
|                                        
|                                        
|                                        
|                                        
|Gain (loss) from discontinued operations |                                   |   | 41,229                         |       |                                |   | 41,229    |       |                |   | (6,656     | )     |   |   | (6,656     | )    
|                                        
|                                        
|                                        
|                                        
|Net loss                                 |                                   | $ | (162,555                       | )     |                                | $ | (61,744   | )     |                | $ | (1,626,431 | )     |   | $ | (1,962,125 | )    
|                                        
|                                        
|                                        
|                                        
|Basic and diluted net loss per share:    |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |      
|                                        
|                                        
|                                        
|                                        
|                                         | Loss from continuing operations   |   | $                              | (0.00 | )                              |   | $         | (0.00 | )              |   | $          | (0.04 | ) |   | $          | (0.05 | )
|                                        
|                                        
|                                        
|                                        
|                                         | Loss from discontinued operations |   |                                | 0.00  |                                |   |           | 0.00  |                |   |            | 0.00  |   |   |            | (0.00 | )
|                                         |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |       |  
|                                        
|                                        
|                                        
|                                        
|                                         | Net loss                          |   | $                              | (0.00 | )                              |   | $         | (0.00 | )              |   | $          | (0.04 | ) |   | $          | (0.05 | )
|                                         |                                   |   |                                |       |                                |   |           |       |                |   |            |       |   |   |            |       |  

|                                               |                                            |   |                              |       |                             |   |            |       |                |   |         |      |  |   |         |      | 
|---------------------------------------------- | ------------------------------------------ | - | ---------------------------- | ----- | --------------------------- | - | ---------- | ----- | -------------- | - | ------- | ---- |  | - | ------- | ---- | 
|                                               |                                            |   | Quarter ended April 30, 2001 |       | Quarter ended July 31, 2001
|                                               |                                            |   |                              |       |                            
|                                               |                                            |   | (As Previously               |       |                             |   |            |       | (As Previously |   |         |      | 
|                                               |                                            |   | Reported)                    |       | (As Restated)               |   | Reported)  |       | (As Restated) 
|                                               |                                            |   |                              |       |                             |   |            |       |               
|Income (loss) from continuing operations       |                                            | $ | (4,879,970                   | )     |                             | $ | (4,826,385 | )     |                | $ | 518,227 |      |  | $ | 622,855 |     
|                                              
|                                              
|                                              
|                                              
|Income (loss) from discontinued operations     |                                            |   | (212,989                     | )     |                             |   | (212,989   | )     |                |   | 49,895  |      |  |   | 49,895  |     
|                                              
|                                              
|                                              
|                                              
|Net income (loss)                              |                                            | $ | (5,092,959                   | )     |                             | $ | (5,039,373 | )     |                | $ | 568,122 |      |  | $ | 672,750 |     
|                                              
|                                              
|                                              
|                                              
|Basic and diluted net income (loss) per share: |                                            |   |                              |       |                             |   |            |       |                |   |         |      |  |   |         |     
|                                              
|                                              
|                                              
|                                              
|                                               | Income (loss) from continuing operations   |   | $                            | (0.12 | )                           |   | $          | (0.12 | )              |   | $       | 0.01 |  |   | $       | 0.02 | 
|                                              
|                                              
|                                              
|                                              
|                                               | Income (loss) from discontinued operations |   |                              | (0.00 | )                           |   |            | (0.00 | )              |   |         | 0.00 |  |   |         | 0.00 | 
|                                               |                                            |   |                              |       |                             |   |            |       |                |   |         |      |  |   |         |      | 
|                                              
|                                              
|                                              
|                                              
|                                               | Net income (loss)                          |   | $                            | (0.12 | )                           |   | $          | (0.12 | )              |   | $       | 0.01 |  |   | $       | 0.02 | 
|                                               |                                            |   |                              |       |                             |   |            |       |                |   |         |      |  |   |         |      | 

F-27



---



##### Table of Contents



SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

|                                            |  |            |           |            |  |            |           |        |  |        |           |  |  |            |         |  |  |  |           | 
|------------------------------------------- |  | ---------- | --------- | ---------- |  | ---------- | --------- | ------ |  | ------ | --------- |  |  | ---------- | ------- |  |  |  | --------- | 
|                                            |  | Balance at |           | Charged to |  |            |           |        |  |        |           |  |  | Balance at
|                                            |  | Beginning  |           | Costs and  |  |            |           |        |  |        |           |  |  | End of    
|Description                                 |  | Of Period  |           | Expenses   |  | Deductions |           | Other* |  | Period
|                                            |  |            |           |            |  |            |           |        |  |       
|Allowance for
doubtful accounts
receivable: |  |            |           |            |  |            |           |        |  |        |           |  |  |            |         |  |  |  |           | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2000                               |  |            | 378,811   |            |  |            | 218,142   |        |  |        | 137,413   |  |  |            | 214,110 |  |  |  | 245,430   | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2001                               |  |            | 245,430   |            |  |            | 245,579   |        |  |        | 222,438   |  |  |            |         |  |  |  | 268,571   | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2002                               |  |            | 268,571   |            |  |            | 95,882    |        |  |        | 231,834   |  |  |            |         |  |  |  | 132,619   | 
|                                           
|                                           
|                                           
|                                           
|Inventory reserve:                          |  |            |           |            |  |            |           |        |  |        |           |  |  |            |         |  |  |  |           | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2000                               |  |            | 148,613   |            |  |            | 40,840    |        |  |        | 7,800     |  |  |            | 148,613 |  |  |  | 33,040    | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2001                               |  |            | 33,040    |            |  |            | 133,771   |        |  |        | 87,608    |  |  |            |         |  |  |  | 79,203    | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2002                               |  |            | 79,203    |            |  |            | 466,085   |        |  |        | 252,563   |  |  |            |         |  |  |  | 292,725   | 
|                                           
|                                           
|                                           
|                                           
|Deferred tax
valuation
allowance:           |  |            |           |            |  |            |           |        |  |        |           |  |  |            |         |  |  |  |           | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2000                               |  |            | 3,860,000 |            |  |            |           |        |  |        | 2,912,000 |  |  |            |         |  |  |  | 948,000   | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2001                               |  |            | 948,000   |            |  |            | 1,422,000 |        |  |        |           |  |  |            |         |  |  |  | 2,370,000 | 
|                                           
|                                           
|                                           
|                                           
|July 31, 2002                               |  |            | 2,370,000 |            |  |            | 9,247,000 |        |  |        | 2,515,000 |  |  |            |         |  |  |  | 9,102,000 | 



---

|* |  | Represent amounts from PracticeWorks and Cygnus both of which were sold in FY
2000.
|- |  | -----------------------------------------------------------------------------------

F-28



---



##### Table of Contents






Exhibit Index

|        |  |                                                                                                                                                                                                           |  |                 
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------
|Exhibit |  |                                                                                                                                                                                                           |  |                 
|Number  |  | Description                                                                                                                                                                                               |  | Method of Filing
|        |  |                                                                                                                                                                                                           |  |                 
|3-A     |  | Certificate of Incorporation, as amended                                                                                                                                                                  |  | A               
|       
|       
|       
|       
|3-B     |  | Amended and Restated Bylaws (as amended through September 26, 2002)                                                                                                                                       |  | *               
|       
|       
|       
|       
|3-C     |  | Certificate of Designations, Preferences and Rights of Series A
Convertible Preferred Stock                                                                                                               |  | C               
|       
|       
|       
|       
|3-D     |  | Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock                                                                                                               |  | L               
|       
|       
|       
|       
|4-A     |  | Specimen Stock Certificate                                                                                                                                                                                |  | A               
|       
|       
|       
|       
|10-A    |  | Revolving Line of Credit Loan Agreement dated February 1, 1999 between
Zila, Inc. and Bank One, Arizona                                                                                                   |  | A               
|       
|       
|       
|       
|10-B    |  | Stock Option Award Plan (as amended through April 10, 1991)                                                                                                                                               |  | B               
|       
|       
|       
|       
|10-C    |  | Non-Employee Directors Stock Option Plan (as amended through April 10, 1991)                                                                                                                              |  | B               
|       
|       
|       
|       
|10-L    |  | Asset Purchase Agreement dated October 28, 1999 between Zila, Inc., Cygnus
Imaging, Inc. and Procare Laboratories, Inc.                                                                                   |  | A               
|       
|       
|       
|       
|10-M    |  | Secured Note dated October 28, 1999 between Zila, Inc. and Procare Laboratories, Inc.                                                                                                                     |  | A               
|       
|       
|       
|       
|10-N    |  | Asset Purchase agreement dated as of November 30, 1999 by and among Zila, Inc.,
Integrated Dental Technologies, Inc., InfoCure Systems, Inc., and InfoCure Corporation                                    |  | E               
|       
|       
|       
|       
|10-O    |  | Revolving Line of Credit Loan Agreement dated December 1, 2000 between Zila, Inc.
and Bank One, Arizona, NA                                                                                               |  | H               
|       
|       
|       
|       
|10-P    |  | First Loan Modification Agreement dated May 7, 2001 between Zila, Inc.
and Bank One Arizona, NA                                                                                                           |  | H               
|       
|       
|       
|       
|10-Q    |  | Engagement Letter dated March 15, 2001 between Zila, Inc. and
Douglas, Curtis and Allyn, LLC                                                                                                              |  | H               
|       
|       
|       
|       
|10-R    |  | Extension to First Loan Modification Agreement dated effective May 31, 2001
between Zila, Inc. and Bank One Arizona, NA                                                                                   |  | H               
|       
|       
|       
|       
|10-S    |  | Second Extension to First Loan Modification Agreement dated effective June 29, 2001
between Zila, Inc. and Bank One Arizona, NA                                                                           |  | I               
|       
|       
|       
|       
|10-T    |  | Third Extension to First Loan Modification Agreement dated effective July 31, 2001
between Zila, Inc. and Bank One Arizona, NA                                                                            |  | J               
|       
|       
|       
|       
|10-U    |  | 1997 Stock Option Award Plan (as amended through September 13, 2001)                                                                                                                                      |  | G               
|       
|       
|       
|       
|10-V    |  | Employee Stock Purchase Plan                                                                                                                                                                              |  | F               
|       
|       
|       
|       
|10-W    |  | Loan and Security Agreement dated August 17, 2001 by and between Congress Financial
Corporation and Zila, Inc., Zila Pharmaceuticals, Inc. Ryker Dental of Kentucky, Inc. and
Inter-Cal Corporation, Inc. |  | K               
|       
|       
|       
|       
|10-X    |  | Asset Purchase Agreement, dated as of November 1, 2001, by and between Ryker Dental
of Kentucky, Inc. and Henry Schein, Inc.                                                                              |  | M               
|       
|       
|       
|       
|10-Y    |  | Amended and Restated Asset Purchase Agreement dated as of December 4, 2001 by
and among Zila, Inc., Ryker Dental of Kentucky, Inc. and PracticeWares, Inc                                                 |  | M               
|       
|       
|       
|       
|10-Z    |  | First Amendment to Engagement Letter dated as of June 6, 2002 between Zila, Inc.
and Douglas, Curtis & Allyn, LLC                                                                                         |  | N               
|       
|       
|       
|       
|10-Aa   |  | Fourth Extension and Modification Agreement dated as of June 6, 2002 between Ryker Dental
of Kentucky, Inc., PracticeWares, Inc. and PracticeWorks, Inc. and Gregory A. Jones                             |  | N               
|       
|       
|       
|       
|10-Ab   |  | First Amendment to Amended and Restated Asset Purchase Agreement dated as of
June 18, 2002 between Ryker Dental of Kentucky, Inc., PracticeWares, Inc. and Zila, Inc.                                     |  | N               
|       
|       
|       
|       
|10-Ac   |  | Stockholders Agreement dated as of June 18, 2002, among PracticeWorks, Inc.,
Gregory A. Jones, Ryker Dental of Kentucky, Inc. and PracticeWares, Inc.                                                     |  | N               
|       
|       
|       
|       
|21      |  | Subsidiaries of Registrant                                                                                                                                                                                |  | D               
|       
|       
|       
|       
|23      |  | Consent of Deloitte & Touche LLP (regarding Form S-8 and Form S-3
Registration Statements)                                                                                                                |  | O               
|       
|       
|       
|       
|24-A    |  | Power of Attorney of Bradley C. Anderson                                                                                                                                                                  |  | O               



---



##### Table of Contents



|        |  |                                                                         |  |                 
|------- |  | ----------------------------------------------------------------------- |  | ----------------
|Exhibit |  |                                                                         |  |                 
|Number  |  | Description                                                             |  | Method of Filing
|        |  |                                                                         |  |                 
|       
|       
|       
|       
|24-B    |  | Power of Attorney of Douglas D. Burkett                                 |  | *               
|       
|       
|       
|       
|24-C    |  | Power of Attorney of H. Richard Grisham                                 |  | *               
|       
|       
|       
|       
|24-D    |  | Power of Attorney of Joseph Hines                                       |  | *               
|       
|       
|       
|       
|24-E    |  | Power of Attorney of Christopher D. Johnson                             |  | *               
|       
|       
|       
|       
|24-F    |  | Power of Attorney of Michael S. Lesser                                  |  | *               
|       
|       
|       
|       
|24-G    |  | Power of Attorney of Curtis M. Rocca                                    |  | *               
|       
|       
|       
|       
|24-H    |  | Power of Attorney of Carl A. Schroeder                                  |  | *               
|       
|       
|       
|       
|24-I    |  | Power of Attorney of Kevin J. Tourek                                    |  | *               
|       
|       
|       
|       
|99.1    |  | Sarbanes-Oxley Section 906 Certification of the Chief Executive Officer |  | *               
|       
|       
|       
|       
|99.2    |  | Sarbanes-Oxley Section 906 Certification of the Chief Financial Officer |  | *               



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|* |  | Filed herewith                                                                                                                      
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|A |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 1999                           
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|B |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the quarterly period ended January 31, 1996, as amended
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|C |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 1997                           
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|D |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 1998                           
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|E |  | Incorporated by reference to the Companys Current Report on Form 8-K dated January 3, 2000                                         
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|F |  | Incorporated by reference to the Companys Form S-8 Registration Statement No. 333-54958 dated February 5, 2001                     
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|G |  | Incorporated by reference to the Companys Form S-8 Registration Statement No. 333-54960
dated February 5, 2001                     
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|H |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the quarterly period ended April 30, 2001              
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|I |  | Incorporated by reference to the Companys Current Report on Form 8-K dated June 29, 2001                                           
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|J |  | Incorporated by reference to the Companys Current Report on Form 8-K dated July 31, 2001                                           
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|K |  | Incorporated by reference to the Companys Current Report on Form 8-K dated August 17, 2001                                         
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|L |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal
year ended July 31, 2001.                          
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|M |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the quarterly period ended October 31, 2001            
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|N |  | Incorporated by reference to the Companys Current Report on Form 8-K dated June 18, 2002                                           
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|O |  | Incorporated by reference to the Companys Annual Report on Form 10-K for fiscal year ended July 31, 2002 located on signature page