##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549




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Form 10-K

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

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 or
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended July 31,
    2004                                                 
|          
|OR        
|          
|o          |  | 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                                                                                |  | 86-0619668                              
|(State or Other Jurisdiction of
    Incorporation or Organization)                      |  | (I.R.S. Employer
    Identification No.)
|                                                                                       
|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 þ          No o

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.     þ

Indicate
by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act
Rule 12b-2).     Yes þ          No o

At
January 31, 2004, the aggregate market value of common
stock held by non-affiliates of the registrant was $225,040,712.
At September 30, 2004, the number of shares of common stock
outstanding was 45,725,031.

DOCUMENTS INCORPORATED BY REFERENCE

Materials
from the Registrants 2004 Proxy Statement have been
incorporated by reference into Part III, Items 10,
11, 12, 13 and 14.



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TABLE OF CONTENTS

|              |          |  |                                                                                                                          |      |  |    | 
|------------- | -------- |  | ------------------------------------------------------------------------------------------------------------------------ | ---- |  | -- | 
|              |          |  |                                                                                                                          | Page
|              |          |  |                                                                                                                          |     
|PART I       
|              | Item 1.  |  | Business                                                                                                                 |      |  | 2  | 
|              | Item 2.  |  | Properties                                                                                                               |      |  | 22 | 
|              | Item 3.  |  | Legal Proceedings                                                                                                        |      |  | 23 | 
|              | Item 4.  |  | Submission of Matters to a
    Vote of Security Holders                                                                  |      |  | 23 | 
|PART II      
|              | Item 5.  |  | Market for the
    Registrants Common Equity, Related Stockholder Matters and
    Issuer Purchases of Equity Securities |      |  | 24 | 
|              | Item 6.  |  | Selected Financial Data                                                                                                  |      |  | 25 | 
|              | Item 7.  |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                                |      |  | 26 | 
|              | Item 7A. |  | Quantitative and Qualitative
    Disclosures                                                                             |      |  | 41 | 
|              | Item 8.  |  | Financial Statements and
    Supplementary Data                                                                          |      |  | 42 | 
|              | Item 9.  |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure                                 |      |  | 42 | 
|              | Item 9A. |  | Controls and Procedures                                                                                                  |      |  | 42 | 
|              | Item 9B. |  | Other Information                                                                                                        |      |  | 43 | 
|PART III     
|PART IV      
|              | Item 15. |  | Exhibits, Financial
    Statement Schedules                                                                              |      |  | 43 | 
|EX-10An      
|EXHIBIT 10.A0
|EXHIBIT 21   
|EXHIBIT 23   
|EXHIBIT 24.A 
|EXHIBIT 24.B 
|EXHIBIT 24.C 
|EXHIBIT 24.D 
|EXHIBIT 24.E 
|EXHIBIT 24.F 
|EXHIBIT 24.G 
|EXHIBIT 24.H 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 



1



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##### Table of Contents



This Annual Report on 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. These
statements relate to future events or our future financial
performance. We have attempted to identify forward-looking
statements by terminology including the words
anticipate, believe, can,
continue, could, estimate,
expect, intend, may,
plan, potential, predict,
should, will and other expressions that
are predictions of or indicate future events and trends and that
do not relate to historical matters. These statements are only
predictions and involve known and unknown risks, uncertainties,
and other factors. 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. Our actual results could
differ materially from those set forth in the forward-looking
statements.




PART I






|        |         
|------- | --------
|Item 1. | Business

Zila, Inc. is an innovator in preventive
healthcare technologies and products, focusing on enhanced body
defense and the detection of pre-disease states. In this report,
Zila, the Company, we,
us, or our refer to Zila, Inc. and its
wholly owned subsidiaries. Zila, Inc. is a holding company that
conducts its business operations through three Business Units:
Nutraceuticals, Pharmaceuticals and Biotechnology.

The Nutraceuticals Business Unit
(Nutraceuticals) manufactures and markets
Ester-C®, a patented, branded, highly effective form of
vitamin C sold in 46 countries worldwide, and
Ester-E®, a proprietary, branded, enhanced form of
vitamin E whose first commercial shipments commenced in May
2004. In fiscal 2004, the Nutraceuticals Business Unit completed
a strategic withdrawal from the Palmettx® line of botanical
products. The Nutraceuticals Business Unit includes Oxycal
Laboratories, Inc., an Arizona corporation (Oxycal),
and its subsidiary, Zila Nutraceuticals, Inc., also an Arizona
corporation.

The Pharmaceuticals Business Unit
(Pharmaceuticals) includes the ViziLite®
chemiluminescent disposable light product for the illumination
of oral mucosal abnormalities, Peridex® prescription mouth
rinse, the Zilactin® family of over-the-counter products
(OTC), and the plastic molded products of Zila Swab
Technologies, Inc., an Arizona corporation dba Innovative
Swab Technologies (IST). The Pharmaceuticals
Business Unit includes Zila Pharmaceuticals, Inc., a Nevada
corporation, and IST.

The Biotechnology Business Unit is our research,
development and licensing division specializing in
pre-cancer/cancer detection through its patented
Zila® Tolonium Chloride and OraTest®
technologies and now manages the OraTest® product, an oral
cancer diagnostic system, which is currently in Food and Drug
Administration (FDA) phase III clinical trials.
The Biotechnology Business Unit includes Zila Biotechnology,
Inc., an Arizona corporation, Zila Technologies, Inc., an
Arizona corporation, and Zila Limited, a United Kingdom company.

Recent Developments

In connection with our dialogue with the FDA, we
have proposed modifications to the current OraTest®
clinical program aimed at reducing its overall duration and
total cost. It is our goal to include the evaluation of
OraTest® in the accurate identification of severe dysplasia
(pre-cancer) in addition to carcinoma in-situ and invasive
carcinoma (cancer) as acceptable clinical endpoints in the
modified program. It is also our objective to collect data in an
incremental population of individuals at high risk of oral
cancer (primary cancer screening) while still reducing the cost
and duration of the current clinical program. If this program
modification is allowed by the FDA and the clinical objectives
are achieved, it may also permit enlargement of the
post-approval target population and the marketable claims for
OraTest®.

No assurances can be made that the FDA will agree
to our proposed program modifications or that the clinical
objectives will be achieved or that there will be an enlargement
of the post-approval target population or the marketable claims
for OraTest®. We assimilated and implemented the FDAs
non-binding comments to our proposed program modifications and
we have submitted our revised clinical test protocols for FDA
review.

2



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We are awaiting the FDAs input regarding
these revised protocols. In the meantime, we continue to collect
patient data from our on-going phase III clinical trial and
to prepare for execution of the modified program.


In May 2004, we commenced commercial shipment of
our Ester-E® product  the first branded line
extension under the successful Ester umbrella. The
Ester-E® technology is based upon a patented process for
manufacturing tocopheryl phosphates to create an enhanced form
of vitamin E. We entered into an agreement with Vital
Health Sciences Ltd. (Vital Health) of Australia
that grants us the exclusive rights in the human dietary
supplement market for certain issued and pending patents,
know-how and data pertaining to tocopheryl phosphates in the
United States, Canada and Indonesia. We also have a right of
first refusal for other international human dietary supplement
markets under the agreement, the term of which expires in 2008
but which we can unilaterally extend for the life of the
underlying patents. Two of such patents were issued, while other
patent applications are still pending. A subsequent agreement
extends the terms to give us extensive rights in the animal
dietary supplement market in these countries.

On February 6, 2004, we entered into a
Credit and Security Agreement with Wells Fargo Business Credit
(WFBC) that provides a $10 million revolving
line of credit. This agreement became effective on
August 17, 2004 concurrent with the expiration of our
agreement with Congress Financial and the perfection of certain
security interests by WFBC. This credit facility bears interest
equal to the prime rate. Funds available under the line of
credit are based upon a percentage of the value of eligible
receivables and inventory. Under this agreement, financial
covenants require maintenance of minimum net worth levels and
limitations on the amount of capital expenditures. We have made
no borrowings against this credit facility.

Financial information for our Business Units for
each of the last three fiscal years is included in our
Consolidated Financial Statements and the notes thereto.

Our Products



| |               
| | --------------
| | Nutraceuticals



| |         
| | --------
| | Ester-C®

Ester-C® is a unique and patented form of
vitamin C containing natural vitamin C metabolites
that may help it work differently than other forms of
vitamin C. It is natural, non-acidic and gentle to the
stomach. Products manufactured with Ester-C® nutritional
ingredients are sold throughout the U.S. and in 46 countries
worldwide. We require our 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 200 brand names distributed by leading supplement
manufacturers and marketers.

The principal forms in which we sell
Ester-C® are bulk granular and powdered Ester-C®
calcium ascorbate plus metabolites. We also distribute
Ester-C® nutritional ingredients 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. Specialty grades of Ester-C® nutritional
ingredients are available for use in multivitamins
(Ester-C® MV), chewable vitamins (Ester-C® CG) and
effervescent products (Ester-C® EG). Ester-C®
Chelated Mineral Blend provides the benefits of supplemental
vitamin C for animals. Opportunities also exist for new
applications and forms of Ester-C®, including personal
care, functional foods and fortified beverages.

We hold three U.S. and corresponding foreign
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 were issued a
patent in the U.S. for methods and compositions for increasing
the effectiveness of cancer chemotherapy agents with
Ester-C® technology. Sales of Ester-C® accounted for
approximately 62%, 55%, and 50% of our net revenues for fiscal
years 2004, 2003 and 2002, respectively. In fiscal 2004,
revenues of one customer, NBTY, Inc, were in excess of 10% of
consolidated net revenues.

3



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| |         
| | --------
| | Ester-E®

Ester-E® is an enhanced vitamin E
formed by joining natural d-alpha tocopherol to a phosphate
molecule in a patent-protected process. This process creates
tocopheryl phosphates, a concentrated form of a naturally
occurring ester of vitamin E. Ester-E® is designed to
protect the antioxidant potential of vitamin E during
absorption, transport and storage in the body to assist in the
delivery of its nutritional benefits when needed. We plan to
conduct human clinical trials during fiscal 2005 to support the
results of preliminary animal studies that suggest specific
health benefits related to Ester-E®. We sell Ester-E®
as a bulk ingredient to nutraceutical manufacturers and plan to
promote it directly to consumers through brand-building national
advertising under a marketing and distribution model similar to
our Ester-C® products.

We entered into a license agreement with Vital
Health granting us the exclusive rights in the human dietary
supplement market for certain issued and pending patents,
know-how and data pertaining to tocopheryl phosphates in the
United States, Canada and Indonesia. A subsequent agreement
extends the terms of the agreement to give us extensive rights
in the animal dietary supplement market in these countries. We
also have a right of first refusal for other international
markets under the agreement, the initial term of which expires
in 2008, but which we can unilaterally extend for the life of
the underlying patents. Two of such patents were issued, while
other patent applications are still pending. Commercial
shipments of Ester-E® commenced in May 2004.



| |          
| | ---------
| | Palmettx®

In 2004, we completed our strategic withdrawal
from the saw palmetto market by selling our small quantity of
remaining inventory of saw palmetto powder. Given the
commodity-like margins offered by this product category, we
decided in 2003 to withdraw from this market.



| |                
| | ---------------
| | Pharmaceuticals



| |          
| | ---------
| | Zilactin®

The Zilactin® brand topically treats
aphthous ulcers, herpetic lesions and other mouth sores and
includes the following OTC, non-prescription products:
Zilactin® Cold Sore Gel, Zilactin®-L Cold Sore Liquid,
Zilactin®-B Canker Sore Gel, Zilactin® Baby Teething
Gel, Zilactin® Medicated Toothache Swabs and Zilactin®
Baby Teething Swabs. The Zilactin® product line accounted
for 14%, 15%, and 28% of our net revenues for fiscal years 2004,
2003 and 2002, respectively. During fiscal 2004, we discontinued
the manufacture and sale of Baby Teething products due to
weakening demand and increased price-based competition.

We own the patent covering the Zilactin®
treatment that includes the composition and film-forming
properties of the gel product formulas. See Part 1.
Business  Patents and Trademarks.
Zilactin® products are packaged as gels, swabs and liquids
and are applied directly to affected areas in quantities large
enough to cover the lesion with the gel or liquid.

The gels contain an active ingredient 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 or outside the mouth, a feature that
makes the formulation suitable for a variety of oral
applications.

In addition to its OTC consumer applications,
Zilactin® is being used by dentists to treat patients with
mouth sores and other oral mucosal ulcers or lesions.



| |         
| | --------
| | Peridex®

Peridex® is a prescription antibacterial
oral rinse used between dental visits as part of a professional
program for the treatment of gingivitis and periodontal disease.
Known as the gold standard among dentists,
Peridex® is highly recognized due to the products
proven efficacy and longevity in the market. The active
ingredient in Peridex® is 0.12% chlorhexidine gluconate.
Peridex® is the first and only rinse to receive the

4



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American Dental Association Seal of Acceptance
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.




| |          
| | ---------
| | ViziLite®

ViziLite® is the only patented, FDA-cleared
device to enhance visualization of oral tissue abnormalities in
patients at high risk for oral cancer. It consists of a
disposable, chemiluminescent, low-wavelength light that lasts
for about ten minutes. This allows a dentist or oral hygienist
to complete a thorough visual oral examination. The wavelengths
of light produced are absorbed by normal cells, but are
reflected by any abnormal cells. Using ViziLite® during a
visual examination, normal cells appear dark, while abnormal
cells appear bright white. The ViziLite® kit includes a
small bottle of 1% acetic acid solution used prior to the
procedure to disrupt the glycoprotein barrier of mucosal
surfaces.

In May 2004, the Code Revision Committee of the
American Dental Association (ADA) approved a new
dental reimbursement code for oral screening products. This new
reimbursement code will be published in the next version of the
Code On Dental Procedures and Nomenclature and will be effective
on January 1, 2005. Reimbursement codes can be used to
report dental procedures provided under public and private
dental insurance benefits plans. Obtaining insurance
reimbursement from specific carriers is a separate process. We
are now engaged in this process for our ViziLite® product.
Until this time, there has not been a reimbursement code
available to dentists because there has never been an FDA
cleared product for screening for oral abnormalities in at-risk
patients. ViziLite® may be the only available product
eligible for coverage under this code at this time.



| |             
| | ------------
| | IST Products

IST manufactures three sizes of dry handled swab
applicators for OEM customers and other of our products. IST
also manufactures a proprietary brand of disposable probe covers
(plastic sheaths for electronic thermometers) sold to healthcare
distributors and custom plastic parts for OEM customers.



| |              
| | -------------
| | Biotechnology



| |         
| | --------
| | OraTest®

Zila® Tolonium Chloride
(ZTCTM) is the active ingredient in
OraTest® and is the pharmaceutical grade form of toluidine
blue. In numerous studies, the technology behind
ZTCTM has been shown to stain cancer and pre-cancer
cells, leaving normal cells unstained. The applications for
ZTCTM may include detecting cancer of the skin,
cervix and esophagus as well as oral cancer, for which
OraTest® is designed.

The OraTest® product is a patent protected
system designed to be an aid in the early detection of oral
squamous cell carcinoma. OraTest® consists of a patented
ZTCTM aqueous solution with acetic acid and alcohol,
and acetic acid pre- and post-rinse solutions. It is a
diagnostic adjunct for oral cancer and may be used as a general
rinse for detecting oral cancer in patients at risk and as an
aid to establish borders for biopsy and surgical site selection,
applied as a chair-side oral rinse or swab and administered by
either a medical practitioner or dentist. OraTest® contains
the active ingredient ZTCTM, a staining agent that
has been shown to adhere to specific cell types within the mouth
that are cancer and pre-cancer and that may not be visible to
physicians or dentists. Research has shown that OraTest®
may detect lesions on the progression pathway to oral cancer
which still appear to be normal under the microscope.

According to the Oral Cancer Foundation,
approximately 30,000 new oral cavity and pharyngeal cancers are
being diagnosed each year, killing approximately 50% of the
people affected within five years. 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 that
only results in the identification of early cancers 35% of the
time. Those

5



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who do survive frequently undergo disfiguring
surgery. When oral cancer is detected early, survival rates are
about 80%; detected late, the survival rate plummets to 20%.


We are concentrating our efforts and investments
on a phase III clinical study to support our application
for approval of the OraTest® product in the United States
by the FDA.

The product has been approved for distribution in
the United Kingdom, Australia, Belgium, Holland, Luxembourg,
Finland, Greece, Portugal, Bermuda and the Bahamas.

Sales and Marketing



| |               
| | --------------
| | Nutraceuticals



| |                      
| | ---------------------
| | Ester-C® and Ester-E®

We market Ester-C® and Ester-E®
products through an atypical but highly effective business model
for the vitamin supplement market, selling patent-protected bulk
vitamin ingredients to supplement manufacturers and marketers
and driving demand for these products through branded consumer
advertising and public relations. Our multi-million dollar
marketing program is designed to generate significant
Ester-C® and Ester-E® awareness and use among current
vitamin C and E consumers. The marketing program utilizes
national television and radio advertising, communicating the
benefits of supplementation with Ester-C® and
Ester-E®. We also work closely with our
manufacturer/marketer customers to support their efforts at
gaining broad scale retail distribution and key retailer display
and promotion. While Ester-C® retains a strong position in
natural food outlets, its most significant growth has been
achieved in the food, drug and mass retail channel.
Ester-E® did not reach the U.S. market until late in
fiscal year 2004, but it set a new product launch sales record
for the Nutraceuticals Business Unit during that period. It will
be promoted directly to consumers through brand-building
national advertising. International sales of Ester-C® are
accomplished through local distributors, who receive our
assistance in public relations and advertising.



| |                
| | ---------------
| | Pharmaceuticals



| |         
| | --------
| | Zilactin

We employ several strategies to market our
Zilactin® family of products:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Consumer
    Marketing We build
    consumer awareness of our products through targeted consumer
    marketing efforts, including nationally aired radio advertising
    and purchasing incentives delivered via print promotional
    vehicles which reach frequent cold and mouth sore sufferers.
    Zap it with ZilactinTM has become the
    logo and slogan across the portfolio.                                                                                                                                                                                                                 
|
| | Trade
    Participation We
    participate in retailer-driven activities, including seasonal
    promotional campaigns, consumer incentive programs, special
    in-store product placements and new store allowances. These
    efforts are designed to make our products available at more
    outlets and to offer value to consumers at the retail store
    level.                                                                                                                                                                                                                                   
|
| | Professional
    Awareness We educate key
    groups of health professionals on the uniqueness and
    effectiveness of our products and build awareness of our
    products by targeting direct mailings, by sample fulfillment and
    by attending trade shows. At trade show meetings, which are
    geared to dental professionals, our representatives interact
    with and distribute information to thousands of interested
    health professionals, resulting in alliances with professionals
    who sample our products and recommend retail purchases of our
    products to their patients.



| |         
| | --------
| | Peridex®

Peridex® is currently concentrated in two
focused channels of distribution: (i) direct to dental and
(ii) retail pharmacies. We market Peridex® direct to
dental healthcare professionals through an exclusive
distribution arrangement with Omnii Oral Pharmaceuticals, Inc.
of Palm Beach, FL (Omnii), a national dental sales
and distribution organization. Omnii has a national network of
field sales representatives with

6



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significant coverage of dental practices, dental
and dental hygiene schools, as well as managed care
organizations, pharmacists and wholesalers. We also utilize
Omnii to fulfill our shipments to national wholesalers, which
supply the second channel of distribution, the retail pharmacy
industry.




| |          
| | ---------
| | ViziLite®

In order to achieve the vision of establishing
ViziLite® as the standard of care for oral abnormality
screening, the overall strategy is to educate the dental
professional and widen distribution. Through a combination of
independent sales representatives and regional distributors, we
have initially focused on five key geographical markets that
have demonstrated early acceptance. Market expansion will be
primarily generated by the following drivers:



| |   |                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Development of self-study training through
    offline and online continuing education programs;                                                                                                                  
|
| |  | Expansion of the field selling effort based on
    achievement of success metrics in existing focus
    markets; and                                                                                              
|
| |  | A comprehensive program targeting insurers
    designed to secure a meaningful level of insurance reimbursement
    for use of the ViziLite® device once the new ADA codes have
    been published;               
|
| |  | Completion and effective communication of
    information about current and planned clinical efficacy trials
    that can provide thought leader support, involvement and
    commitment to the ViziLite® concept.



| |             
| | ------------
| | 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.



| |              
| | -------------
| | Biotechnology



| |         
| | --------
| | OraTest®

We sell the OraTest® product through our
wholly-owned subsidiary, Zila Limited, in the U.K. During fiscal
2003 we stopped promoting the product in Europe in favor of
funding the FDA clinical trials. As of July 1, 2004, we
entered into an agreement with Scope Advertising and Marketing
Services, Ltd. for future European marketing and sales of the
OraTest® product, and (i) to assist in securing the
Conformité Européene (CE) Marking for
ViziLite® and (ii) to develop and implement marketing
plans for ViziLite®. CE Marking is a symbol that indicates
a product conforms to the legal requirements of the European
Union Directive with respect to health, environment and consumer
protection.

Manufacturing and Supply



| |               
| | --------------
| | Nutraceuticals

All Ester-C® and Ester-E® products are
manufactured at our Prescott, Arizona location. This
65,000 square foot state of the art facility integrates all
manufacturing, quality assurance/quality control, warehousing
and distribution for Ester-C® and Ester-E®.

Ascorbic acid is the principal raw material in
the formulation and processing of our Ester-C® products and
is subject to periodic price fluctuations. While ascorbic acid
prices rose dramatically during fiscal year 2003 and during the
first half of fiscal year 2004, we have obtained a supply of
ascorbic acid for a substantial portion of our anticipated
requirements through fiscal 2007 by entering into longer term
agreements. Prices under these agreements are below our
historical average cost, providing cost predictability through
the three-year terms of the agreements. Pricing under one of
these agreements can fluctuate within a defined range based on
foreign currency rates.

7



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##### Table of Contents



The key ingredient in the formulation and
processing of Ester-E® is d-alpha tocopherol. We are
undertaking a strategy to ensure adequate supply and pricing
stability by negotiating with suppliers for long-term supply
contracts.



| |                
| | ---------------
| | Pharmaceuticals



| |          
| | ---------
| | Zilactin®

We employ a network of contract manufacturers to
produce and package all of our Zilactin® products, with the
exception of our toothache swab which is packaged by IST. For
each of our Zilactin® products we currently rely on a
single source of supply.



| |         
| | --------
| | Peridex®

Peridex® is manufactured at a contract
facility in Chicago, Illinois. We rely on a single source of
supply for the Peridex® product.



| |          
| | ---------
| | ViziLite®

The ViziLite® product consists of a number
of components produced and assembled by different contract
manufacturers. For each component, we currently rely on a single
source of supply.



| |             
| | ------------
| | IST Products

All IST products are manufactured at the Antioch,
Illinois location.



| |              
| | -------------
| | Biotechnology



| |         
| | --------
| | OraTest®

A contract manufacturing facility in the United
Kingdom produces and packages the OraTest® product for sale
in that country and other selected countries. In order to ensure
an available and stable supply of ZTCTM, the
worlds only pharmaceutical grade tolonium chloride and the
active ingredient in the OraTest® product, we established
our own manufacturing facility. No other pharmaceutical grade of
tolonium chloride was available. The facility, located in
Phoenix, Arizona, manufacturers ZTCTM under
FDAs exacting current Good Manufacturing Practices
(cGMP) standards, providing the pharmaceutical-grade
quality required.

Competition

All of the 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 nutraceutical, pharmaceutical and
biotechnology industries are 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.



| |               
| | --------------
| | Nutraceuticals



| |         
| | --------
| | Ester-C®

Due to our patent position, we are the sole
global producer of calcium ascorbates containing vitamin C
metabolites. However, Ester-C® does compete directly with
all vitamin C products. Approximately 60% of the world
supply of ascorbic acid is produced in China by four
manufacturers for export to world markets. The predominant
competing vitamin C manufacturer outside Asia is DSM
Nutritional Products, Inc., located in Parsippany, New Jersey.
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, which we
believe we provide.

8



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We believe that we compete favorably with other
producers of vitamin C because of the positive attributes
of our patented Ester-C® products, high customer-order fill
rate, strong distribution network, and advertising and
promotional support. Our sales trends for Ester-C® products
for 2004 are significantly better than those for traditional
vitamin C. We believe that our commitment to research
demonstrating the benefits of Ester-C® products and our
commitment to our marketing partners and consumer focused
advertising gives Ester-C® a competitive advantage.

Although the Ester-C® patent expires in
2007, we continue to perform research and development activities
to provide additional patent protection for the brand. A new
international patent application was filed in 2001 covering a
modified version of our Ester-C® formulation. Corresponding
patent applications are pending in the United States, Europe and
eight additional foreign markets. A new International
Application was filed in 2003 based on studies that suggest
end-use benefits related to anti-oxidant and environmental
oxidant stresses. If issued, the patent may prevent any future
manufacturer/marketer of a product containing a mineral
ascorbate and a vitamin C metabolite as an imitator
Ester-C® type of product (after expiration of the
Ester-C® patent in 2007) from making claims similar to
those specified in the patent. There can be no assurance that
any new patents pertaining to the modified Ester-C® product
will be issued.



| |         
| | --------
| | Ester-E®

Under a licensing arrangement with Vital Health,
we utilized Vital Healths patented technology to develop
Ester-E® a form of d-alpha tocopheryl phosphate tailored
for the dietary supplement marketplace. The first commercial
shipments of Ester-E® occurred in May 2004. We believe that
Ester-E® will compete directly with all vitamin E products.
The predominant competing vitamin E manufacturers are Archer
Daniels Midland (ADM) and DSM Nutritional Products.
As the first branded line extension under our successful
Ester umbrella, the goal is for Ester-E® to
reshape the vitamin E supplement market as Ester-C® has
reshaped the vitamin C supplement market, although we cannot
offer assurances that we will achieve this goal.



| |          
| | ---------
| | Palmettx®

Given the commodity-like margins offered by this
product category, we decided to withdraw from this market and
completed the sale of our remaining low levels of saw palmetto
powder inventory in the normal course of business in June 2004.



| |                
| | ---------------
| | Pharmaceuticals



| |          
| | ---------
| | Zilactin®

We compete in two primary categories: Lip Care
(includes cold sores and fever blisters) and Oral Care (includes
mouth sores). Numerous products exist for the treatment of cold
sores, fever blisters and mouth sores, including: Orajel by Del
Pharmaceuticals, Inc., Abreva by GlaxoSmithKline, Anbesol by
Wyeth Labs, Campho Phenique by The Bayer Corporation, Novitra by
Boericke Tafel and Herpecin-L by Chattem, Inc. Many of these
companies have greater financial resources than we have,
including some with greater name recognition and closer ties to
major food, drug and mass retail chains. In the cold sore
category, we have been adversely affected by superior product
claims by our competitors, supported by aggressive advertising
campaigns. In the mouth sore category, we have a competitive
advantage with our patented film-forming technology, which
allows the user to eat and drink pain-free for up to six hours.



| |         
| | --------
| | 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 the
reputation of Peridex® as the gold standard
prescription antibacterial oral rinse within the dental
profession and our relationship with Omnii as our distributor to
professionals will allow us to continue to compete effectively
in the dental healthcare professional marketplace. In addition,
we anticipate that new packaging options and new product
development activities will allow us to counter inroads made by
generic equivalents.

9



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##### Table of Contents





| |          
| | ---------
| | ViziLite®

ViziLite® is a patented, FDA-cleared device,
used to view and evaluate oral mucosal abnormalities.
ViziLite® must contend with altering the conventional
method of visual and tactile testing for abnormalities that has
previously been the only available methodology for identifying
lesions.



| |             
| | ------------
| | 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.



| |              
| | -------------
| | Biotechnology



| |         
| | --------
| | OraTest®

The OraTest® product is in a phase III
clinical trial and therefore we are not marketing the product in
the U.S. Because of our focus on the phase III clinical
trial, we have not placed emphasis, funding or resources on
international markets for the product. However, there are no
known competitors to the OraTest® product in the U.S. or
worldwide. Because the conventional method of using visual
examinations by medical personnel to detect oral cancer is still
a widely accepted practice, it may also be viewed as a
competitor. ZTCTM and its technology are protected by
issued and pending patents. See also
Item 1. Business  Patents and
Trademarks.

Licensing



| |               
| | --------------
| | Nutraceuticals



| |         
| | --------
| | Ester-E®

On October 31, 2003, we entered into a
license agreement with Vital Health that grants us the exclusive
rights in the human dietary supplement market for certain issued
and pending patents, know-how and data pertaining to tocopheryl
phosphates in the United States, Canada and Indonesia. A
subsequent agreement entered into on August 4, 2004,
extends the terms of the original agreement to give us extensive
rights in the animal dietary supplement market in these
countries. The initial term of the license is five years, and we
have the right, unilaterally, to extend the term until the
expiration of the last of the licensed patents. Two of such
patents were issued while other patent applications are still
pending. We also have a right of first refusal for all other
international human dietary supplement markets under the
agreement. Zila Nutraceuticals is currently using Vital
Healths patented tocopheryl phosphate technology to
produce its Ester-E® product tailored for the dietary
supplement market. Under the agreement, starting in fiscal 2005
we are required to make royalty payments based on certain levels
of sales volume. Additionally, we are subject to minimum annual
royalty payment amounts, as defined.



| |                
| | ---------------
| | Pharmaceuticals



| |         
| | --------
| | Peridex®

On January 30, 2001, we signed a 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.



| |          
| | ---------
| | ViziLite®

In December 2001, we entered into an exclusive
agreement with The Trylon Corporation of Torrence, California
(Trylon) to license the ViziLite® technology.
That agreement was modified in October 2003 to reduce the
royalties and now provides that we pay Trylon: (i) a 5%
royalty on the net sales of the ViziLite® product during
the first five years and (ii) a 2.5% royalty on the net
sales during the period commencing on the

10



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##### Table of Contents



fifth anniversary of the closing date through the
tenth anniversary of the closing date after which the royalty
payment ends. The license is based on the life of the patents,
unless terminated early in accordance with the agreement for
certain defaults. This agreement was further modified in March
2004. Under this modification, as of July 31, 2004, we now
have the right to acquire either direct ownership or a royalty
free license for a ViziLite® product line extension that is
the subject of a pending 510(k) application with the FDA.




| |              
| | -------------
| | Biotechnology



| |         
| | --------
| | OraTest®

We have entered into agreements for the
manufacture, marketing and distribution of our OraTest®
products in several foreign countries. These arrangements are
currently inactive as a result of our strategic decision to
focus our efforts to obtain the requisite clearances from the
FDA to bring our OraTest® product to market in the United
States.

Royalty payments would be required should sales
of OraTest® product commence in the foreign countries
covered by these arrangements.

Governmental Regulation



| |        
| | -------
| | General

Our operations are subject to regulation by
governmental authorities in the United States and other
countries with respect to the testing, approval, manufacture,
labeling, marketing, distribution and sale of our products. We
devote significant time, effort and expense addressing the
extensive government regulations applicable to our business. 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 and the sale of such products 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 cGMPs (current Good Manufacturing
Practices). Compliance with cGMPs requires the dedication
of substantial resources and requires significant costs. The FDA
periodically inspects both our manufacturing facilities and our
contract manufacturing plants and laboratories to review
compliance with applicable regulations and procedures. 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. If 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 respective 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 or
nutraceutical 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.

11



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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.

Manufacturing companies, especially those engaged
in health care related fields, are subject to a wide range of
laws and regulations. Concern for maintaining compliance with
federal, state, local and foreign laws and 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.



| |                         
| | ------------------------
| | Ester-C®and
    Ester-E®

Dietary supplements and ingredients in dietary
supplements are regulated in the United States by the various
states and the FDA. The FDA, however, has been the most active
governmental regulator of dietary supplements. Under the Dietary
Supplement Health & Education Act of 1994 (DSHEA), it
is a manufacturers responsibility to ensure that its
products are safe and properly labeled prior to marketing. One
of the ways in which a dietary supplement may be adulterated is
if it or one of its ingredients presents a significant or
unreasonable risk of illness or injury when used as
directed on the label, or under normal conditions of use (if
there are no directions). A dietary supplement that contains a
new dietary ingredient (i.e., an ingredient not marketed for
dietary supplement use in the U.S. prior to October 15,
1994) is also considered adulterated unless the dietary
supplement contains only ingredients which have been present in
the food supply in a form in which the food has not been
chemically altered, or for which there is a history of use or
other evidence of safety establishing that the dietary
ingredient, when used under the conditions recommended or
suggested in the labeling of the dietary supplement, will
reasonably be expected to be safe and that the supplement itself
that contains the dietary ingredient will be reasonably expected
to be safe.

Ester-C® is not considered a new dietary
ingredient under the DSHEA because it was marketed before
October 15, 1994. Vitamin E also was marketed prior to
October 15, 1994. We believe that Ester-E® is not
considered to be a new dietary ingredient because its components
are not materially different in molecular structure as compared
to conventional vitamin E. We believe that we have
sufficient information to conclude that the ingredient will not
present a significant or unreasonable risk of illness or injury.

The FDA also regulates the facilities and
procedures used to manufacture dietary supplement products in
the United States or for sale in the United States. Such
facilities must be registered with the FDA under the Public
Health Security and Bioterrorism and Preparedness Act of 2002
and all products made in such facilities must be manufactured in
accordance with cGMPs. The cGMPs with which we must comply are
the Current Good Manufacturing Practice in Manufacturing,
Packing or Holding Human Food; however, the FDA has proposed
GMPs specific to the manufacturing, packing or holding of
dietary supplements with which we must comply when finalized.
The FDA announced it expects to finalize those regulations by
the end of 2004. We have been preparing for implementation of
these GMPs since the proposed rule was published and anticipate
no issues with compliance.

The FDA and the FTC work in tandem to regulate
the manufacture and sale of dietary supplements and to enforce
laws governing fraud, deception and unfair business practices.
The FDA has primary responsibility for claims on product
labeling, while the FTC has primary responsibility for claims in
advertising. All claims for existing and new products are
reviewed with regulatory counsel for risk assessment, and
substantiation folders are maintained for each claim.

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In the European Union, a dietary supplement or
ingredient must be on an approved list before it can
be marketed in member countries. Any ingredient currently on the
market in Europe but not on the approved list (which includes
Ester-C®) must be submitted with a dossier to support its
inclusion no later than July 2005. Since we are not currently
marketing Ester-E® in Europe, a similar application for
Ester-E® is not required by the 2005 deadline.

In Canada, new regulations governing natural
health products, which include vitamin C and
vitamin E, were implemented on January 1, 2004.
Products on the market prior to that time will be grandfathered,
but products not previously on the market and not included in
the Canadian compendium of monographs, such as our
Ester-E®, will require submission by our customers of an
extensive application to support the safety, efficacy, and
quality of finished goods containing Ester-E®. We will be
preparing a package in fiscal 2005 that our customers can use to
submit their finished goods applications.



| |          
| | ---------
| | Zilactin®

We market Zilactin® products as a treatment
for the symptomatic relief of mouth sores (oral mucosal ulcers
and lesions), cold sores and swollen gums from teething and
toothaches. We do not believe that we are 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 our Zilactin® family
of products) has been finalized, and we produce and market the
Zilactin® family of products in compliance with FDAs
OTC enforcement policy. 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®

We have not received final FDA approval for
OraTest® and are conducting a phase III clinical trial
to include it in an amended NDA. We have made a significant
financial investment to obtain FDA approval of the OraTest®
product, develop our manufacturing facility and 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.

Although we have received regulatory approval to
market the OraTest® product in various Asian and European
countries, we are currently not actively marketing in these
countries due to our emphasis on obtaining market approval
within the United States.

Patents and Trademarks



| |         
| | --------
| | Ester-C®

In 1989, three United States patents were issued
in connection with Ester-C® nutritional ingredients. All
three patents expire in 2007. Twenty-five corresponding foreign
patents in countries important to our marketing and distribution
strategy have been awarded, with expiration dates ranging from
September 2005 in Australia to 2020 in Canada. The first patent
covers compositions for administering vitamin C that
contain vitamin C metabolites including threonate. The
second and third patents cover improvements to the metabolite
technology, which enhance the absorption of vitamin C from
the Ester-C® formulation and is applicable to a wide
variety of other non-prescription and prescription drugs.

A new international patent application was filed
in 2001 covering improved vitamin C compositions that may
result in additional patent protection of the improved
Ester-C® product for several additional years.
Corresponding patent applications are pending in the United
States, Europe and eight additional foreign markets. There can
be no assurance that any new patents pertaining to the improved
Ester-C® product will be issued.

Ester-C® Topical Concentrate, a stable form
of vitamin C that in preliminary studies appears to
penetrate the skin to help produce collagen and supporting
structures, was awarded a United States patent in March

13



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##### Table of Contents



2001 and expires in 2018 for Stable Liquid
Mineral Ascorbate Composition and Methods of Manufacturing and
Use. Patents have been issued in Australia, New Zealand
and Singapore. Corresponding patent applications are pending in
several other foreign countries.


In 2002, a United States patent was granted
for Methods and Compositions for Potentiating Cancer
Chemotherapeutic Agents. This patent is based on cancer
chemotherapy research, which showed that two of the
vitamin C metabolites found in Ester-C® increased the
effects of chemotherapeutic agents. Two related
U.S. patents are pending, along with several corresponding
foreign applications, one of which has been granted in New
Zealand.

A new patent application was filed in 2003 based
on studies that suggest end-use benefits related to anti-oxidant
and environmental oxidant stresses. If issued, the patent may
prevent any future manufacturer/marketer of a product containing
a mineral ascorbate and a vitamin C metabolite as an
imitator Ester-C® type of product (after expiration of the
Ester-C® patent in 2007) from making claims similar to
those specified in the patent. We also filed an International
Application along with national applications in Malaysia and
Taiwan and will file additional national stage applications
early in 2006.

Several trademarks have been issued by the United
States Patent and Trademark Office (USPTO) including
the following three major trademarks: (i) the Ester-C®
trademark; (ii) the EC® logo trademark; and
(iii) the C-Flex® trademark. Related trademarks have
been issued in 45 countries with trademarks pending in
several other countries.



| |         
| | --------
| | Ester E®

We entered into a license agreement with Vital
Health granting us the exclusive rights in the human dietary
supplement market for certain issued and pending patents,
know-how and data pertaining to tocopheryl phosphates in the
United States, Canada and Indonesia. A subsequent agreement
extends the terms of the agreement to give us extensive rights
in the animal dietary supplement market in these countries. We
also have a right of first refusal for all other international
human dietary supplement markets under the agreement, the
initial term of which expires in 2008, but which can be
unilaterally extended by us for the life of the underlying
patents. United States and Australian patents have been granted
that cover the Improved Process for Phosphorylation and
Compounds Produced by this Process, while other patent
applications are still pending.

We utilized Vital Healths patented
technology to develop Ester-E® tocopheryl phosphates, a
form of vitamin E tailored for the dietary supplement
marketplace, at our state-of-the-art Arizona laboratories and
manufacturing facility. Ester-E® is formed by joining
natural d-alpha tocopherol to a phosphate molecule. The
patent-protected process is designed to protect the antioxidant
potential of vitamin E during absorption, transport, and storage
in the body to assist in the delivery of its nutritional
benefits when needed.

Preliminary animal studies conducted by Vital
Health indicate potential advantages for tocopheryl phosphates
in absorption and in the support of cardiovascular health. We
plan to conduct human clinical trials during fiscal 2005 to
support the health benefits of Ester-E®.

We launched Ester-E® in May 2004. We sell it
as a bulk ingredient to nutraceutical manufacturers and promote
it directly to consumers through brand-building national
advertising. The product began appearing on the shelves of
several national retailers in August 2004.

The application for registration of Ester-E®
as a mark was allowed for registration on the principal
register. Corresponding trademarks have been issued in eight
foreign countries, with applications pending in several others.



| |          
| | ---------
| | Zilactin®

Two comprehensive United States patents covering
present film-forming Zilactin® gel products were issued in
1992 and will expire in 2009. Two additional applications are
pending in the United States and in several foreign countries.
We own two United States patents related to the dry handle swab
assembly in the

14



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##### Table of Contents



Zilactin® Toothache Swabs and Zilactin®
Baby Teething Swabs. The trademarks Zila® and
Zilactin® are registered in the United States, Canada and
in several important foreign countries and there are
applications pending to register these trademarks in other
countries. Application was made recently for the Zap It with
ZilactinTM in the United States. We believe that
widespread use of the Zila® and Zilactin® trademark
alone and as the dominant features of other marks, such as
Zilactin®-B and Zilactin®-L, 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® with the USPTO in June 1998 and with the Canadian
Registrar of Trademarks in July 1998.



| |          
| | ---------
| | ViziLite®

The December 2001 license agreement with Trylon
grants us exclusive and perpetual rights to the ViziLite®
technology covered by United States patent numbers 5,179,938 and
5,329,938 issued January 19, 1993, and July 19, 1994,
respectively. Together, the patents cover the apparatus and
method for endoscopic examination of certain body cavities using
a chemiluminescent light source. The license covers reissues and
extensions of, along with foreign patents granted and pending
based upon, the licensed patents. The ViziLite® trademark
was granted registration by the USPTO in December, 2002 and by
the European Union in June, 2003.

We have filed an International Application for a
technology that will cover use of the ViziLite chemiluminescent
technology entitled Methods for Detecting Abnormal
Epithelial Tissue.



| |             
| | ------------
| | IST Products

With the February 1, 2001 purchase of the
assets from National Healthcare Manufacturing Corporation
(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, which will expire in 2021. The USPTO
issued a certificate of registration for the Innovative®
trademark in July 2002.



| |         
| | --------
| | OraTest®

When we purchased the shares of CTM Associates,
Inc. (CTM) in June 1996, we acquired certain
technology rights and United States and foreign patent rights
related to the OraTest® product. On June 18, 2003, we
were granted a patent in the United States covering the method
by which our ZTCTM has been shown to detect
pre-cancer and cancer cells. The patent is based upon in-vitro
studies of the ZTCTM mechanism of action. We now have
eight issued United States patents related to ZTCTM
and/or the OraTest® product with expiration dates ranging
from 2011 to 2020. An additional 27 corresponding foreign
patents have been issued and there are pending United States and
international applications that would result in coverage of
ZTCTM and/or OraTest® related technology by over
300 United States and foreign patents. These patents and pending
applications cover: (i) the composition of matter for
ZTCTM; (ii) the process for manufacturing
ZTCTM; (iii) the methods and products for using
ZTCTM to detect epithelial cancer; and
(iv) other compounds that are chemically related to
Tolonium Chloride for use in detecting epithelial cancer.

The OraTest® trademark was registered in the
United States in June 1998. We also have trademarks registered
in Canada, Japan, Taiwan, Israel, Norway, Switzerland, South
Africa plus 15 European countries that have signed the
European Community Trademark treaty. The trademark
OraScreen® was registered in Australia, Austria, Benelux,
France, Germany, Italy, Spain, Switzerland, Ireland, United
Kingdom, Canada, Japan and New Zealand.

15



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Employees

As of July 31, 2004, we had a total of
142 employees. No employees are represented by a labor
union. We believe our relationship with our employees is good.

Available Information

We file annual, quarterly, and current reports,
proxy statements, and other documents with the Securities and
Exchange Commission (SEC) under the Securities
Exchange Act. The public may read and copy any materials that we
file with the SEC at the SECs Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. The public
may obtain information on the operation of the Public Reference
Room by calling the SEC at 1-800-SEC-0330. Also, the SEC
maintains an Internet web site that contains reports, proxy and
information statements, and other information regarding issuers,
including Zila, Inc., that file electronically with the SEC. The
public can obtain any documents that we file with the SEC at
http:/www.sec.gov.

We make available free of charge through our
internet web-site, www.zila.com, our Annual Report on
Form 10-K, our Quarterly Reports on Form 10-Q, our
current reports on Form 8-K, and amendments to those
reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act as well as Section 16
reports on Forms 3, 4 and 5, as soon as reasonably
practicable after we electronically file such material, or
furnish it to, the Securities and Exchange Commission.

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, such as
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.



| |                                         
| | ----------------------------------------
| | Uncertainties of Regulatory
    Approval

The rigorous clinical testing and 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
ultimately be 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. If the compounds in testing are modified or optimized,
it may extend 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.

16



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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

We are seeking FDA approval for OraTest® and
are conducting a phase III clinical trial to include in an
amended NDA. We have made a significant financial investment to
obtain FDA approval of the OraTest® product, to build our
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 may 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 dental profession
or we must obtain the assistance of a pharmaceutical company or
a distributor with a sales force. There is no assurance that we
will be successful in gaining market acceptance of the
OraTest® product.

Based on recent evaluations of the anticipated
scope of the clinical program, we believe that our current cash
and cash equivalents, along with cash generated internally from
our Nutraceuticals and Pharmaceuticals Business Units, will be
adequate to fund the OraTest® clinical study to its
completion for submission to the FDA review process. There can
be no assurances that these amounts will be adequate to support
the future clinical study costs if the trial proceeds at a
slower rate than expected, the costs increase beyond current
estimates or we are unable to sustain our current level of cash
flow from operations. Factors that affect the cost and timing of
completion of the clinical study 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. No assurances can be made that the FDA will agree
to our proposed program modifications, that the clinical
objectives will be achieved or that there will be an enlargement
of the post-approval target population or the marketable claims
for OraTest®.

At July 31, 2004, we had approximately
$552,000 of OraTest® clinical rinse and swab inventory,
ZTCTM drug substance, the active ingredient in the
OraTest® product, and its related components. We intend to
realize the value of this drug substance during the next twelve
months (i) through its consumption during the conduct of
the clinical trials, process development, toxicology studies and
validation testing of our manufacturing process and
(ii) through sales in Europe and Asia prior to the date
that we expect sales in the United States. The drug substance
currently has shelf lives with expiration dates which will
expire through 2006. Our periodic testing has indicated that the
drug substance is stable and we anticipate being able to extend
the expiration dates of the entire drug substance beyond these
dates if our plans are delayed. However, no assurance can be
given in this regard.



| |                           
| | --------------------------
| | Dependence on Key Products

Nearly all of our revenues are derived 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 and single suppliers
for nearly all of our Zilactin®, Peridex® and
ViziLite® products and any supply problems resulting from
regulatory issues

17



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applicable to such parties or failures to comply
with cGMP could have a material adverse impact on our revenues.




| |                            
| | ---------------------------
| | Dependence on Key Customers

In fiscal 2004, approximately 43% of our revenues
were generated from four customers. Receivables due from four of
our customers at July 31, 2004, represent 63% of our
accounts receivable. A loss of any of these key customers, a
reduction in their level of business or a failure to fulfill
their obligations due to us could have a material adverse affect
on our business, financial condition and results of operation.



| |                            
| | ---------------------------
| | Dependence on Key Personnel

Our success is largely dependent on the efforts
and abilities of our senior management. The loss of services of
one or more of our key executives could adversely impact our
financial performance and our ability to execute our strategies.
Additionally, if we are unable to attract and retain key
personnel, our business could be harmed.



| |                                  
| | ---------------------------------
| | Commercialization of
    Ester-E®

A number of factors could impact our plans to
commercialize our new Ester-E® product, including, but not
limited to, difficulties in the production process, controlling
the costs to produce, market and distribute the product on a
commercial scale and our ability to do so with favorable gross
margins and otherwise on a profitable basis; the inherent
difficulty of gaining market acceptance for a new product in the
mass market and especially in a mature market, such as the one
for vitamin E supplements; our ability to obtain a price
for our Ester-E® product which exceeds that of generic
forms of vitamin E; the competition from larger, more
established companies with greater resources that are already
producing vitamin E supplements; changes in raw material
supplies that could result in production delays and higher raw
material costs; difficulties in promoting consumer awareness for
the new product; and the cost, timing and ultimate results of
human efficacy studies that we undertake.

We can offer no assurances regarding the strength
of the patent portfolio underlying Ester-E® or whether
patents will issue from any of the pending patent applications
related to tocopheryl phosphate or its technology, or if the
patents do issue, that any claims allowed will be sufficiently
broad to cover the product or production process to effectively
limit competition against us is uncertain. Although we intend to
defend our proprietary rights, policing unauthorized use of
intellectual property is difficult and any patents that may be
issued relating to tocopheryl phosphate or its production or to
Ester-E® may be challenged, invalidated or circumvented.



| |                                                        
| | -------------------------------------------------------
| | Regulatory Issues Relating to Ester-C®
    and Ester-E®

We and our Ester-C® and Ester-E®
products are subject to risks associated with new federal,
state, local or foreign legislation or regulation or adverse
determinations by regulators under existing regulations,
including the interpretation of and compliance with existing,
proposed and future regulatory requirements and dietary
supplement and dietary supplement ingredient regulations imposed
by the FDA and by other governmental authorities, such as the
U.S. Federal Trade Commission with its regulatory authority
over, among other items, the efficacy claims made in product
labeling and advertising. A regulatory determination or
development that affects our ability to market or produce one or
more of our products could have a material adverse impact on our
business, results of operation and financial condition.



| |                                         
| | ----------------------------------------
| | 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 or by us. We maintain product liability
insurance coverage for claims arising from the use 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.

18



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##### Table of Contents





| |                                          
| | -----------------------------------------
| | Competition; Research and
    Development

The nutraceutical, pharmaceutical and
biotechnology industries are highly competitive. A number of
companies, many of which have 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. It may be
difficult for us to maintain or increase sales volume and market
share due to such competition.



| |                    
| | -------------------
| | Generic Competition

In the United States, competition with producers
of generic products is a major challenge. The loss of any of our
products patent protection could lead to a significant
loss in sales of our products in the United States 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, it is
uncertain that any claims allowed will be sufficiently broad to
cover our products or to effectively limit competition against
us. 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 damage 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 we do business.



| |              
| | -------------
| | Raw Materials

Raw materials essential to our business are
generally readily available. However, certain raw materials and
components used in the manufacture of nutraceutical and
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. During 2003 and early 2004, ascorbic acid prices
increased substantially. In fiscal 2004, we executed a strategy
to lock in a stable, lower cost ascorbic acid supply for a
significant part of our anticipated needs by securing three-year
supply contracts from two sources at prices below our historical
average cost. If ascorbic acid prices decline sharply, we would
be at risk of being committed to purchase ascorbic acid at
higher than market prices. Additionally, if our sales were to
significantly decline, we would be obligated to purchase
ascorbic acid in excess of our needs.



| |                                                          
| | ---------------------------------------------------------
| | Future Capital Requirements and Uncertainty
    of Future

The development of our products may 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 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 to

19



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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 Congress Agreement) with
Congress Financial Corporation (Congress). The
Congress Agreement expired on August 17, 2004. Under the
Congress Agreement, Congress provided a $12 million
revolving line of credit to us at an interest rate equal to the
prime rate plus  3/4 percent per annum. The amount of
funds available to us from the line of credit was based upon a
percentage of the value of eligible receivables and inventory
and was $8.7 million at July 31, 2004. At
July 31, 2004, our adjusted tangible net worth was, as
defined, $27.0 million compared to a required amount of
$12.0 million. There were no borrowings outstanding under
this line of credit at any time during fiscal 2004.

On February 6, 2004, we entered into a
Credit and Security Agreement (the Wells Fargo
Agreement) with Wells Fargo Business Credit, Inc.
(Wells Fargo) that provided a $10 million
revolving line of credit on August 17, 2004 upon the
expiration of the Congress Agreement and upon the perfection of
certain security interests by Wells Fargo. Borrowings will bear
interest equal to the prime rate. Funds available under the
Wells Fargo Agreement are based upon a percentage of the value
of eligible receivables and inventory. Obligations under the
Wells Fargo Agreement are collateralized by various assets,
including, but not limited to trade accounts receivable,
inventories, equipment and intangible assets. The parent
company, Zila, Inc., guarantees the obligations under the Wells
Fargo Agreement.

Under the Wells Fargo Agreement, we are required
to maintain net worth, as defined, and to limit capital
expenditures to $1.7 million in fiscal 2005. At
July 31, 2004, our net worth, as defined, was
$50.2 million compared to the required amount, of
$47.0 million. Additionally, payment of dividends is
restricted. The net worth and capital expenditures covenants are
established annually as of August 1. The Wells Fargo
Agreement contains a provision whereby Wells Fargo can call for
immediate repayment of all amounts due under the line upon its
sole determination that a material adverse change
has occurred. As a result of this provision, any borrowings
under the Wells Fargo Agreement will be classified as short-term
debt. There have been no borrowings under the Wells Fargo
Agreement.

If we continue to incur additional operating
losses, reduce the value of our net worth, or incur additional
debt we may become out of compliance with the covenants and thus
have a reduced ability to borrow under the Wells Fargo Agreement.



| |                                              
| | ---------------------------------------------
| | Possible Volatility of Common Stock
    Price

The market price of 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 of 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, 2004,
all of these shares remained outstanding.

20



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| |                                                            
| | -----------------------------------------------------------
| | 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, 2004, the carrying values of the
IDA Bonds approximated fair value.



| |                 
| | ----------------
| | 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.



| |                             
| | ----------------------------
| | 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 Industrial Development Revenue
Bonds (the Bonds), the proceeds of which were loaned
to Nutraceuticals 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. At July 31, 2004, the Nutraceuticals
Business Unit employed 61 individuals, complying with this
agreement. There is no assurance we will be able to maintain or
add the required number of employees.



| |                                           
| | ------------------------------------------
| | Inspection of Manufacturing
    Facilities

The FDA, OSHA and other regulatory agencies
periodically inspect our manufacturing facilities and certain
facilities of our suppliers. Such inspections resulted in the
identification of certain minor deficiencies. We developed and
implemented action plans to remedy the deficiencies. Should
these deficiencies not be remedied to the satisfaction of the
regulatory body, product supply could be affected.



| |                                       
| | --------------------------------------
| | New Product Acceptance 
    ViziLite®

Recently, we have adjusted our product-to-market
strategy for ViziLite® based on our experiences in
promoting awareness, education, trial and repeat purchases of
this unique product within the dental profession. However, the
redirected product rollout strategy is currently in the
implementation stage and thus the acceptance of ViziLite®
among dental professionals cannot be determined at this time. If
sales of ViziLite® do not meet certain minimum levels, an
impairment charge may be incurred.

In May 2004, the Code Revisions Committee of the
ADA approved a new dental reimbursement code for oral screening
products. Such codes can be used to report dental procedures
provided under public and private dental insurance benefit
plans. We may be unable to obtain general acceptance of
reimbursement by insurance companies of the cost for the
ViziLite® product. Such a failure could hamper our efforts
to gain market acceptance for ViziLite®.

21



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| |                                   
| | ----------------------------------
| | IST Loss of Principal
    Customer

On March 31, 2004, ISTs contract with
a major customer expired and as anticipated the contract was not
renewed. This customer represented approximately 80% of
ISTs net revenues. We are attempting to recoup this lost
volume through other new customers, although there are no firm
commitments at this time and there can be no assurances that we
will be able to do so.

In September 2004, our Board of Directors
reversed an earlier decision to divest the net assets of IST.
The reversal was driven by the failure to locate an appropriate
strategic buyer at a satisfactory price and by a new Zila
product that may be manufactured by IST. No assurance can be
given that the new product will be successful or that it or any
future customer will replace a meaningful portion of the sales
volume IST generated before the loss of its principal customer
in fiscal 2004.






|        |           
|------- | ----------
|Item 2. | Properties



| |                       
| | ----------------------
| | Corporate Headquarters

On January 31, 2004, we completed the sale
and five-year leaseback of our 16,000 square foot corporate
headquarters building located at 5227 North Seventh Street,
Phoenix, Arizona 85014-2800 for approximately $1.7 million
in net cash. The leaseback was accounted for as an operating
lease. Monthly lease payments are currently $13,600 increasing
to $14,800 in the final year of the lease. The lease has two
five-year renewal options with monthly rent beginning at $15,100
and increasing annually to $18,000 at the end of the second
five-year renewal option.



| |                         
| | ------------------------
| | Manufacturing Facilities

We currently lease 13,400 square feet for a
manufacturing facility and laboratory in Phoenix, Arizona. This
facility produces ZTCTM, which is the active
ingredient in the OraTest® product as well as provides
technical support and testing for the Zilactin® line of
products. The facility is leased under a 56-month agreement,
which expires December 31, 2005. We plan to negotiate for
the renewal of the lease on these premises. Monthly lease
payments are $10,400. 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
Supply.

The Nutraceuticals Business Unit owns five 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 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 $5,700.



| |      
| | -----
| | Other

The Pharmaceuticals Business Unit leases a
2,420 square foot storage facility in Phoenix, Az. for
certain of its products. This facility is leased under a
six-month lease which expires on February 28, 2005 and is
renewable at that time. Monthly lease payments are $2,100.

We are still responsible for three building
leases related to the facilities of ZDS, our discontinued dental
supply operations. We lease 19,200 square feet within an
office/warehouse complex with a current lease rate of
$3,300 per month, and lease expiration on December 31,
2004. The full cost of this lease was assumed by the buyer of
the ZDS mail order business on November 5, 2001. We lease
7,708 square feet in an office building with a current
lease rate of $9,600 per month and lease expiration on
December 31, 2004. We lease 4,761 square feet in an
office building with a current lease rate of $4,600 per
month and lease expiration on

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November 30, 2004. This building was
subleased October 1, 2002 through November 30, 2004,
providing sublease income of $59,000 through the lease period.







|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

In connection with the acquisition of patent
rights in 1980, we agreed to pay to Dr. James E. Tinnell
(Tinnell), the inventor of one of our treatment
compositions, a royalty of 5% of gross sales of the invention
disclosed in his then pending patent application. In September
2000, we notified Tinnell that we would no longer pay such
royalties since the obligations ceased in August 1998 when the
related product patents expired and we requested reimbursement
of royalties paid since August 1998. We then filed suit in the
Federal District Court requesting a declaratory judgment that we
had no royalty obligations to Tinnell and a judgment for the
overpaid royalties. Tinnell asserted several counterclaims. The
Court has since ruled in our favor stating that we do not owe
royalty obligations to Tinnell and denied several of
Tinnells counterclaims. However, one of Tinnells
counterclaims is still outstanding for breach of contract.
Furthermore, the Court dismissed our request for reimbursement
of overpaid royalties. Tinnell filed a motion asking the trial
court to certify the issue of our royalty obligation for
immediate appeal. In May 2004, we joined the request and also
asked the trial court to certify the issue of our right to
reimbursement of the overpaid royalties. Tinnell also moved
under Rule 54(b) of the Arizona Rules of Civil Procedure
for a money judgment in the amount of royalties due under the
original agreement based on sales in Canada, up to the time the
Canadian patent expired, plus prejudgment interest. We filed an
opposition to this motion on the grounds that the royalty
contract was completely unenforceable and neither party could
assert any claims based on it, neither Tinnell for unpaid
royalties nor us for reimbursement of overpayments. Since the
judge previously ruled that we could not receive reimbursement,
it would be an unenforceable action for any party to be entitled
to receive monies.

We are subject to other legal proceedings and
claims, which arise in the ordinary course of business. In our
opinion and in the opinion of our legal counsel, 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.

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PART II






|        |                                                                                                                           
|------- | --------------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common
    Equity, Related Stockholder Matters and Issuer Repurchases of
    Equity Securities

Information regarding the market for our 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 our Common
Stock as reported by the National Association of Securities
Dealers Automated Quotation System (NASDAQ).

|                                |                |      |   |      |  |  |   |      | 
|------------------------------- | -------------- | ---- | - | ---- |  |  | - | ---- | 
|                                |                | High |   | Low 
|                                |                |      |   |     
|Fiscal Year Ended July 31, 2004 |                |      |   |      |  |  |   |     
|                                | First Quarter  |      | $ | 4.01 |  |  | $ | 2.43 | 
|                                | Second Quarter |      |   | 4.97 |  |  |   | 3.50 | 
|                                | Third Quarter  |      |   | 5.53 |  |  |   | 3.87 | 
|                                | Fourth Quarter |      |   | 5.28 |  |  |   | 3.81 | 
|Fiscal Year Ended July 31, 2003 |                |      |   |      |  |  |   |     
|                                | First Quarter  |      | $ | 1.90 |  |  | $ | 0.77 | 
|                                | Second Quarter |      |   | 1.20 |  |  |   | 0.67 | 
|                                | Third Quarter  |      |   | 1.69 |  |  |   | 0.94 | 
|                                | Fourth Quarter |      |   | 3.41 |  |  |   | 1.37 | 

The number of stockholders of record of the
common stock as of July 31, 2004 and September 30,
2004 were approximately 2,990 and 2,989, respectively. As of
July 31, 2004, there are 100,000 shares of our
Series B Preferred Stock outstanding.

We have not paid dividends on our common stock.
The policy of our Board of Directors has been to retain future
earnings to finance the growth and development of our business.
Payment of cash dividends is restricted by the terms of our
credit agreements with Wells Fargo Business Credit, Inc.

On March 11, 2004, we entered into an
agreement with a sales representative. Under the terms of the
agreement, on June 17, 2004, we issued a warrant to
purchase 25,000 shares of our common stock for
$4.06 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 Securities Act). The
warrant will become exercisable on March 31, 2005 if
certain defined sales milestones are met by December 31,
2004. We may be required to record non-cash charges in the first
and second quarters of fiscal 2005 in connection with the
achievement of these product sales milestones.

On March 14, 2003, we issued warrants to
purchase 104,000 shares of our common stock to members of
our Medical Advisory Board. The exercise price is $0.98 per
share. The warrants were issued pursuant to the exemption set
forth in Section 4(2) of the Securities Act.

We entered into an agreement with a financial
advisor during fiscal 2002 to perform consulting services. Under
the agreement, we are committed to issue warrants to
purchase 30,000 shares of our common stock for
$4.00 per share. At July 31, 2003, $28,000 was
included in accrued liabilities representing the fair value of
the warrants expected to be issued. The warrants were effective
as of July 24, 2002 and subsequently issued on
November 6, 2003. The warrants were issued pursuant to the
exemption set forth in Section 4(2) of the Securities Act.

On December 4, 2001, we acquired the world
wide marketing and distribution rights (excluding the Pacific
Rim) for the FDA cleared ViziLite® chemiluminescent light
technology from Trylon. In connection with 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. Thereafter, we
conducted a mediation with Trylon and entered into a mediation
settlement on October 15, 2003. This settlement addressed
the contractual restrictions affecting 875,000 of the
1,625,000 shares originally delivered to Trylon and the
escrow

24



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##### Table of Contents



restrictions on the 375,000 shares held in
escrow. We further modified the agreements with Trylon on
March 26, 2004 and July 31, 2004. Those modifications
also addressed the contractual and escrow stock restrictions. As
a result of the mediation settlement and the other
modifications, on March 26, 2004 we agreed to lift
contractual restrictions on 312,500 of the 875,000 shares
referred to above. We agreed to lift contractual restrictions on
another 312,500 of the 875,000 shares referred to above on
July 31, 2004, leaving contractual restrictions on
250,000 shares. The restrictions on these remaining
250,000 shares will be removed, subject to certain
exceptions, upon the earlier of (i) the obtaining of the
required governmental approvals relating to a product
development milestone, if obtained by May 1, 2005 or
(ii) December 4, 2011. On June 30, 2004, Trylon
forfeited all of its rights to the 375,000 shares subject
to the escrow restrictions and the escrow agent returned these
shares to us. All 1,625,000 shares issued to Trylon were
issued pursuant to the exemption set forth in Section 4(2)
of the Securities Act and are restricted within the meaning of
Rule 144 under the Securities Act. Subject to the
contractual restrictions remaining on 250,000 of the shares, all
of those shares may be eligible for sale subject to the holding
period and other requirements of that Rule.


On February 1, 2001, as part of the IST
acquisition, we issued 100,000 shares of Series B
Convertible Preferred Stock to National Healthcare Manufacturing
Corporation for 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 Stock have no voting rights
except as required by applicable law. We paid the holders of the
preferred stock dividends of $19,500 during 2004, $49,000 during
2003 and $29,000 during 2002. Accumulated accrued dividends are
$39,000 as of July 31, 2004. 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.

On September 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 and the
warrant expires on September 21, 2008. The warrant was
issued pursuant to the exemption set forth in Section 4(2)
of the Securities Act.

Issuer Repurchase of Equity
Securities

We did not repurchase any of our equity
securities during fiscal 2004.






|        |                        
|------- | -----------------------
|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. (Dollars in thousands, except
per share amounts.)

|                                                                                      |  |                            |        |      |  |      |        |      |  |      |         |   |  |   |        |   |  |   |        |    
|------------------------------------------------------------------------------------- |  | -------------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------- | - |  | - | ------ | - |  | - | ------ | ---
|                                                                                      |  |                           
|                                                                                      |  | Fiscal Year Ended July 31,
|                                                                                      |  |                           
|Statement of Operations Data:                                                         |  | 2004                       |        | 2003 |  | 2002 |        | 2001 |  | 2000
|                                                                                      |  |                            |        |      |  |      |        |      |  |     
|Net Revenues                                                                          |  | $                          | 49,428 |      |  | $    | 47,107 |      |  | $    | 34,872  |   |  | $ | 30,711 |   |  | $ | 36,608 |    
|Net Income (Loss) from Continuing Operations
    Before Accounting Change             |  |                            | (4,337 | )    |  |      | 11,360 | (1)  |  |      | (11,338 | ) |  |   | (6,269 | ) |  |   | 3,177  | (3)
|Net Income (Loss) Attributable to Common
    Shareholders                             |  |                            | (4,376 | )    |  |      | 7,246  | (2)  |  |      | (12,069 | ) |  |   | (6,390 | ) |  |   | 3,344  |    
|Basic and Diluted Net Income (Loss) Per Share
    Attributable to Common Shareholders |  | $                          | (0.10  | )    |  | $    | 0.16   |      |  | $    | (0.27   | ) |  | $ | (0.15  | ) |  | $ | 0.08   |    

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|                                     |  |             |        |      |  |      |         |      |  |      |        |  |  |   |        |  |  |   |        | 
|------------------------------------ |  | ----------- | ------ | ---- |  | ---- | ------- | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                                     |  |            
|                                     |  | At July 31,
|                                     |  |            
|Balance Sheet Data:                  |  | 2004        |        | 2003 |  | 2002 |         | 2001 |  | 2000
|                                     |  |             |        |      |  |      |         |      |  |     
|Current Assets                       |  | $           | 30,122 |      |  | $    | 35,326  |      |  | $    | 20,810 |  |  | $ | 34,090 |  |  | $ | 31,380 | 
|Total Assets                         |  |             | 62,109 |      |  |      | 69,020  |      |  |      | 57,361 |  |  |   | 75,603 |  |  |   | 77,041 | 
|Current Liabilities                  |  |             | 7,696  |      |  |      | 11,544  |      |  |      | 7,427  |  |  |   | 15,803 |  |  |   | 11,377 | 
|Long-Term Debt                       |  |             | 3,650  |      |  |      | 3,728   |      |  |      | 3,610  |  |  |   | 4,153  |  |  |   | 4,549  | 
|Total Liabilities                    |  |             | 11,880 |      |  |      | 15,272, |      |  |      | 11,038 |  |  |   | 19,956 |  |  |   | 15,926 | 
|Series B Convertible Preferred Stock |  |             | 463    |      |  |      | 463     |      |  |      | 463    |  |  |   | 463    |  |  |   |       | 
|Shareholders Equity                 |  |             | 50,228 |      |  |      | 53,748  |      |  |      | 46,323 |  |  |   | 55,646 |  |  |   | 61,114 | 



---



|    |                                                                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes $14.8 million contract settlement
    gain from our former contract research organization (see
    Note 5)                                                                                                                                        
|   
|(2) | Includes adoption of SFAS No. 142,
    Goodwill and Other Intangibles Assets, in which we
    recorded a charge of $4.1 million reported under the
    caption Cumulative effect of accounting change on
    our Consolidated Statements of Operations.
|   
|(3) | Includes a gain of $4.7 million primarily
    related to the sale of assets of in our subsidiaries, Zila
    Technology, Inc. and Integrated Technologies, Inc.                                                                                            






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

This report on 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. A wide variety of factors could cause or
contribute to such differences and could adversely impact
revenues, profitability, cash flow and capital needs. 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) increased
competition from current competitors and new market entrants;
(iv) our reliance on single source manufacturing locations
for several of our products; (v) adverse publicity
regarding the industries in which we market our products;
(vi) our dependence upon our ability to develop new
products; (vii) our ability to gain or expand distribution
within new or existing channels of trade; (viii) 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
advertising, or rebates; (ix) adverse changes in or
interpretations of government regulations, especially those
related to dietary supplements and ingredients in dietary
supplements and those related to OTC products; (x) our
suppliers and our ability to comply with current and proposed
GMPs and other applicable regulatory requirements;
(xi) exposure to product liability claims;
(xii) dependence on significant customers and our
customers ability to repay obligations due to us;
(xiii) our ability to keep and attract key management
employees; (xiv) our inability to manage growth and execute
our business plan; (xv) sales and earnings volatility;
(xvi) volatility of the stock market; (xvii) our
reliance on independent brokers to sell many of our products;
(xviii) our inability to protect our intellectual

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property; (xix) charges resulting from an
impairment of our goodwill, intangible assets and other
long-lived assets; (xx) future decreases in the cost of ascorbic
acid that may result in purchases under our supply arrangements
at prices above market; (xxi) our ability to gain market
acceptance of our ViziLite® and Ester-E® products;
(xii) our ability to replace the loss of ISTs
principal customer with new business; and (xxiii) 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 program; (ii) the FDAs decision regarding
our proposed modifications for the OraTest® clinical
program; (iii) our ability to accelerate, expand and fund
the clinical study under terms that are reasonable and prudent
for us; (iv) the FDAs ultimate decision regarding the
OraTest® clinical program and product; (v) the length, size
and expense of our clinical program and the FDA review process;
(vi) stability of the ZTCTM drug substance;
(vii) the limitations on indicated uses for which the
OraTest® product may be marketed if we receive FDA
approval; and (viii) 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.

Overview

You should read the following discussion and
analysis together with the financial data in the section labeled
Selected Financial Data and with our audited
Consolidated Financial Statements and Notes thereto.

We are an innovator in preventive healthcare
technologies and nutraceutical, pharmaceutical and biotechnology
products, focusing on enhanced body defense and the detection of
pre-disease states. Our Business Units are aligned as follows:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Zila Nutraceuticals, manufacturer and marketer of
    Advanced Protection Ester-C® and Ester-E®,
    proprietary, branded, highly effective forms of vitamins C
    and E.                                                                                                                                                                                                                                   
|
| |  | Zila Pharmaceuticals, manufacturer and marketer
    of superior products to promote oral health and prevent oral
    disease, including the ViziLite® chemiluminescent light for
    illumination of oral mucosal abnormalities, Peridex®
    prescription periodontal rinse, the Zilactin® family of OTC
    oral care products and the plastic molded products of Zila Swab
    Technologies, Inc. (IST).
|
| |  | Zila Biotechnology, a research, development and
    licensing business specializing in pre-cancer/ cancer detection
    through its patented Zila Tolonium Chloride and OraTest®
    technologies, which are in FDA phase III clinical studies.                                                                                                                                                              

Our strategic approach to the management of our
business units is driven by our commitment to grow our
Nutraceutical and Pharmaceutical businesses while we
successfully complete the OraTest® product clinical trials.
To that end, we are investing more aggressively in our core
nutraceutical and pharmaceutical products to drive greater
profitability and the required cash flows to fund the research
and development efforts being managed by the Biotechnology
Business Unit. In doing so, our corporate goal is to manage the
entire portfolio of business units in a manner such that over
the course of a given fiscal year, our earnings before interest,
taxes, depreciation and amortization (EBITDA) would
be at a near break-even level. We expect to continue with this
goal until such time as we obtain the requisite clearances from
the U.S. Food and Drug Administration (FDA) to
bring our OraTest® product to market in the United States.
Market forces, such as the market acceptance of new products
such as our new Ester-E® product, and other such variables
and risk factors, can and do influence our ability to accomplish
this goal. We fell short of this goal in fiscal 2004 due
primarily to the impact of abnormally high ascorbic acid costs
that reduced our profit margins on our Ester-C®products,
the delay in the commercial launch of Ester-E® until May
2004, and increased biotechnology investment. See page 16
for further discussion of the risk factors that we face in our
businesses. Additionally, our level of future research and
development activities, and the associated cost, will likely
trend above our historical levels as we accelerate our efforts
to advance our clinical program. Unless our other

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business units produce a sufficient, higher level
of EBITDA to offset these additional costs, we will operate on a
negative EBITDA basis during such period.


We believe that our current cash balances, cash
generated from our operations, net proceeds from our investing
activities and the availability of cash under our line of credit
are sufficient to finance our level of operations, the
OraTest® clinical program, the continuation of the launch
of Ester-E® and anticipated capital expenditures during
this period.

In connection with our dialogue with the FDA, we
have proposed modifications to the current OraTest®
clinical program aimed at reducing its overall duration and
total cost. It is our goal to include the evaluation of
OraTest® in the accurate identification of severe dysplasia
(pre-cancer) in addition to carcinoma in-situ and invasive
carcinoma (cancer) as acceptable clinical endpoints in the
modified program. It is also our objective to collect data in an
incremental population of individuals at high risk of oral
cancer (primary cancer screening) while still reducing the cost
and duration of the current clinical program. If this program
modification is allowed by the FDA and the clinical objectives
are achieved, it may also permit enlargement of the
post-approval target population and the marketable claims for
OraTest®.

No assurances can be made that the FDA will agree
to our proposed program modifications or that the clinical
objectives will be achieved. We have assimilated and implemented
the FDAs non-binding comments to our proposed program
modifications and we have submitted our revised clinical test
protocols for FDA review. We are awaiting the FDAs input
regarding these revised protocols. In the meantime, we continue
to collect patient data from our on-going phase III
clinical trial and we are preparing for execution of the
modified program.

In March 2004, our Board of Directors authorized
the divestiture of the net assets of IST, our plastic molded
products manufacturing subsidiary, in order to focus on our core
business operations. IST is included within our Pharmaceuticals
Business Unit. In September 2004, our Board of Directors
reversed the divestiture decision and withdrew IST from the
market. IST has been determined by management to be the best
available sourcing option for a new product that is being
developed and therefore its importance to future operations has
changed. Furthermore, no acceptable purchase offer was produced
by the effort to market IST. In the first quarter of fiscal
2005, IST will be reclassified as held and used
under the requirements of SFAS No. 144 
Impairment and Disposition of Long-lived Assets.

Effective March 31, 2004, ISTs
contract with a major customer expired. Sales under this
contract represented approximately 80% of ISTs net
revenues. Cost reduction measures underway at IST should
mitigate part of the loss of net revenues at IST until new
customers can be obtained.

Results of Operations

Fiscal Year Ended July 31, 2004
Compared to Fiscal Year Ended July 31, 2003



| |              
| | -------------
| | Total Company

Net revenues increased 4.9% to $49.4 million
for fiscal 2004, compared to revenues of $47.1 million for
fiscal 2003. The increase is due to a 10.2% net revenue increase
in the Nutraceuticals Business Unit offset by a 3.8% decrease in
the Pharmaceuticals Business Unit. When the net revenues of the
discontinued Saw Palmetto oil product line are removed from both
years, net revenues increased 23.9% at the Nutraceuticals
Business Unit and 12.7% for the total Company. Increased
spending in advertising and promotional programs and the
commercial introduction of our new Ester-E® product
contributed to the sales gains.

Cost of products sold as a percentage of net
revenues for fiscal 2004 decreased to 39.3% from 42.2%. This
decrease is due primarily to the lower relative cost of product
at IST resulting from a March 2003 selling price increase and
the effect of sales of the low margin saw palmetto products in
the prior year in our Nutraceuticals Business Unit as we sought
to liquidate our remaining inventories. These reductions were
offset by an increase in the cost of products for our
Ester-C® caused primarily by a $3.0 million increase
in the cost of ascorbic acid, principally in the first half of
fiscal 2004. Also, to a lesser extent, the reductions in our
cost of products were

28



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##### Table of Contents



offset by increased product costs related to
promotional activities and increased manufacturing costs in the
Pharmaceuticals Business Unit.


Marketing and selling expenses as a percentage of
net revenues for fiscal 2004 increased to 24.6% from 20.9%. This
increase was primarily due to heavy brand and media advertising
support for the Nutraceuticals Business Unit product,
Ester-C®, and increased marketing support for
certain Pharmaceuticals Business Unit products.

General and administrative expenses were
$13.0 million, or 26.3% of net revenues, for fiscal 2004,
compared to $12.7 million, or 26.9% of net revenue, for
fiscal 2003. In fiscal 2004, legal fees of $900,000 associated
with the Beutlich and Trylon settlements offset cost reductions
over the previous year.

Severance and related charges of $350,000 in
connection with employee terminations, recruiting fees and
relocation expenses were incurred in fiscal 2004, compared to
$1.3 million incurred in fiscal 2003. Higher severance and
related charges were incurred in the prior year due primarily to
the significant changes in our management and the resulting
reorganization.

Research and development expenses increased
$1.8 million, or 44.2%, to $6.0 million for fiscal
2004 from $4.1 million for fiscal 2003. The increase is due
primarily to an increase in the OraTest® phase III
clinical program expenses of $1.9 million, or 51.7%, and
included a non-cash charge of $72,000 discussed below in the
Biotechnology Business Unit section.

An impairment charge of $289,000 was recorded in
the Pharmaceuticals Business Unit in the fourth quarter of
fiscal 2004.

Depreciation and amortization expenses increased
$254,000, or 10.5%, to $2.7 million for fiscal 2004 from
$2.4 million for fiscal 2003. The increase in depreciation
and amortization relates to expenditures for property and
equipment and patents and trademarks in the Nutraceuticals and
Pharmaceuticals business units. These increases were mitigated
by the suspension of depreciation and amortization of ISTs
property and equipment and patents and trademarks in April 2004
as a result of our decision to divest the net assets of IST.

On January 30, 2004, as part of our strategy
to employ financial assets in core business competencies, we
completed the sale and a five-year leaseback of our corporate
headquarters for approximately $1.7 million in net cash. We
realized a pre-tax gain of $1.2 million, of which we
recognized approximately $470,000 in the quarter ended
January 31, 2004. The $470,000 gain represents the excess
of the net proceeds over the net present value of the future
lease payments. The balance of the gain of $765,000 was deferred
and will be amortized on a straight-line basis over the
five-year lease term as a reduction of rent expense in general
and administrative expenses. The leaseback is accounted for as
an operating lease.



| |                             
| | ----------------------------
| | Nutraceuticals Business Unit

A number of factors have influenced the unit
revenue growth, strong profitability and other financial
performance of the Nutraceuticals Business Unit in 2004,
including:



| |   |                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Growing consumer awareness and trial of
    Ester-C® in response to increased media and promotion
    investment and improved advertising;                                                                                             
|
| |  | The commercial introduction of our Ester-E®
    tocopheryl phosphates, an enhanced form of natural vitamin E and
    the first line extension under our successful Ester
    umbrella of products;                                   
|
| |  | Negotiation of supply agreements for ascorbic
    acid that will provide a substantial portion of our annual
    requirements at prices equivalent to historical averages,
    providing cost predictability for our Ester-C® products;
|
| |  | A controlled exit from the saw palmetto market,
    liquidating all remaining inventory at pricing that offsets our
    carrying value; and                                                                                            
|
| |  | Reducing general and administrative costs from
    fiscal year 2003 despite significant volume growth.                                                                                                                                 

29



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##### Table of Contents



Net revenues for the Nutraceuticals Business Unit
for fiscal 2004 increased 10.2% to $32.4 million compared
to $29.4 million for fiscal 2003. This growth was driven by
an 18.0% increase in Ester-C® net revenues for fiscal 2004
over fiscal 2003 and the introduction of Ester-E® in May
2004. These increases were offset by the sharp reduction in saw
palmetto oil products revenue in fiscal 2004 as we exited that
business. Excluding saw palmetto, Nutraceuticals net revenues
grew by 23.9% in fiscal 2004. Domestic net revenues for
Ester-C® grew by 24.5% in fiscal 2004. The growth in
Ester-C® net revenues was driven principally by increased
radio and television advertising support for the Ester-C®
products in our continuing strategy of brand development. In
2004, we completed our strategic withdrawal from the saw
palmetto market by selling our remaining small inventory of saw
palmetto powder in the normal course of business.

Cost of products sold as a percentage of net
revenues for the Nutraceuticals Business Unit decreased to 37.5%
for fiscal 2004 compared to 40.6% for fiscal 2003. This decrease
resulted primarily from the effect of sales of the low margin
saw palmetto products in the prior year as we sought to
liquidate our remaining inventories and to a lesser extent sales
of higher margin Ester-E® product. Offsetting this decrease
was an increase in the cost of products for our Ester-C®.
This increase was caused primarily by a $3.0 million
increase in Ester-C® cost of products sold due to higher
costs of ascorbic acid, principally in the first half of fiscal
2004.

Ascorbic acid is the principal raw material in
our Ester-C® products and is subject to periodic price
fluctuations. While ascorbic acid prices rose dramatically
during fiscal year 2003 and during the first half of fiscal year
2004, we have obtained a supply of ascorbic acid for a
substantial portion of our anticipated requirements from two
sources and at prices equivalent to our historical averages,
providing cost predictability through the three-year terms of
the agreements. Pricing under one of these agreements can
fluctuate within a defined ranged based on foreign currency
rates. On April 1, 2003, a price increase for Ester-C®
products was instituted to partially offset the effects of the
higher ascorbic acid prices.

The fiscal year 2004 growth of Ester-C®
continued to be driven principally by increased media spending,
up 34.0% over the prior year. This sustained media investment,
focused on increasing brand awareness for Ester-C® and
introducing our Ester-E®, and this increase in media
spending, led to significant distribution gains, high impact
retail promotion and new manufacturer/ marketer customers.

The Nutraceuticals Business Unit demonstrated
gains in operating efficiency during 2004. The increase in net
revenues for the year was achieved while spending on General and
Administrative costs decreased for fiscal 2004 compared to the
prior year as a result of reduced legal and employee related
costs.

During fiscal 2004, we made progress towards
completion of our $524,000 second-phase Ester-C® production
expansion project to double our capacity to support
approximately $60 million in annual revenue. We also
completed the $100,000 installation of our Ester-E®
production line and constructed a pilot plant facility for new
product development and current production optimization. The
capital expenditures completed in fiscal 2003 resulted in a 30%
increase in Ester-C® production capacity.



| |                              
| | -----------------------------
| | Pharmaceuticals Business Unit

The Pharmaceuticals Business Unit has more
complex operations than our Nutraceuticals Business Unit since
it competes in multiple markets (consumer packaged goods, direct
to dental professionals, sales to dental distributors via
independent reps and swab applications) with four distribution
methods (wholesalers, master distributor arrangement,
independent sales representatives and direct sales team). The
key factors influencing the Pharmaceuticals Business Units
financial performance and operations during fiscal 2004 include:



| |   |                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------
| |  | Stabilizing declining Zilactin® sales
    through improved marketing efforts;                                                      
|
| |  | Strengthening the position of Peridex® in
    the direct to dental market through the introduction of new
    dispensing offerings;
|
| |  | A disciplined product rollout of ViziLite®
    that resulted in improving sales trends;                                            
|
| |  | Cost of goods increases for production due to
    supplier changes and an increase in regulatory
    compliance; and               

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| |   |                              
| | - | -----------------------------
| |  | Loss of a major IST customer.

Net revenues for the Pharmaceuticals Business
Unit for fiscal 2004 decreased 3.8% to $17.0 million
compared to $17.7 million for fiscal 2003. Decreased
revenues for our Peridex® product, driven largely by softer
United States wholesaler demand, were primarily responsible for
this decline. Net revenues of the Zilactin® line of
products were essentially flat for fiscal 2004 as we
discontinued our Baby Teething products. Net revenues for the
Pharmaceuticals Business Unit include the net revenues of IST.
Our contract with ISTs major customer expired on
March 31, 2004, and our net revenues from IST declined
significantly during the balance of fiscal 2004. IST is actively
pursuing new customer arrangements to mitigate the loss of net
revenues. There can be no assurances that it will be successful
in this regard. An impairment charge of $289,000 was recorded in
the Pharmaceuticals Business Unit in the fourth quarter of
fiscal 2004.

Cost of products sold as a percentage of net
revenues for the Pharmaceuticals Business Unit decreased to
43.0% during fiscal 2004 from 44.3% for fiscal 2003, primarily
due to lower cost of product at IST offset by an increase in
Zilactin® product costs. The relative lower cost of product
at IST resulted from a March 2003 selling price increase for
products made for our major customer and to a lesser extent from
improvement in manufacturing efficiencies due to the full
utilization of new machinery installed in fiscal year 2003. The
Zilactin® increase was due to the higher cost of
promotional events, along with increased production costs
incurred as the transfer of certain Zilactin® product
production to a contract manufacturer was completed.

For Zilactin®, during fiscal 2004 we saw a
continuing trend towards intense media and consumer-oriented
advertising competition from several rival products. As a result
of our advertising and promotional efforts, we were able to
stabilize our sales base and achieve a slight increase in sales
for the year. Because consumer research points to a large group
of consumers who are not loyal to any specific brand, we have
tailored our marketing program to improve positioning and
packaging of the products in an attempt to increase awareness
and shelf impact to reach new users.

In 2004, Peridex® efforts were focused
around strengthening our position in the direct to dental
market, exclusively distributed by Omnii, through the
introduction of a 64 oz. dispensing unit and a 4 oz. convenience
bottle. Product development activities were initiated to counter
inroads made by generic equivalents and resulted in a 4.4%
increase over the prior year in our direct-to
dentist unit sales.

During 2004, we continued to fine-tune our
product-to-market strategy for ViziLite® based on our
experience relating to the requirements for achieving awareness,
education, trial and repeat purchases of this unique product
within the dental profession. A network of independent
representatives was contracted to serve as an overlay to the
national network of distributors carrying ViziLite®, as
well as to bring additional focus to the device during
distributor representative sales calls. Additionally, the
American Dental Association in May established a new
reimbursement code intended to cover the ViziLite exam. The new
code is expected to be available for use beginning in January
2005. Reimbursement codes can be used to report dental
procedures provided under public and private dental insurance
benefits plans. Obtaining insurance reimbursement from specific
carriers is a separate process. We are now engaged in this
process for our ViziLite®product.



| |                            
| | ---------------------------
| | Biotechnology Business Unit

A number of factors have influenced the financial
results for the Biotechnology Business Unit in 2004, including:



| |   |                                                                                                                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Increased spending for the OraTest® product
    phase III clinical program;                                                                                                                            
|
| |  | Selecting new regulatory consultants and
    continued development of a commercialization strategy for the
    OraTest® product;                                                                       
|
| |  | Proposed modifications to the current
    OraTest® clinical program submitted to the FDA aimed at
    reducing its overall duration and total cost;                                                    
|
| |  | Renegotiation of the General Services Agreement
    with Quintiles Transnational Corp. (Quintiles), our
    contract research organization, to support the modifications to
    our clinical program;

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| |   |                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Expanded use of our Medical Advisory Board, whose
    members are some of the worlds leading researchers in the
    field of head and neck cancer, to assist in development of our
    regulatory strategy to reduce the cost and duration of our
    current clinical program and in development of our product
    commercialization strategy;
|
| |  | Emphasizing the U.S. domestic market sales
    potential and de-emphasizing European and Asian marketing
    efforts; and                                                                                                                                                                                                                        
|
| |  | Evaluation of other Tolonium Chloride pre-cancer
    and cancer detection applications.                                                                                                                                                                                                                                                          

Revenues from sales of the OraTest® product
in the United Kingdom and the Pacific Rim area were nominal
during fiscal 2004 and 2003, as we focused on obtaining FDA
approval in the United States.

Total operating expenses for the Biotechnology
Business Unit were $7.3 million for fiscal 2004, a 34.8%
increase over the $5.4 million for fiscal 2003. This was
driven by an increase of approximately $1.9 million, or
51.7%, in the clinical program expenses related to the
OraTest® product and a non-cash charge of $72,000. As more
fully described in Note 2 to the Consolidated Financial
Statements, this non-cash charge relates to the removal of
contractual restrictions on common stock held by The Trylon
Corporation in recognition of its achievement of a product
development milestone.

We believe that our current cash balances, cash
generated from our operations and the availability of cash under
our line of credit are sufficient to finance our level of
operations, the OraTest® clinical program, the launch of
Ester-E® and anticipated capital expenditures.

Fiscal Year Ended July 31, 2003
Compared to Fiscal Year Ended July 31, 2002



| |              
| | -------------
| | Total Company

Net revenues for the year ended July 31,
2003 were $47.1 million, a 35.1% increase compared to the
$34.9 million for the year ended July 31, 2002. Due to
this net revenue increase our loss from operations improved from
a loss of $7.1 million in 2002 to a loss of
$3.4 million in 2003. Income from continuing operations
turned around significantly from a loss from continuing
operations before accounting changes of $11.3 million in
2002 to income from continuing operations in 2003 of
$11.4 million as a result of the gain from the settlement
with our former contract research operator and the sale of our
investment in PracticeWares. We believe that other factors
contributing to these improvements were our focus on our three
Business Units, our core competencies and investment in needed
infrastructure.

On a segment basis, the main driver of growth in
net revenues was a 50.4% increase in the net revenues of the
Nutraceuticals Business Unit, to $29.4 million in 2003 from
$19.6 million in 2002. This represented 62.5% of net
revenues and 64.2% of the gross margin in 2003. This growth was
due primarily to an increased market acceptance of and demand
for Ester-C® tracing to effective consumer advertising and
media investment aimed at building broadscale brand awareness
and to overhead cost controls. The Pharmaceuticals Business Unit
increased its net revenues 16.2%, to $17.7 million in 2003
from $15.2 million in 2002, representing 37.5% of our net
revenues and 36.2% of the gross margin in 2003. Net revenues for
the Biotechnology Business Unit were not significant as we
concentrated on continued execution of the FDA phase III
clinical program for OraTest®.

Cost of products sold as a percentage of net
revenues increased to 42.2% for the year ended July 31,
2003 compared to 33.5% for the year ended July 31, 2002.
The increase was caused by the higher percentage of sales of the
Palmettx® line which was essentially sold at cost, higher
percentage sales of the IST product line and higher costs of
ascorbic acid which depressed the Ester-C® gross margins.

Marketing, selling, general and administrative
costs for the year ended July 31, 2003 were
$22.5 million, an increase of $701,000 or 3%, compared to
the $21.8 million for the year ended July 31, 2002.
This increase was primarily due to $339,000 in accounting and
legal costs related to the 2002 restatement of our financial
statements, $200,000 in additional insurance costs and $190,000
in additional personnel costs.

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Severance and related charges for the year ended
July 31, 2003 were $1.3 million compared to
$0 (zero) for the year ended July 31, 2002 due
primarily to the significant change in our management and the
resulting reorganization.

Research and development costs for the year ended
July 31, 2003 were $4.1 million, a decrease of
approximately $600,000 or 12.7%, compared to the
$4.7 million for the year ended July 31, 2002. This
decrease is due to reduced ViziLite® costs as we moved from
product development to product marketing activities.
OraTest® clinical research increased 16.9% from
$3.1 million to $3.6 million.

An impairment charge of $141,000 was recorded in
fiscal 2003 in connection with certain assets related to the
Pro-TiesTM product line.

Depreciation and amortization costs for the year
ended July 31, 2003 were $2.4 million, a decrease of
approximately $1.1 million or 30%, compared to
$3.5 million for the year ended July 31, 2002. This
decrease is due to the adoption of SFAS No. 142,
Goodwill and Other Intangible Assets. Under the
requirements of this SFAS, goodwill is no longer amortized.



| |                             
| | ----------------------------
| | Nutraceuticals Business Unit

A number of factors influenced the unit revenue
growth, strong profitability and other financial performance of
the Nutraceuticals Business Unit in 2003, including:



| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Growing consumer awareness and trial of
    Ester-C® in response to increased advertising and promotion
    support;                                        
|
| |  | A controlled exit from the saw palmetto oil
    market, liquidating all remaining oil inventory at pricing that
    offset nearly all of our carrying value;
|
| |  | Controlled overhead costs, with general and
    administrative expenses unchanged from fiscal year 2002 despite
    significant volume growth;              
|
| |  | Rapidly increasing costs of ascorbic acid eroding
    Ester-C® gross margins;                                                                               
|
| |  | An April 2003 10% price increase for
    Ester-C® product and our strategic sourcing initiative to
    provide stable supplies and costs; and               
|
| |  | Addition of a second vertical mixer in our
    Prescott facility, providing a 30% increase in Ester-C®
    production capacity.                             

Net revenues for fiscal 2003 were
$29.4 million, a 50.4% increase compared to the
$19.6 million reached in fiscal 2002. Driving this growth
was the patented Ester-C® brand, which leveraged its
position as a leading branded, enhanced vitamin C to achieve a
51% increase in net revenues. Fiscal 2003 also marked the
complete sell through of our saw palmetto oil inventory,
delivering revenue of $3.3 million, roughly equivalent to
our carrying cost. This controlled exit generated cash, as the
inventory was not replenished.

Cost of products sold, as a percentage of net
revenues was 40.6% for fiscal year 2003 and 36.8% for fiscal
2002. This increase in product costs is attributable to selling
our saw palmetto inventory at approximately our carrying value,
generating zero gross margins, and the impact of escalating
ascorbic acid prices on the finished product cost of
Ester-C®. We undertook a strategy to lock in ascorbic acid
supplies for the majority of our raw material needs through long
term contracts to secure stable, reduced prices. Further, the
Nutraceuticals Business Unit implemented a 10% price increase to
partially offset the fiscal year 2003 ascorbic acid cost
increases.

The fiscal year 2003 growth of Ester-C® was
driven principally by a second consecutive year of increased
media spending, as total marketing and selling expense was up
15.5% versus the prior year. This sustained media investment,
focused on increasing brand awareness for Ester-C®, and the
resulting increase in retail sales, led to significant
distribution gains, high impact retail promotion and new
manufacturer/ marketer customers.

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The Nutraceuticals Business Unit demonstrated
gains in operating efficiency during 2003. The 50% increase in
revenue for the year was achieved without increases in dollar
spending on General and Administrative costs for fiscal 2003
compared to the prior year.

An Ester-C® capacity expansion project was
completed during July 2003. A second vertical mixer was added to
the Ester-C® production area at a cost of approximately
$160,000. This project yielded a 30% increase in Ester-C®
output capacity. This project represented the completion of the
first phase of capacity expansion. The second phase, which was
initiated in July 2003 will represent a $600,000 capital
expenditure and will double Ester-C® production capacity to
support approximately $60 million in revenue.

Pharmaceuticals
Business Unit

The key factors influencing the Pharmaceutical
Business Units financial performance and operations during
fiscal 2003 included:



| |   |                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Declining Zilactin® sales, offset by an
    increase in Peridex® sales, an increase in IST sales and a
    disciplined product rollout of ViziLite®;
|
| |  | Cost of goods increases for production due to a
    change in suppliers and an increase in regulatory compliance;                                   
|
| |  | Product shortages as a result of delays in
    qualifying and transitioning to new suppliers;                                                       
|
| |  | Management turnover; and                                                                                                                            
|
| |  | Unit volume growth at IST.                                                                                                                          

Net revenues for fiscal 2003 were
$17.7 million, a 16.2% increase or $2.5 million,
compared to the $15.2 million for fiscal 2002. In fiscal
2003, Zilactin® sales declined from the prior year while
Peridex® sales increased. For fiscal 2003, ViziLite®
sales were nominal as we built critical infrastructure,
completed key clinical studies and performed education and
training as we continued our launch of the new product. IST
experienced growth with sales up $3.7 million or 322.2% in
fiscal 2003 compared to the prior year.

Cost of products sold, as a percentage of net
revenues was 44.3% for fiscal 2003 compared to 28.8% for fiscal
2002. This increase is attributable to cost increases in the
Zilactin® line and a shift in product mix toward the lower
margin IST products. During 2003, cost of products sold for the
Zilactin® line increased over 2002 due primarily to
non-recurring increased production costs related to the
transition to qualified new suppliers. For Peridex®, cost
of products sold decreased in 2003 as the mix of higher margin
U.S. wholesale sales grew to 46% from 35% in the prior
year. At IST, cost of products sold also increased due to a
higher percentage of sales of lower margin products.

For Zilactin®, fiscal 2003 marked the second
year of intense media and consumer-oriented advertising
competition from several rival products resulting in a
significant decline in retail sales for the year. Because
consumer research points to a large group of consumers who are
not loyal to any specific brand, we have tailored our marketing
program to improve positioning of the products in an attempt to
increase awareness and shelf impact to reach new users.

In fiscal 2003, Peridex® improved its
performance due to expanded sales to its exclusive distributor
to the dental profession coupled with a substantial increase in
sales to the drug wholesale market. Gross margins improved in
fiscal 2003 due to a higher percentage of sales into the higher
margin drug wholesale market. Based on distributor demand, we
developed new packaging geared toward the in-office market for
rinses and we are investigating product development activities
to counter inroads made by generic equivalents.

During fiscal 2003, we adjusted our
product-to-market strategy for ViziLite® based on our
experience relating to the process required to achieve
awareness, education, trial and repeat purchases of this unique
product within the dental profession. We realized that the
original strategy which provided an exclusive distribution right
to a large national distributor would not provide sufficient
contact with individual dentists. Therefore, a network of
independent representatives was contracted to manage a national
network of

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distributors. We are now determining the needed
level of additional support for educating and converting
interested dentists to trial as well as securing a stream of
repeat purchases.


IST achieved a settlement of the Matrixx
litigation matter in 2003. In fiscal 2003, Matrixx represented
over 70% of IST sales and 5.2% of our gross margin. Thus, the
successful settlement of this matter which enforced our price
increase and extended our supply contract through March 2004
ensured a profitable fiscal 2003. However, we lost this customer
in March 2004 when our contract expired.

Biotechnology
Business Unit

A number of factors have influenced the financial
results for the Biotechnology Business Unit in 2003:



| |   |                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------
| |  | Transitioning the OraTest® clinical program
    to Quintiles Transnational;                                              
|
| |  | An investment by PharmaBio in the OraTest®
    program;                                                                  
|
| |  | Accelerated phase III clinical trial
    spending;                                                                       
|
| |  | Achieving a $20 million settlement with our
    former contract research organization;                                   
|
| |  | Selecting new regulatory consultants and
    development of a new commercialization strategy for
    OraTest®;           
|
| |  | Emphasizing the U.S. domestic market sales
    potential and de-emphasizing European and Asian marketing
    efforts; and
|
| |  | Evaluation of other Tolonium Chloride pre-cancer
    and cancer detection applications.                                  

In December 2002, we contracted with Quintiles,
the worlds largest pharmaceutical services company, to
take over as our new contract research organization for the
continuing phase III clinical program of our OraTest®
oral cancer detection product. Through its product development
group, Quintiles provided us with a full range of drug
development services focused on helping us achieve regulatory
success. Also, PharmaBio Development, Inc.
(PharmaBio), the strategic investment group of
Quintiles made a $500,000 investment in our Company in exchange
for a royalty payment based on U.S. and European OraTest®
sales until they have received a maximum return of
$1.25 million.

Total operating expenses for the Biotechnology
Business Unit were $5.4 million for fiscal 2003 compared to
$5.5 million for fiscal 2002. However, while total costs
decreased 1.8%, the clinical program investment for
OraTest® increased from $3.1 million in fiscal year
2002 to $3.6 million in fiscal year 2003, an increase of
$521,000 or 16.9%. With the April 2003 settlement of a dispute
with our former contract research organization and the
approximately $14.8 million in net cash proceeds, along
with internally-generated cash, we currently anticipate we will
be able to fund the clinical program to FDA marketing clearance,
assuming that it is achieved.

With the creation of the Medical Advisory Board
in late 2002, we aligned ourselves with some of the worlds
leading researchers in the field of head and neck cancer. The
input of this board was critical in the selection of our new
contract research organization, the development of an improved
regulatory strategy to reduce the cost and duration of our
current clinical program and establishment of the groundwork for
product commercialization.

Substantially all of our efforts are focused on
the OraTest® product FDA phase III clinical study with
little emphasis, funding and resources given towards
international marketing efforts.

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.

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Liquidity and Capital Resources

Overview

Our liquidity needs arise from working capital
requirements, the funding of our OraTest® clinical program
and the launch of our new products, ViziLite® and
Ester-E®, and debt service. We have met these cash
requirements through our cash and cash equivalents, cash from
operations and working capital management, the sale of non-core
assets and proceeds from the issuance of common stock under our
employee stock option and stock purchase programs.

Significant items in 2004 that improved our
liquidity and cash position were the sale of our corporate
headquarters and the five-year leaseback of this facility for
net cash of $1.7 million, the return of $1.1 million
of deposits and a reduction in our inventory levels of
$1.3 million, or 16.1%, while sales increased 4.9%.

At July 31, 2004, our primary sources of
liquidity included cash and cash equivalents of
$11.7 million and the line of credit discussed below. This
compares to cash and cash equivalents of $16.2 million at
July 31, 2003. Excess cash and cash equivalents are
invested primarily in money market accounts. Our working capital
was $22.4 million at July 31, 2004 compared to
$23.7 million at July 31, 2003. The primary reason for
the decrease of $4.5 million in our cash and cash
equivalents was the funding of our operating loss and debt
service, the reduction in our accounts payable, the placement of
$517,000 of cash collateral, and capital expenditures for
property and equipment and intangibles. These uses of cash were
offset by the proceeds from the sale leaseback of our corporate
headquarters facility and proceeds from the issuance of common
stock under our employee stock programs. Our current ratio was
3.9 at July 31, 2004, compared to 3.1 at July 31, 2003.

We believe that our current cash balances, cash
generated from our operations and the availability of cash under
our line of credit are sufficient to finance our level of
operations, the OraTest® clinical program, the launch of
Ester-E® and anticipated capital expenditures.

Operating
Activities

Operating activities for fiscal 2004 used cash of
$3.6 million. The primary components in this use of cash
were: (i) the funding of our loss of $4.3 million,
offset by non-cash items of $2.8 million related primarily
to depreciation and amortization; and (ii) a
$3.7 million reduction in our accounts payable and accrued
liabilities, offset by cash provided from the $1.6 million
net reduction in our operating assets.

Significant changes in operating assets and
liabilities were comprised of (i) an increase in accounts
receivable of $1.3 million due to increased sales in the
fourth quarter; (ii) a decrease in inventory of
$1.3 million through improved working capital management;
(iii) a decrease of $1.6 million in prepaid expenses
and other assets resulting primarily from the return of cash
deposits from our contract research organization; and
(iv) a decrease in accounts payable and accrued expenses of
$3.7 million, primarily in the Nutraceuticals and
Pharmaceuticals Business Units, to be more in line with industry
standards.

Investing
Activities

Net cash used in investing activities was
$279,000, related primarily to $2.0 million used for
capital asset purchases and expenditures for patents and
trademarks, offset by net proceeds of $1.7 million received
from the sale and leaseback of our corporate headquarters.

Capital expenditures for property and equipment
of $1.3 million in fiscal 2004 was directed toward
investment in new computer systems for financial reporting and
investment in production expansion at the Nutraceuticals
Business Unit. Capital spending in the Nutraceuticals Business
Unit was focused on modification of existing infrastructure and
equipment to enable development and commercial production of
Ester-E®, purchase of manufacturing equipment that will be
installed in the first quarter of fiscal year 2005 that will
increase production capacity and assure continuity of production
of Ester-C® and construction of a pilot plant for new
product development and existing product optimization.

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Intangible asset expenditures for patent and
trademarks were $724,000 in fiscal 2004. Our most significant
expenditures were for the licensing rights and trademarks for
Ester-E® and patent and trademark expenditures in the other
business units.

Financing
Activities

Net cash used by financing activities was
$591,000 related primarily to the pay down of the outstanding
principal balance of the bonds related to Zila Nutraceuticals
facility and other borrowings and the deposit of $517,000 into a
restricted cash collateral account related to the replacement
letter of credit obtain for the Zila Nutraceuticals industrial
revenue bonds. These expenditures were offset by the proceeds of
$653,000 received from the issuance of common stock under our
employee stock option and stock purchase programs.

Income
Taxes

At July 31, 2004, we had net operating loss
(NOL) carry forwards for federal tax purposes of
approximately $11.4 million that expire in years 2009
through 2024. Our ability to utilize the federal NOL carry
forwards may be impaired if we continue to incur operating
losses.

Credit
Facilities

On August 27, 2001, we entered into a Loan
and Security Agreement (the Congress Agreement) with
Congress Financial Corporation (Congress). The
Congress Agreement expired on August 17, 2004. Under the
Congress Agreement, Congress provided a $12 million
revolving line of credit to us at an interest rate equal to the
prime rate plus  3/4 percent per annum. The amount of
funds available to us from the line of credit was based upon a
percentage of the value of eligible receivables and inventory
and was $8.7 million at July 31, 2004. There were no
borrowings outstanding under this line of credit at any time
during fiscal 2004. Obligations under the Congress Agreement
were collateralized by various assets, including, but not
limited to our trade accounts receivable, inventories, equipment
and intangible assets of certain of our operating subsidiaries.
Zila and all of its direct and indirect operating subsidiaries
guarantee the obligations under the Congress Agreement. Under
the Congress Agreement, payment of cash dividends was restricted
and we were also required to comply with a financial covenant
based on an adjusted tangible net worth calculation. At
July 31, 2004, our adjusted tangible net worth was
$27.1 million, as defined, compared to a required amount of
$12.0 million.

On February 6, 2004, our subsidiaries, Zila
Nutraceuticals, Inc., Zila Pharmaceuticals, Inc., Zila
Biotechnology, Inc., Zila Swab Technologies, Inc., and Oxycal
Laboratories, Inc., entered into a Credit and Security Agreement
(the Wells Fargo Agreement) with Wells Fargo
Business Credit, Inc. (Wells Fargo) that provides a
$10 million revolving line of credit effective on
August 17, 2004 upon the expiration of the Congress
Agreement and upon the perfection of certain security interests
by Wells Fargo. Borrowings will bear interest equal to the prime
rate. Funds available under the Wells Fargo Agreement are based
upon a percentage of the value of eligible receivables and
inventory. Obligations under the Wells Fargo Agreement are
collateralized by various assets, including, but not limited to
trade accounts receivable, inventories, equipment and intangible
assets. The parent company, Zila, Inc., guarantees the
obligations under the Wells Fargo Agreement.

Under the Wells Fargo Agreement, we are required
to maintain net worth, as defined, and to limit capital
expenditures to $1.7 million in fiscal 2005. At
July 31, 2004, our net worth, as defined, was
$50.3 million compared to the required amount of
$47.0 million. Additionally, payment of dividends is
restricted. The net worth and capital expenditures covenants are
established annually as of August 1. The Wells Fargo
Agreement contains a provision whereby Wells Fargo can call for
immediate repayment of all amounts due under the line upon its
sole determination that a material adverse change
has occurred. As a result of this provision, any borrowings
under the Wells Fargo Agreement will be classified as short-term
debt. There have been no borrowings under the Wells Fargo
Agreement.

In the ordinary course of its business, our
wholly-owned subsidiary, Zila Nutraceuticals, Inc., purchases
ascorbic acid from several direct and broker-arranged suppliers.
Zila Nutraceuticals, Inc. entered into three-

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year supply agreements with two major producers
for the purchase of $26.7 million of ascorbic acid.
Ascorbic acid is the primary ingredient in our Ester-C®
products. Purchases under one of these agreements commenced in
July 2004, with the other agreement starting in January 2005.
The agreements provide a substantial portion of our anticipated
annual requirements for ascorbic acid and will provide important
cost predictability during the terms of the agreements. If
ascorbic acid prices decline sharply, we would be at risk of
being committed to purchase ascorbic acid at higher than market
prices. Additionally, if our sales were to significantly
decline, we would be obligated to purchase ascorbic acid in
excess of our needs. In May 2003, Zila, Inc. provided a
continuing guaranty to one broker for up to $2 million of
ascorbic acid purchases made by Zila Nutraceuticals, Inc.


On February 5, 2001, we issued
100,000 shares of Series B Convertible Preferred Stock
(Series B Preferred) as part of the IST
acquisition. The holders of the Series B Preferred are
entitled to receive cumulative quarterly dividends at a rate of
$0.0975 per share per fiscal quarter, payable in arrears. We
paid $49,000 and $29,000 in dividends in 2003 and 2002,
respectively, and we accumulated accrued dividends of $39,000 as
of July 31, 2004. The Series B Preferred can be
redeemed at our option if our common stock maintains a closing
price on each trading day equal to or greater than $9.00 per
share for any ten trading day period. The redemption price shall
be the average bid closing price on our common stock for the
five trading days immediately proceeding the date we give
notice. The Series B Preferred shall be convertible at the
option of the holder at any time on or before December 31,
2010 into our common stock at the ratio of one-to-one. On
December 31, 2010, all of the remaining Series B
Preferred will be converted into our common stock at a ratio of
one-to-one.

During October 2000, Zila Nutraceuticals 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
Industrial Development Revenue Bonds (the Bonds),
the proceeds of which were loaned to the Inter-Cal Corporation
(now known as Zila Nutraceuticals, Inc.) 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, 2004, the Bonds outstanding
consist of $3.5 million Series A, which carried an
interest rate of 1.3% per annum. The Bonds were marketed
and sold by Banc One Capital Markets and mature in 2019. In
connection with the issuance of the Bonds, the Authority
required that we 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, expired in March 2004. A replacement letter of credit
of $3.7 million was obtained from WFBC that expires in
March 2019. This letter of credit is guaranteed by Zila, Inc.
Under the requirements of the replacement letter of credit, we
placed $517,000 in a restricted cash collateral account for the
benefit of Wells Fargo.

Stock
Repurchase Program

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. During fiscal 2003, 30,100 shares were repurchased
and no shares were repurchased in fiscal 2004. As of
July 31, 2004, 225,100 shares had been repurchased for
$571,400, and we have currently suspended purchases under this
program.

38



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##### Table of Contents



Contractual
Obligations

The table below summarizes our future cash
contractual obligations at July 31, 2004, and the effect
that such obligations are expected to have on our liquidity and
cash flows for fiscal years ending July 31 (in thousands).

|                          |  |      |        |             |  |             |        |            |  |       |       |  |  |   |       |  |  |   |        | 
|------------------------- |  | ---- | ------ | ----------- |  | ----------- | ------ | ---------- |  | ----- | ----- |  |  | - | ----- |  |  | - | ------ | 
|                          |  | 2005 |        | 2006 & 2007 |  | 2008 & 2009 |        | Thereafter |  | Total
|                          |  |      |        |             |  |             |        |            |  |      
|Long-term debt            |  | $    | 296    |             |  | $           | 520    |            |  | $     | 990   |  |  | $ | 1,986 |  |  | $ | 3,792  | 
|Operating leases          |  |      | 466    |             |  |             | 447    |            |  |       | 295   |  |  |   |      |  |  |   | 1,208  | 
|Capital lease obligations |  |      | 47     |             |  |             | 98     |            |  |       | 56    |  |  |   |      |  |  |   | 201    | 
|Purchase obligations      |  |      | 12,166 |             |  |             | 19,018 |            |  |       | 1,717 |  |  |   |      |  |  |   | 32,901 | 
|                          |  |      |        |             |  |             |        |            |  |       |       |  |  |   |       |  |  |   |        | 
|Total                     |  | $    | 12,975 |             |  | $           | 20,083 |            |  | $     | 3,058 |  |  | $ | 1,986 |  |  | $ | 38,102 | 
|                          |  |      |        |             |  |             |        |            |  |       |       |  |  |   |       |  |  |   |        | 

Purchase obligations include contractual
arrangements for the purchase of raw materials and advertising
that are legally binding and enforceable. These contractual
arrangements specify all significant terms, including: fixed or
minimum quantities to be purchased, pricing provisions and the
approximate timing of the transaction. The timing of payments
for our purchase obligations is estimated based upon current
information. The actual timing and amount of payment may differ
from this estimate.

Purchase orders for raw materials and other goods
and services are not included in the above table. Our purchase
orders may represent authorizations to purchase rather than
definitive binding contractual obligations. Contractual
arrangements for goods and services that contain clauses
allowing for cancellation without significant penalty were not
included in the above table.

Critical Accounting Policies and
Estimates

There are several accounting policies that we
believe are significant to the presentation of our consolidated
financial statements and require managements most
difficult, complex or subjective judgments about matters that
are inherently uncertain. Note 1 to our consolidated
financial statements Nature of Business Activities and
Summary of Significant Accounting Policies summarizes each
of our significant accounting policies. We believe our most
critical accounting policies are as follows:

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 when delivery to the
designated location or carrier has occurred. Cash discounts,
sales incentives, and returns are estimated and recognized as a
reduction of revenue at the time of sale based upon historical
activity and current customer commitments. We evaluate these
estimates on a quarterly basis and revise them as necessary.

We provide for allowances for doubtful accounts
and sales returns based on historical experience and a review of
our receivables. Receivables are presented net of allowances for
doubtful accounts and for sales returns of $281,000 at
July 31, 2004 and $544,000 at July 31, 2003. 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.

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Use of
Estimates The preparation
of financial statements in conformity with accounting principles
generally accepted in the United States of America necessarily
requires that we make estimates and assumptions that affect the
reported amounts of assets and liabilities, as well as
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. The accounting estimates
used in the preparation of our consolidated financial statements
will change as new events occur, as more experience is acquired,
as additional information is obtained and as our operating
environment changes. Actual results could differ from those
estimates.

Significant estimates include: (i) useful
lives of intangibles; (ii) impairment analyses;
(iii) depreciable lives of assets; (iv) income tax
valuation allowances; (v) contingency and litigation
reserves; (vi) inventory valuation; (vii) the
valuation of the lack of marketability discount for restricted
common stock; and (viii) allowances for accounts
receivable, cash discounts, sales incentives and sales returns.

We make changes in estimates as appropriate, and
as we become aware of circumstances surrounding those estimates.
Such changes and refinements in estimation methodologies are
reflected in reported results of operations in the period in
which the changes are made and, if material, their effects are
disclosed in the Notes to Consolidated Financial Statements.

Our impairment analyses include significant
estimates with respect to cash flows and fair values. The
factors that affect these estimates include the following:

The cash flows used to measure long-lived assets
related to the OraTest® product are dependent upon
obtaining 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 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. Net long-lived assets related to the
OraTest® product as of July 31, 2004 of
$5.6 million have been capitalized.

The cash flows used to measure long-lived assets
related to the ViziLite® product are dependent upon our
ability to properly market the product to a sufficient number of
dentists so it becomes integrated within their practice.
ViziLite® is a chemiluminescent light technology used in
combination with traditional oral screening to increase
identification, evaluation and monitoring of oral mucosal
abnormalities. Achieving our sales goals requires significant
training and education about the products attributes to
the dental professionals. As a result of organizational and
sales strategy changes in 2003 and 2004, we have revised our
business model with current sales and costs assumptions. We have
added significant marketing, sales and educational costs
targeted towards achieving market acceptance within a reasonable
timeframe. Net long-lived assets related to the ViziLite®
product as of July 31, 2004 of $2.0 million have been
capitalized.

Goodwill, Intangibles and Other Long-Lived
Assets We have made
acquisitions of products and businesses that include goodwill,
license agreements, patents and trademarks, product rights and
other intangible and long-lived assets. We assess the impairment
of goodwill, intangibles and other long-lived assets whenever
events or changes in circumstances indicate that the carrying
value of any of these assets may not be recoverable. Such events
or circumstances might include a significant decline in market
share and/or significant negative industry or economic trends, a
significant decline in profits and/or significant
underperformance relative to expected historical or projected
operating results, significant changes in the manner of our use
of the acquired assets or the strategy for our overall business,
rapid changes in technology, significant litigation or other
items. In evaluating the recoverability of goodwill, intangibles
and other long-lived 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 events or
circumstances, including reductions in anticipated cash flows
generated by our operations or determinations to divest of
certain assets, certain assets could be impaired which would
result in a charge to earnings.

40



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In accordance with
SFAS No. 142  Goodwill and Other
Intangibles, our policy is to review the carrying amounts
of goodwill and certain intangible assets with indefinite lives
at least annually as of April 30 or, as described above,
whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable.

The following is a summary of the significant
components of our goodwill and intangible assets and our
impairment methodology for each.

Zila Pharmaceuticals
Goodwill Goodwill is
related to the Peridex® product which was acquired from
Procter & Gamble in November 1997 and to the IST
acquisition in February 2001. As part of the implementation for
SFAS No. 142, Goodwill and Other Intangible
Assets on August 1, 2002, the Company retained an
independent financial advisor who compared the fair values and
corresponding carrying values of the Peridex® and IST
assets as of the adoption date for SFAS No. 142. Based
upon the financial advisors findings, we determined that
approximately $3.0 million of the Peridex® goodwill
and the entire $1.1 million of IST goodwill was impaired
thus reducing goodwill to approximately $4.1 million. This
transitional impairment charge of $4.1 million was recorded
as a change in accounting principle and retroactively restated
to August 1, 2002, the beginning of our fiscal year. We
review the carrying value of Zila Pharmaceuticals goodwill at
least annually as of April 30 or, as described above,
whenever events or changes in circumstances indicate that the
carrying amount of the asset may not be recoverable.

Zila Nutraceuticals
Goodwill Goodwill and
trademarks totaling approximately $11.3 million (net of
accumulated amortization of $4.0 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. We review the carrying value of Zila Nutraceuticals
goodwill at least annually as of April 30 or, as described
above, whenever events or changes in circumstances indicate that
the carrying amount of the asset may not be recoverable.

OraTest®
The purchase of CTM eliminated our obligation to pay royalties
to CTM on future sales of the OraTest® product. The
recoverability of the $3.5 million net purchased technology
rights is dependent upon obtaining FDA approval and generating
sufficient revenues from future sales of the OraTest®
products. For purposes of testing recoverability, the following
are grouped with purchased technology rights: (i) fixed
assets of approximately $726,000 (primarily related to our
manufacturing facility); (ii) patents and patents pending
of $1,324,000; and (iii) $552,000 of OraTest® clinical
rinse and swab inventory, ZTCTM drug substance, the
active ingredient in the OraTest® product, and its related
components. 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.

Recent Accounting Prouncements

No Recent Accounting Pronouncements had or would
have a significant effect on our results of operations or
financial position upon adoption.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

We are exposed to market risks primarily from
interest rates and from changes in foreign currency exchange
rates, as well as changes in our credit standing. In addition, a
market risk exists associated with the cost of ascorbic acid, a
raw material used in our Nutraceuticals Business Unit. In fiscal
2004 we executed extended-term supply contracts to mitigate the
risk of increased cost of ascorbic acid.

At July 31, 2004, we had a revolving line of
credit with Congress Financial 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, 2004). (At August 17, 2004, this revolving
line of credit was replaced by a similar facility with Wells
Fargo.) At July 31, 2004, 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

41



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effect since average outstanding balances under
our revolving credit facility are not expected to be
significant. We also have long-term debt associated with the
Industrial Development Revenue Bonds (Bonds) that
carries a variable interest rate. The rate is set weekly by Bank
One Capital Markets and fluctuates based on market conditions
and was 1.3% per annum at July 31, 2004. A 10%
proportional increase in the average interest rate on the bonds
would increase annual interest expense by less than $10,000.


We have certain exposures to foreign currency
risk through our subsidiaries that conduct business in Canada
and Europe and through a subsidiary that uses the British pound
as its functional currency. Additionally, under one of our
ascorbic acid supply agreements, we are subject to defined
pricing adjustments based on fluctuations in foreign currency.
We believe that such exposure does not present a significant
risk due to the limited number of transactions and/or accounts
denominated in foreign currency.

With respect to our ascorbic acid supply
arrangements, if ascorbic acid prices decline sharply, we would
be at risk of being committed to purchase ascorbic acid at
higher than market prices. Additionally, if our sales were to
significantly decline, we would be obligated to purchase
ascorbic acid in excess of our needs.






|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

Consolidated financial statements, together with
the related notes and the report of Deloitte & Touche
LLP, an independent registered public accounting firm, 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.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Our Chief Executive Officer and Chief Financial
Officer, with the participation of our management, carried out
an evaluation of the effectiveness of the our disclosure
controls and procedures pursuant to Exchange Act
Rule 13a-15(c). Based upon that evaluation, our Chief
Executive Officer and Chief Financial Officer believe that, as
of the end of the period covered by this report, our disclosure
controls and procedures are effective in making known to them,
recording, processing, summarizing and reporting on a timely
basis, material information relating to us (including our
consolidated subsidiaries) required to be included in this
report.

A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met.
Because of the inherent limitations in all control systems no
evaluation of controls can provide absolute assurance that all
control issues, if any, within a company have been detected.

As more fully described in Item 9A in our
Annual Report on Form 10-K for the fiscal year ended
July 31, 2003, during our annual audit covering such
period, weaknesses were found in our general computer controls
at our corporate headquarters and at Zila Nutraceuticals. For
the period covered by this report, we completed efforts to
improve general computer controls and resolved these weaknesses.

Other than the above issue, there were no changes
in our internal control over financial reporting known to our
Chief Executive Officer or Chief Financial Officer that occurred
during the quarter ended July 31, 2004 that have materially
affected, or are reasonably likely to materially affect, our
internal control over financial reporting.

We are not required at this time to provide the
information specified in Items 308(a) and (b) of the
SECs Regulation S-K regarding an annual report by
management on our internal control over financial reporting or
an attestation report by our independent registered public
accountants with regard thereto.

42



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|         |                  
|-------- | -----------------
|Item 9B. | Other Information

Not applicable.




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
December 16, 2004, which will be filed with the SEC not
later than 120 days after July 31, 2004.




PART IV






|         |                                                          
|-------- | ---------------------------------------------------------
|Item 15. | Exhibits, Financial Statements, Schedules
    and Reports

(a) Financial Statements

|                                                                                                                                                                                                                                                                                                                                                      |  |               
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------
|                                                                                                                                                                                                                                                                                                                                                      |  | Method of     
|                                                                                                                                                                                                                                                                                                                                                      |  | Filing        
|                                                                                                                                                                                                                                                                                                                                                      |  |               
|(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, 2004 and 2003 and related
    Consolidated Statements of Operations, Comprehensive Income
    (Loss), Shareholders Equity, and Cash Flows for each of
    the years in the three year period ended July 31, 2004 |  | Filed herewith
|(3) Financial Statement Schedule II
    Valuation and Qualifying Accounts                                                                                                                                                                                                                                                                             |  | Filed herewith

(b) Reports on Form 8-K for the quarter
ended July 31, 2004. During the quarter ended July 31,
2004, we filed one Current Report on Form 8-K dated
June 10, 2004.

(c) Exhibits

|        |     |             |  |                                                                                                                                                                                    |  |  |   | 
|------- | --- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | - | 
|Exhibit |     |             |  | Method of                                                                                                                                                                         
|Number  |     | Description |  | Filing                                                                                                                                                                            
|        |     |             |  |                                                                                                                                                                                   
|        | 3-  | A           |  | Certificate of Incorporation, as amended                                                                                                                                           |  |  | A | 
|        | 3-  | B           |  | Amended and Restated Bylaws (as amended through
    September 26, 2002)                                                                                                            |  |  | O | 
|        | 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)(1)                                                                                                                 |  |  | B | 
|        | 10- | C           |  | Non-Employee Directors Stock Option Plan (as
    amended through September 26, 2002)(1)                                                                                            |  |  | R | 
|        | 10- | L           |  | Asset Purchase Agreement dated October 28,
    1999 between Zila, Inc., and 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 | 

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|        |     |             |  |                                                                                                                                                                                                                                                                             |  |  |   | 
|------- | --- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | - | 
|Exhibit |     |             |  | Method of                                                                                                                                                                                                                                                                  
|Number  |     | Description |  | Filing                                                                                                                                                                                                                                                                     
|        |     |             |  |                                                                                                                                                                                                                                                                            
|        | 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)(1)                                                                                                                                                                                                 |  |  | G | 
|        | 10- | V           |  | Employee Stock Purchase Plan(1)                                                                                                                                                                                                                                             |  |  | 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 | 
|        | 10- | Ad          |  | Third Amendment dated December 13, 2002 to
    the 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        |  |  | P | 
|        | 10- | Ae          |  | General Services Agreement between Zila, Inc. and
    Quintiles, Inc. dated December 18, 2002 (without exhibits)                                                                                                                                                            |  |  | Q | 
|        | 10- | Af          |  | Investment Agreement between Zila, Inc. and
    PharmaBio Development, Inc. dated December 18, 2002                                                                                                                                                                         |  |  | Q | 
|        | 10- | Ag          |  | Offer letter between Zila, Inc. and Lawrence J.
    Batina dated January 27, 2003                                                                                                                                                                                           |  |  | Q | 
|        | 10- | Ah          |  | Fourth Amendment dated January 31, 2003 to
    the Loan and Security Agreement dated August 17, 2001 by
    and between Congress Financial Corporation and Zila, Inc., Zila
    Pharmaceuticals, Inc., and Inter-Cal Corporation                                            |  |  | Q | 
|        | 10- | Ai          |  | Credit and Security Agreement between Zila
    Nutraceuticals, Inc., Zila Biotechnology, Inc., Zila
    Pharmaceuticals, Inc., Zila Swab Technologies, Inc., Oxycal
    Laboratories, Incorporated, and Wells Fargo Business Credit,
    Inc., date as of February 6, 2004. |  |  | S | 

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|        |      |             |  |                                                                                                                                                                                                                                                                                                                                  |  |  |    | 
|------- | ---- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | -- | 
|Exhibit |      |             |  | Method of                                                                                                                                                                                                                                                                                                                       
|Number  |      | Description |  | Filing                                                                                                                                                                                                                                                                                                                          
|        |      |             |  |                                                                                                                                                                                                                                                                                                                                 
|        | 10-  | Aj          |  | Reimbursement Agreement between Oxycal
    Laboratories, Incorporated, an Arizona Corporation, and Wells
    Fargo Business Credit, Inc. relating to $3,900,000 
    The Industrial Development Authority Revenue Bonds (Oxycal
    Laboratories, Incorporated Project) Series 1999A, dated as
    of February 6, 2004          |  |  | S  | 
|        | 10-  | Ak          |  | Employment Agreement between Zila, Inc. and
    Douglas D. Burkett, Ph.D., dated as of October 21,
    2003(1)                                                                                                                                                                                                                   |  |  | S  | 
|        | 10-  | Al          |  | Purchase Agreement between Zila, Inc. and Gary
    and Janet Hedge, dated as of November 7, 2003                                                                                                                                                                                                                                 |  |  | S  | 
|        | 10-  | Am          |  | Lease between Zila, Inc. and Phoenix 7 LLC, dated
    January 30, 2004                                                                                                                                                                                                                                                           |  |  | S  | 
|        | 10-  | An          |  | Offer letter between Zila, Inc. and Andrew A.
    Stevens dated January 15, 2004(1)                                                                                                                                                                                                                                              |  |  | *  | 
|        | 10-  | Ao          |  | First Amendment dated August 17, 2004 to the
    Credit and Security Agreement dated February 6, 2004 by and
    between Wells Fargo Business Credit, Inc. and Zila
    Nutraceuticals, Inc., Zila Biotechnology, Inc., Zila
    Pharmaceuticals, Inc., Zila Swab Technologies, Inc., and Oxycal
    Laboratories, Incorporated. |  |  | *  | 
|        | 21   |             |  | Subsidiaries of Registrant                                                                                                                                                                                                                                                                                                       |  |  | *  | 
|        | 23   |             |  | Consent of Deloitte & Touche LLP
    (regarding Form S-8 and Form S-3 Registration
    Statements)                                                                                                                                                                                                                               |  |  | *  | 
|        | 24-  | A           |  | Power of Attorney of Douglas D.
    Burkett, Ph.D.                                                                                                                                                                                                                                                                               |  |  | *  | 
|        | 24-  | B           |  | Power of Attorney of Andrew A. Stevens                                                                                                                                                                                                                                                                                           |  |  | *  | 
|        | 24-  | C           |  | Power of Attorney of Morris C. Aaron                                                                                                                                                                                                                                                                                             |  |  | *  | 
|        | 24-  | D           |  | Power of Attorney of Leslie H. Green                                                                                                                                                                                                                                                                                             |  |  | *  | 
|        | 24-  | E           |  | Power of Attorney of Christopher D. Johnson                                                                                                                                                                                                                                                                                      |  |  | *  | 
|        | 24-  | F           |  | Power of Attorney of Michael S. Lesser                                                                                                                                                                                                                                                                                           |  |  | *  | 
|        | 24-  | G           |  | Power of Attorney of John Edward Porter                                                                                                                                                                                                                                                                                          |  |  | *  | 
|        | 24-  | H           |  | Power of Attorney of Timothy Rose                                                                                                                                                                                                                                                                                                |  |  | *  | 
|        | 31.1 |             |  | Sarbanes-Oxley Section 302 Certification of
    the Chief Executive Officer                                                                                                                                                                                                                                                      |  |  | *  | 
|        | 31.2 |             |  | Sarbanes-Oxley Section 302 Certification of
    the Chief Financial Officer                                                                                                                                                                                                                                                      |  |  | *  | 
|        | 32.1 |             |  | Sarbanes-Oxley Section 906 Certification of
    the Chief Executive Officer                                                                                                                                                                                                                                                      |  |  | ** | 
|        | 32.2 |             |  | Sarbanes-Oxley Section 906 Certification of
    the Chief Financial Officer                                                                                                                                                                                                                                                      |  |  | ** | 



---

|    |  |                                                                                                                                             
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------
|(1) |  | Management contract or compensatory plan or
    arrangement                                                                                 
|*   |  | Filed herewith                                                                                                                              
|**  |  | Furnished 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
    Proxy Statement on Schedule 14A filed November 7, 2000                                       
|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              

45



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##### Table of Contents



|  |  |                                                                                                                                 
|- |  | --------------------------------------------------------------------------------------------------------------------------------
|I |  | Incorporated by reference to the Companys
    Current Report on Form 8-K filed July 6, 2001                                    
|J |  | Incorporated by reference to the Companys
    Current Report on Form 8-K filed August 10, 2001                                 
|K |  | Incorporated by reference to the Companys
    Current Report on Form 8-K filed September 4, 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 July 3, 2002                                    
|O |  | Incorporated by reference to the Companys
    Annual Report on Form 10-K for fiscal year ended
    July 31, 2002               
|P |  | Incorporated by reference to the Companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended October 31, 2002
|Q |  | Incorporated by reference to the Companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended January 31, 2003
|R |  | Incorporated by reference to the Companys
    Proxy Statement on Schedule 14A filed December 12, 2002                          
|S |  | Incorporated by reference to the Companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended January 31, 2004

46



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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
14th day of October, 2004.



| |                                   
| | ----------------------------------
| | ZILA, INC., a Delaware corporation



| |    |                      
| | -- | ---------------------
| | By | /s/ ANDREW A. STEVENS

| |                                                 
| | ------------------------------------------------
| |                                                 
| | Andrew A. Stevens                               
| | 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, and Chief
    Executive Officer |  | October 14, 2004
|                                                     
|*Morris C. Aaron                                      |  | Director                                                          |  | October 14, 2004
|                                                     
|*Leslie Green                                         |  | Director                                                          |  | October 14, 2004
|                                                     
|*Christopher D. Johnson                               |  | Director                                                          |  | October 14, 2004
|                                                     
|*Michael S. Lesser                                    |  | Director                                                          |  | October 14, 2004
|                                                     
|*John Edward Porter                                   |  | Director                                                          |  | October 14, 2004
|                                                     
|*S. Timothy Rose                                      |  | Director                                                          |  | October 14, 2004
|                                                     
|By                                                    |  | /s/ ANDREW A. STEVENSAndrew A. StevensAttorney-in-Fact            |  |                  |  | October 14, 2004

47



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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

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, 2004 and 2003, 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, 2004. 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 the
standards of the Public Company Accounting Oversight Board
(United States). 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, 2004 and 2003, and the results of their operations
and their cash flows for each of the three years in the period
ended July 31, 2004, 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 1 to the consolidated
financial statements, in 2003 the Company changed its method of
accounting for goodwill and other intangible assets to conform
to Statement of Financial Accounting Standards No. 142.

DELOITTE & TOUCHE LLP

Phoenix, Arizona

October 13, 2004


F-1



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

July 31, 2004 and 2003


|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |             |            |            | 
|------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ---------- | ----------- | ---------- | ---------- | ---------- | ----------- | ---------- | ---------- | 
|                                                                          |                                                                                                                                                          | 2004                       |            | 2003       
|                                                                          |                                                                                                                                                          |                            |            |            
|ASSETS                                                                   
|CURRENT ASSETS:                                                           |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          | Cash and cash equivalents                                                                                                                                |                            | $          | 11,679,915  |            |            | $          | 16,160,484  |           
|                                                                          | Restricted cash collateral                                                                                                                               |                            |            | 517,353     |            |            |            |            |           
|                                                                          | Trade receivables  net of allowances
    of $281,000 (July 31, 2004) and $544,000 (July 31,
    2003)                                                   |                            |            | 8,027,341   |            |            |            | 6,754,771   |           
|                                                                          | Inventories  net                                                                                                                                        |                            |            | 6,579,235   |            |            |            | 7,847,604   |           
|                                                                          | Prepaid expenses and other current assets                                                                                                                |                            |            | 1,813,133   |            |            |            | 1,719,856   |           
|                                                                          | Assets held for sale                                                                                                                                     |                            |            | 1,505,658   |            |            |            | 2,843,774   |           
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          |                                                                                                                                                          | Total current assets       |            |             | 30,122,635 |            |            |             | 35,326,489 |           
|PROPERTY AND EQUIPMENT  net                                              |                                                                                                                                                          |                            | 8,116,177  |             |            |            | 8,162,793  |            
|PURCHASED TECHNOLOGY RIGHTS  net                                         |                                                                                                                                                          |                            | 3,510,288  |             |            |            | 3,988,964  |            
|GOODWILL  net                                                            |                                                                                                                                                          |                            | 6,930,192  |             |            |            | 6,930,192  |            
|TRADEMARKS AND OTHER INTANGIBLE
    ASSETS  net                          |                                                                                                                                                          |                            | 13,023,566 |             |            |            | 13,054,392 |            
|OTHER ASSETS                                                              |                                                                                                                                                          |                            | 405,785    |             |            |            | 1,557,486  |            
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          |                                                                                                                                                          |                            | TOTAL      |             | $          | 62,108,643 |            |             | $          | 69,020,316 | 
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                         
|LIABILITIES AND SHAREHOLDERS
    EQUITY                                 
|CURRENT LIABILITIES:                                                      |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          | Accounts payable                                                                                                                                         |                            | $          | 4,159,242   |            |            | $          | 6,868,037   |           
|                                                                          | Accrued liabilities                                                                                                                                      |                            |            | 2,960,062   |            |            |            | 3,269,335   |           
|                                                                          | Short-term borrowings                                                                                                                                    |                            |            |            |            |            |            | 154,793     |           
|                                                                          | Current portion of long-term debt and capital
    lease obligations                                                                                      |                            |            | 343,403     |            |            |            | 487,449     |           
|                                                                          | Liabilities related to assets held for sale                                                                                                              |                            |            | 233,446     |            |            |            | 764,449     |           
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          |                                                                                                                                                          | Total current liabilities  |            |             | 7,696,153  |            |            |             | 11,544,063 |           
|Deferred gain on sale leaseback                                           |                                                                                                                                                          |                            | 534,587    |             |            |            |           |            
|Long-term debt and capital lease
    obligations  net of current portion |                                                                                                                                                          |                            | 3,649,733  |             |            |            | 3,728,126  |            
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          |                                                                                                                                                          | Total liabilities          |            |             | 11,880,473 |            |            |             | 15,272,189 |           
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|COMMITMENTS AND CONTINGENCIES
    (Note 16)                               |                                                                                                                                                          |                            |            |             |            |            |            |            
|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 45,723,296 shares
    (July 31, 2004) and 45,439,893 shares (July 31,
    2003) |                            |            | 45,723      |            |            |            | 45,440      |           
|                                                                          | Capital in excess of par value                                                                                                                           |                            |            | 83,968,913  |            |            |            | 83,115,533  |           
|                                                                          | Accumulated other comprehensive loss                                                                                                                     |                            |            | (73,453     | )          |            |            | (75,644     | )         
|                                                                          | Accumulated deficit                                                                                                                                      |                            |            | (33,604,140 | )          |            |            | (29,228,329 | )         
|                                                                          | Common stock in treasury, at cost,
    225,100 shares (July 31, 2004 and 2003)                                                                           |                            |            | (571,373    | )          |            |            | (571,373    | )         
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          |                                                                                                                                                          | Total shareholders equity |            |             | 50,228,170 |            |            |             | 53,748,127 |           
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            
|                                                                          |                                                                                                                                                          |                            | TOTAL      |             | $          | 62,108,643 |            |             | $          | 69,020,316 | 
|                                                                          |                                                                                                                                                          |                            |            |             |            |            |            |            

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, 2004, 2003 and
2002


|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |            |          |  
|-------------------------------------------------------------------------------------- | -------------------------------------------------------------- | ---------------------------------------------- | ---------- | ---------- | - | ---- | ---------- | ---------- | ------ | - | ----------- | ---------- | -------- | -
|                                                                                       |                                                                | 2004                                           |            | 2003       |   | 2002
|                                                                                       |                                                                |                                                |            |            |   |     
|NET REVENUES                                                                           |                                                                | $                                              | 49,427,965 |            |   | $    | 47,106,865 |            |        | $ | 34,871,770  |           
|OPERATING COSTS AND EXPENSES:                                                          |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Cost of products sold                                          |                                                |            | 19,436,262 |   |      |            | 19,895,871 |        |   |             | 11,671,746 |         
|                                                                                       | Marketing and selling                                          |                                                |            | 12,152,133 |   |      |            | 9,851,918  |        |   |             | 10,185,522 |         
|                                                                                       | General and administrative                                     |                                                |            | 12,973,817 |   |      |            | 12,692,172 |        |   |             | 11,657,878 |         
|                                                                                       | Severance and related charges                                  |                                                |            | 349,533    |   |      |            | 1,322,147  |        |   |             |           |         
|                                                                                       | Research and development                                       |                                                |            | 5,979,095  |   |      |            | 4,145,783  |        |   |             | 4,748,125  |         
|                                                                                       | Impairment of assets                                           |                                                |            | 288,940    |   |      |            | 140,794    |        |   |             | 224,347    |         
|                                                                                       | Depreciation and amortization                                  |                                                |            | 2,670,940  |   |      |            | 2,416,585  |        |   |             | 3,452,182  |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       |                                                                |                                                | 53,850,720 |            |   |      | 50,465,270 |            |        |   | 41,939,800  |           
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|LOSS FROM OPERATIONS                                                                   |                                                                |                                                | (4,422,755 | )          |   |      | (3,358,405 | )          |        |   | (7,068,030  | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|OTHER INCOME (EXPENSE):                                                                |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Interest income                                                |                                                |            | 109,245    |   |      |            | 15,132     |        |   |             | 68,959     |         
|                                                                                       | Interest expense                                               |                                                |            | (342,114   | ) |      |            | (389,628   | )      |   |             | (502,798   | )       
|                                                                                       | Contract settlement gain, net of related expenses              |                                                |            |           |   |      |            | 14,844,093 |        |   |             |           |         
|                                                                                       | Gain on sale of assets                                         |                                                |            | 470,462    |   |      |            | 530,756    |        |   |             |           |         
|                                                                                       | Other income (expense)                                         |                                                |            | (149,543   | ) |      |            | (94,270    | )      |   |             | 117,908    |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       |                                                                |                                                | 88,050     |            |   |      | 14,906,083 |            |        |   | (315,931    | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|INCOME (LOSS) FROM CONTINUING OPERATIONS
    BEFORE INCOME TAXES AND ACCOUNTING CHANGE |                                                                |                                                | (4,334,705 | )          |   |      | 11,547,678 |            |        |   | (7,383,961  | )         
|INCOME TAX EXPENSE                                                                     |                                                                |                                                | (2,106     | )          |   |      | (188,126   | )          |        |   | (3,954,319  | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|INCOME (LOSS) FROM CONTINUING OPERATIONS
    BEFORE ACCOUNTING CHANGE                  |                                                                |                                                | (4,336,811 | )          |   |      | 11,359,552 |            |        |   | (11,338,280 | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|DISCONTINUED OPERATIONS:                                                               |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Loss from operations of discontinued Dental
    Supply segment |                                                |            |           |   |      |            |           |        |   |             | (815,460   | )       
|                                                                                       | Net gain from disposal of Dental Supply segment                |                                                |            |           |   |      |            | 10,000     |        |   |             | 143,456    |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       |                                                                | Total gain (loss) from discontinued operations |            |            |  |      |            |            | 10,000 |   |             |            | (672,004 | )
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|INCOME (LOSS) BEFORE ACCOUNTING CHANGE                                                 |                                                                |                                                | (4,336,811 | )          |   |      | 11,369,552 |            |        |   | (12,010,284 | )         
|                                                                                       | Cumulative effect of accounting change                         |                                                |            |           |   |      |            | (4,084,193 | )      |   |             |           |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|NET INCOME (LOSS)                                                                      |                                                                |                                                | (4,336,811 | )          |   |      | 7,285,359  |            |        |   | (12,010,284 | )         
|                                                                                       | Preferred stock dividends                                      |                                                |            | 39,000     |   |      |            | 39,000     |        |   |             | 58,500     |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|Net income (loss) attributable to common
    shareholders                              |                                                                | $                                              | (4,375,811 | )          |   | $    | 7,246,359  |            |        | $ | (12,068,784 | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|BASIC NET INCOME (LOSS) PER COMMON SHARE:                                              |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Income (loss) from continuing operations                       |                                                | $          | (0.10      | ) |      | $          | 0.25       |        |   | $           | (0.25      | )       
|                                                                                       | Loss from discontinued operations                              |                                                |            |           |   |      |            |           |        |   |             | (0.02      | )       
|                                                                                       | Accounting change                                              |                                                |            |           |   |      |            | (0.09      | )      |   |             |           |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|NET INCOME (LOSS)                                                                      |                                                                | $                                              | (0.10      | )          |   | $    | 0.16       |            |        | $ | (0.27       | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Weighted average shares outstanding                            |                                                |            | 45,333,794 |   |      |            | 45,115,111 |        |   |             | 44,592,932 |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|DILUTED NET INCOME (LOSS) PER COMMON SHARE:                                            |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Income (loss) from continuing operations                       |                                                | $          | (0.10      | ) |      | $          | 0.25       |        |   | $           | (0.25      | )       
|                                                                                       | Income (loss) from discontinued operations                     |                                                |            |           |   |      |            |           |        |   |             | (0.02      | )       
|                                                                                       | Accounting change                                              |                                                |            |           |   |      |            | (0.09      | )      |   |             |           |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|NET INCOME (LOSS)                                                                      |                                                                | $                                              | (0.10      | )          |   | $    | 0.16       |            |        | $ | (0.27       | )         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           
|                                                                                       | Weighted average shares outstanding                            |                                                |            | 45,333,794 |   |      |            | 45,390,939 |        |   |             | 44,592,932 |         
|                                                                                       |                                                                |                                                |            |            |   |      |            |            |        |   |             |           

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, 2004, 2003 and
2002


|                                  |                                         |      |            |       |  |      |           |      |   |   |             |          |  
|--------------------------------- | --------------------------------------- | ---- | ---------- | ----- |  | ---- | --------- | ---- | - | - | ----------- | -------- | -
|                                  |                                         | 2004 |            | 2003  |  | 2002
|                                  |                                         |      |            |       |  |     
|Net income (loss)                 |                                         | $    | (4,336,811 | )     |  | $    | 7,285,359 |      |   | $ | (12,010,284 | )       
|Other comprehensive income (loss) |                                         |      |            |       |  |      |           |      |   |   |             |         
|                                  | Foreign currency translation adjustment |      |            | 2,191 |  |      |           | (268 | ) |   |             | (226,352 | )
|                                  |                                         |      |            |       |  |      |           |      |   |   |             |         
|Comprehensive income (loss)       |                                         | $    | (4,334,620 | )     |  | $    | 7,285,091 |      |   | $ | (12,236,636 | )       
|                                  |                                         |      |            |       |  |      |           |      |   |   |             |         

|                         |                            |             |         |               |   |   |         |       |  
|------------------------ | -------------------------- | ----------- | ------- | ------------- | - | - | ------- | ----- | -
|                         |                            | Foreign     |         | Accumulated  
|                         |                            | Currency    |         | Other        
|                         |                            | Translation |         | Comprehensive
|                         |                            | Adjustments |         | Loss         
|                         |                            |             |         |              
|Balance at July 31, 2002 |                            | $           | (75,376 | )             |   | $ | (75,376 | )    
|                         | Other comprehensive loss   |             |         | (268          | ) |   |         | (268  | )
|                         |                            |             |         |               |   |   |         |      
|Balance at July 31, 2003 |                            |             | (75,644 | )             |   |   | (75,644 | )    
|                         | Other comprehensive income |             |         | 2,191         |   |   |         | 2,191 |  
|                         |                            |             |         |               |   |   |         |      
|Balance at July 31, 2004 |                            | $           | (73,453 | )             |   | $ | (73,453 | )    
|                         |                            |             |         |               |   |   |         |      

See notes to consolidated financial statements.

F-4



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

Years Ended July 31, 2004, 2003 and
2002


|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |             |  
|---------------------- | --------------------------------------------------------------- | -------------------- | ------- | ------------ |  | ---------- | ------- | ----------- |  | ----------- | ---------- | --------- |  | ------------- | ------ | ------------- |  | ------ | ---------- | --------- |  | - | ----------- | ----------- | - | - | -------- | ------- | - | - | ------- | -------- | - | - | ---------- | ----------- | -
|                       |                                                                 |                     
|                       |                                                                 | Shareholders Equity
|                       |                                                                 |                     
|                       |                                                                 |                      |         |              |  |           
|                       |                                                                 | Preferred Stock      |         | Common Stock |  |            |         | Accumulated |  |            
|                       |                                                                 |                      |         |              |  | Capital in |         |             |  | Other       |            | Total    
|                       |                                                                 |                      |         |              |  | Par        |         | Excess of   |  | Accumulated |            | Treasury  |  | Comprehensive |        | Shareholders
|                       |                                                                 | Shares               |         | Amount       |  | Shares     |         | Value       |  | Par Value   |            | Deficit   |  | Stock         |        | Income (Loss) |  | Equity
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |       
|BALANCE, JULY 31, 2001 |                                                                 |                      | 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 under employee stock
    purchase plan |                      |         |              |  |            |         |             |  |             |            | 12,433    |  |               |        | 12            |  |        |            | 25,351    |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 25,363      |  
|                       | Issuance of shares for Trylon acquisition                       |                      |         |              |  |            |         |             |  |             |            | 1,625,000 |  |               |        | 1,625         |  |        |            | 2,944,897 |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 2,946,522   |  
|                       | Foreign currency translation                                    |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         | (226,352 | ) |   |            | (226,352    | )
|                       | Net loss                                                        |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             | (12,010,284 | ) |   |          |         |   |   |         |          |   |   |            | (12,010,284 | )
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |            
|BALANCE, JULY 31, 2002 |                                                                 |                      | 100,000 |              |  | $          | 462,500 |             |  |             | 45,291,160 |           |  | $             | 45,291 |               |  | $      | 82,900,342 |           |  | $ | (36,474,688 | )           |   | $ | (535,120 | )       |   | $ | (75,376 | )        |   | $ | 46,322,949 |            
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |            
|                       | Warrants issued for services provided                           |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            | 70,569    |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 70,569      |  
|                       | Dividends on preferred stock                                    |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             | (39,000     | ) |   |          |         |   |   |         |          |   |   |            | (39,000     | )
|                       | Purchase of common stock for treasury                           |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          | (36,253 | ) |   |         |          |   |   |            | (36,253     | )
|                       | Issuance of common stock under employee stock
    purchase plan |                      |         |              |  |            |         |             |  |             |            | 143,733   |  |               |        | 144           |  |        |            | 139,377   |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 139,521     |  
|                       | Exercise of common stock warrants                               |                      |         |              |  |            |         |             |  |             |            | 5,000     |  |               |        | 5             |  |        |            | 5,245     |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 5,250       |  
|                       | Foreign currency translation                                    |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         | (268     | ) |   |            | (268        | )
|                       | Net income                                                      |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             | 7,285,359   |   |   |          |         |   |   |         |          |   |   |            | 7,285,359   |  
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |            
|BALANCE, JULY 31, 2003 |                                                                 |                      | 100,000 |              |  | $          | 462,500 |             |  |             | 45,439,893 |           |  | $             | 45,440 |               |  | $      | 83,115,533 |           |  | $ | (29,228,329 | )           |   | $ | (571,373 | )       |   | $ | (75,644 | )        |   | $ | 53,748,127 |            
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |            
|                       | Warrants issued for services provided                           |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            | 28,028    |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 28,028      |  
|                       | Dividends on preferred stock                                    |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             | (39,000     | ) |   |          |         |   |   |         |          |   |   |            | (39,000     | )
|                       | Issuance of common stock under employee stock
    purchase plan |                      |         |              |  |            |         |             |  |             |            | 76,803    |  |               |        | 77            |  |        |            | 249,883   |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 249,960     |  
|                       | Exercise of common stock options                                |                      |         |              |  |            |         |             |  |             |            | 206,600   |  |               |        | 206           |  |        |            | 440,001   |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 440,207     |  
|                       | Trylon shares adjustment to market value                        |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            | 135,468   |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            | 135,468     |  
|                       | Foreign currency translation                                    |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         | 2,191    |   |   |            | 2,191       |  
|                       | Net loss                                                        |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             | (4,336,811  | ) |   |          |         |   |   |         |          |   |   |            | (4,336,811  | )
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |            
|BALANCE, JULY 31, 2004 |                                                                 |                      | 100,000 |              |  | $          | 462,500 |             |  |             | 45,723,296 |           |  | $             | 45,723 |               |  | $      | 83,968,913 |           |  | $ | (33,604,140 | )           |   | $ | (571,373 | )       |   | $ | (73,453 | )        |   | $ | 50,228,170 |            
|                       |                                                                 |                      |         |              |  |            |         |             |  |             |            |           |  |               |        |               |  |        |            |           |  |   |             |             |   |   |          |         |   |   |         |          |   |   |            |            

See notes to consolidated financial statements.

F-5



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH
FLOWS

Years Ended July 31, 2004, 2003,
2002


|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |            |           |            |  
|----------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------ | ---------------------------------------- | ------------------------------------------------------- | ---------- | ---------- | ---------- | ---------- | -------- | ---------- | ---------- | ----------- | ---------- | --------- | ---------- | -
|                                                                                                      |                                                                                                        | 2004                                     |                                                         | 2003       |            | 2002      
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |           
|OPERATING ACTIVITIES:                                                                                 |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|Net income (loss)                                                                                     |                                                                                                        | $                                        | (4,336,811                                              | )          |            | $          | 7,285,359  |          |            | $          | (12,010,284 | )         
|                                                                                                      | Adjustments to reconcile net income (loss) to net
    cash provided by (used in) operating activities: |                                          |                                                         |            |            |            |            |          |            |            |             |            |          
|                                                                                                      |                                                                                                        | Depreciation and amortization            |                                                         |            | 2,670,940  |            |            |          | 2,416,585  |            |             |            | 3,452,182 |           
|                                                                                                      |                                                                                                        | Effect of change in accounting principle |                                                         |            |           |            |            |          | 4,084,193  |            |             |            |          |           
|                                                                                                      |                                                                                                        | Amortization of deferred financing costs |                                                         |            | 186,086    |            |            |          | 183,519    |            |             |            | 122,605   |           
|                                                                                                      |                                                                                                        | Gain on sale of assets                   |                                                         |            | (470,462   | )          |            |          | (530,756   | )          |             |            |          |           
|                                                                                                      |                                                                                                        | Loss (gain) from discontinued operations |                                                         |            |           |            |            |          | (10,000    | )          |             |            | 672,004   |           
|                                                                                                      |                                                                                                        | Impairment of assets                     |                                                         |            | 288,940    |            |            |          | 140,794    |            |             |            | 224,347   |           
|                                                                                                      |                                                                                                        | Noncash stock based compensation expense |                                                         |            | 37,410     |            |            |          | 18,191     |            |             |            |          |           
|                                                                                                      |                                                                                                        | Noncash research and development expense |                                                         |            | 72,187     |            |            |          |           |            |             |            |          |           
|                                                                                                      |                                                                                                        | Warrants issued for services             |                                                         |            |           |            |            |          | 70,569     |            |             |            |          |           
|                                                                                                      |                                                                                                        | Deferred income taxes and other          |                                                         |            | 48,565     |            |            |          | (11,717    | )          |             |            | 4,303,550 |           
|                                                                                                      | Change in assets and liabilities:                                                                      |                                          |                                                         |            |            |            |            |          |            |            |             |            |          
|                                                                                                      |                                                                                                        | Receivables  net                        |                                                         |            | (1,272,570 | )          |            |          | (1,417,526 | )          |             |            | 996,891   |           
|                                                                                                      |                                                                                                        | Inventories                              |                                                         |            | 1,268,369  |            |            |          | 586,216    |            |             |            | 2,408,271 |           
|                                                                                                      |                                                                                                        | Prepaid expenses and other assets        |                                                         |            | 1,576,773  |            |            |          | (1,912,060 | )          |             |            | 291,220   |           
|                                                                                                      |                                                                                                        | Accounts payable and accrued liabilities |                                                         |            | (3,698,035 | )          |            |          | 4,045,115  |            |             |            | 940,143   |           
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|                                                                                                      |                                                                                                        |                                          | Net cash provided by (used in) operating
    activities |            |            | (3,628,608 | )          |          |            | 14,948,482 |             |            |           | 1,400,929  |  
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|INVESTING ACTIVITIES:                                                                                 |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|                                                                                                      | Additions to property and equipment, net                                                               |                                          |                                                         | (1,276,811 | )          |            |            | (932,396 | )          |            |             | (477,276   | )        
|                                                                                                      | Net proceeds from sale of assets                                                                       |                                          |                                                         | 1,721,876  |            |            |            | 531,966  |            |            |             |           |          
|                                                                                                      | Retained liabilities of discontinued operations                                                        |                                          |                                                         |           |            |            |            |         |            |            |             | (2,080,325 | )        
|                                                                                                      | Net proceeds from disposition of discontinued
    operations                                           |                                          |                                                         |           |            |            |            | 10,000   |            |            |             | 9,719,125  |          
|                                                                                                      | Additions to intangible assets, net                                                                    |                                          |                                                         | (723,967   | )          |            |            | (195,815 | )          |            |             | (1,016,782 | )        
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|                                                                                                      |                                                                                                        |                                          | Net cash provided by (used in) investing
    activities |            |            | (278,902   | )          |          |            | (586,245   | )           |            |           | 6,144,742  |  
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|FINANCING ACTIVITIES:                                                                                 |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|                                                                                                      | Net (repayments) proceeds from short-term
    borrowings                                               |                                          |                                                         | (154,793   | )          |            |            | 55,009   |            |            |             | (6,061,163 | )        
|                                                                                                      | Proceeds from issuance of common stock                                                                 |                                          |                                                         | 652,757    |            |            |            | 126,561  |            |            |             | 25,363     |          
|                                                                                                      | Acquisition of treasury stock                                                                          |                                          |                                                         |           |            |            |            | (36,253  | )          |            |             |           |          
|                                                                                                      | Dividends paid to preferred stockholders                                                               |                                          |                                                         | (19,500    | )          |            |            | (49,000  | )          |            |             | (29,000    | )        
|                                                                                                      | Restricted cash deposited to collaterize letter
    of credit                                          |                                          |                                                         | (517,353   | )          |            |            |         |            |            |             |           |          
|                                                                                                      | Proceeds from long-term borrowings                                                                     |                                          |                                                         |           |            |            |            | 641,515  |            |            |             |           |          
|                                                                                                      | Financing costs                                                                                        |                                          |                                                         | (91,531    | )          |            |            | (18,206  | )          |            |             | (413,101   | )        
|                                                                                                      | Principal payments on long-term debt                                                                   |                                          |                                                         | (442,639   | )          |            |            | (525,584 | )          |            |             | (727,500   | )        
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|                                                                                                      |                                                                                                        |                                          | Net cash provided by (used in) financing
    activities |            |            | (573,059   | )          |          |            | 194,042    |             |            |           | (7,205,401 | )
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|NET INCREASE (DECREASE) IN CASH AND CASH
    EQUIVALENTS                                              |                                                                                                        |                                          | (4,480,569                                              | )          |            |            | 14,556,279 |          |            |            | 340,270     |           
|CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR                                                          |                                                                                                        |                                          | 16,160,484                                              |            |            |            | 1,604,205  |          |            |            | 1,263,935   |           
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|CASH AND CASH EQUIVALENTS, END OF YEAR                                                                |                                                                                                        | $                                        | 11,679,915                                              |            |            | $          | 16,160,484 |          |            | $          | 1,604,205   |           
|                                                                                                      |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|CASH PAID FOR INTEREST                                                                                |                                                                                                        | $                                        | 157,612                                                 |            |            | $          | 197,067    |          |            | $          | 415,832     |           
|CASH PAID FOR INCOME TAXES                                                                            |                                                                                                        | $                                        | 192,195                                                 |            |            | $          |           |          |            | $          | 17,051      |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING
    AND FINANCING ACTIVITIES:                          |                                                                                                        |                                          |                                                         |            |            |            |            |          |            |            |             |           
|Capital lease obligation for new equipment                                                            |                                                                                                        | $                                        | 232,200                                                 |            |            | $          |           |          |            | $          |            |           
|Issuance of common stock related to ViziLite in
    exchange for license and research and development |                                                                                                        | $                                        |                                                        |            |            | $          |           |          |            | $          | 2,946,522   |           
|Noncash effect of removal of contractual
    restrictions on issued common stock                      |                                                                                                        | $                                        | 135,468                                                 |            |            | $          |           |          |            | $          |            |           
|Liability satisfied through the issuance of
    warrants                                              |                                                                                                        | $                                        | 28,028                                                  |            |            | $          |           |          |            | $          |            |           

See notes to consolidated financial statements.

F-6



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

Years Ended July 31, 2004, 2003 and
2002




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



| |                              
| | -----------------------------
| | Nature of Business Activities

Zila, Inc. and subsidiaries (Zila), a
Delaware corporation, is an innovator in preventive healthcare
technologies and products, focusing on enhanced body defense and
the detection of pre-disease states. Our business is organized
into the following Business Units: Nutraceuticals,
Pharmaceuticals and Biotechnology. The Nutraceuticals Business
Unit is comprised of Oxycal Laboratories, Inc.
(Oxycal) and its subsidiary, Zila Nutraceuticals,
Inc., a manufacturer and marketer of Ester-C®, a patented,
branded, highly effective form of vitamin C sold in
46 countries worldwide and of patented Ester-E®, an
enhanced vitamin E product whose initial commercial
shipments occurred in May 2004. The Zila Pharmaceuticals
Business Unit includes Zila Pharmaceuticals, Inc. and the
Zilactin® family of products, Peridex® prescription
mouth rinse, the ViziLite® chemiluminescent light for
illumination of oral mucosal abnormalities and the plastic
molded products of Zila Swab Technologies, Inc.,
dba Innovative Swab Technologies (IST). The
Zila Biotechnology Unit includes Zila Biotechnology Inc., Zila
Technology, Inc. and Zila Limited, and is the research,
development and licensing business specializing in
pre-cancer/cancer detection through its patented Zila®
Tolonium Chloride and OraTest® technologies and now manages
the OraTest® product, an oral cancer diagnostic system,
which is currently in Food and Drug Administration
(FDA) phase III clinical trials.

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

Certain reclassifications have been made to the
prior years to conform to the current year presentation.



| |                                               
| | ----------------------------------------------
| | Summary of Significant Accounting
    Policies

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 Biotechnology, Inc., Zila
Ltd., Bio-Dental Technologies Corporation
(Bio-Dental), Zila Technologies, Inc, Zila Swab
Technologies, Inc., dba Innovative Swab Technologies
(IST), Zila Acquisition, Inc. and Oxycal
Laboratories, Inc. Zila International Inc. and Zila Acquisition,
Inc. have no operations. All significant intercompany balances
and transactions are eliminated in consolidation.

In March 2004, our Board of Directors authorized
the divesture of the net assets of IST, our plastic molded
products manufacturing subsidiary. As more fully described in
Note 3, in accordance with Statement of Financial
Accounting Standards (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets, we reclassified all of the assets and related
liabilities to assets held for sale and
liabilities related to assets held for sale,
respectively, and recorded an impairment charge in the fourth
quarter of fiscal 2004 of $289,000.

Use of Estimates and Risks and
Uncertainties The
preparation of financial statements in conformity with generally
accepted accounting principles necessarily requires management
to make estimates and assumptions that affect the amounts
reported in the consolidated financial statements and
accompanying notes. Actual results could differ from those
estimates based upon future events, which could include, among
other risks, changes in the regulations governing the manner in
which we sell our products, changes in the health care
environment, and reliance on contract manufacturing services.
Significant use of estimates include: (i) useful lives of
intangibles; (ii) impairment analyses;
(iii) depreciable lives of assets; (iv) income tax
valuation allowances; (v) contingency and litigation
reserves; (vi) inventory valuation; (vii) the
valuation of the lack of marketability discount for restricted
common stock; and (viii) allowances for accounts
receivable, cash discounts, sales incentives and sales returns.

F-7



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In our Biotechnology Business Unit, the cash
flows used to measure long-lived assets related to the
OraTest® product are dependent upon obtaining 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 can take a number of years and require the expenditure
of substantial resources. We anticipate that our current cash
and cash equivalents, along with cash generated from our
Nutraceuticals and Pharmaceuticals groups, will be adequate to
support these activities. However, 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, 2004 of
$5.6 million have been capitalized.

Business
Concentration We extend
credit on a non-collaterized basis primarily to manufacturing
companies, wholesale distributors and retail chains in the
United States, Canada and 45 other foreign countries. We are
required to estimate the level of accounts receivable which will
ultimately not be paid. Historically, we have not experienced
significant credit losses. For each of the last three fiscal
years, there have been sales to significant customers. Sales to
these significant customers as a percent of net revenues were
42.8% (four customers), 30.5% (four customers) and 35.0% (five
customers) in fiscal years 2004, 2003 and 2002, respectively. As
of July 31, 2004, accounts receivable due from the four
significant customers represented 62.5% of our consolidated
accounts receivable.

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 when delivery to the
designated location or carrier has occurred. Cash discounts,
sales incentives, and returns are estimated and recognized at
the time of sale based upon historical activity and current
customer commitments.

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 as the
milestones are achieved, 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, the fees are recognized as revenue at the time
the arrangement becomes effective.

Cash, Cash Equivalents and Restricted
Cash Cash equivalents and
restricted cash include highly liquid investments purchased with
remaining maturities of three months or less.

Allowances for doubtful accounts and sales
returns We provide for an
allowance for doubtful accounts based on historical experience
and a review of our accounts receivables. Receivables are
presented net of allowances for doubtful accounts and for sales
returns of $281,000 at July 31, 2004 and $544,000 at
July 31, 2003. We evaluate these estimates on a quarterly
basis and revise them as necessary.

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

Property and Equipmentare stated at cost and are depreciated
using the straight-line method over their respective estimated
useful lives, ranging from 3 to 40 years. Leasehold
improvements and capital leased assets are depreciated over the
lease term or the estimated useful life, whichever is shorter.

F-8



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ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

|                                   |  |           
|---------------------------------- |  | ----------
|Building                           |  | 40 years  
|Building improvements              |  | 10 years  
|Furniture and equipment            |  | 3-5 years 
|Production and warehouse equipment |  | 7-10 years

Impairment of Long-Lived Assets and Long-Lived
Assets to be Disposed of
Our policy is to review the carrying value of long-lived assets
to be held and used and long-lived assets to be disposed of,
including intangibles with estimated useful lives, under the
provisions of SFAS No. 144 and its related
interpretations, whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be
recoverable. An evaluation of recoverability is performed using
such information as the estimated future undiscounted cash flows
associated with the asset compared to the assets carrying
value, the work of specialists, and other available information
to determine if impairment exists. An impairment loss is
measured as the difference between the carrying amount and the
fair value of the impaired asset.

In fiscal years 2004, 2003 and 2002, asset
impairment charges of approximately $289,000, $141,000 and
$224,000, respectively, were recorded related to the write down
of: (i) fixtures, equipment, patents and trademarks of
IST; (ii) a mold and certain intangible assets related to
the Pro-TiesTM product line; and (iii) the
Peridex® product distribution rights for Western Europe.
The expected future cash flows for each of these assets was used
to determine the amount of impairment. The charges are included
in the Pharmaceuticals reporting segment.

Goodwill and Other Intangible
Assets As of
August 1, 2002, we adopted SFAS No. 142,
Goodwill and Other Intangible Assets. Under the
requirements of this SFAS, goodwill is no longer amortized but
rather tested periodically for impairment using a fair value
approach at the reporting unit level. A reporting unit is the
operating segment, or a business one level below the operating
segment (component level) if discrete financial
information is prepared and regularly reviewed by management at
the component level. An impairment charge is recognized for any
amount by which the carrying amount of a reporting units
goodwill exceeds it fair value. We use discounted cash flows to
establish fair values. Our policy is to test goodwill for
impairment annually as of April 30, the end of our third
fiscal quarter. (See Note 9 for additional discussion.) We
completed our fiscal year 2004 goodwill impairment test of our
identified reporting units as of April 30, 2004, and
determined that there was no goodwill impairment. Upon adoption
of SFAS No. 142 as of August 1, 2002, we
completed the transitional goodwill impairment test for our
reporting units and recorded a charge of $4,084,000 related to
our Pharmaceuticals Business Unit.

We amortize the cost of other intangibles over
their estimated useful lives unless such lives are deemed
indefinite. We continually evaluate the reasonableness of the
estimated useful lives of amortizable intangibles.

Our policy is to review the carrying amounts of
intangible 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 other
intangible assets, our policy is to compare the carrying amounts
of such assets with the estimated undiscounted future operating
cash flows. In the event impairment 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.

F-9



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The components of goodwill at July 31, 2004
are as follows:

Pharmaceuticals
Goodwill Goodwill totaling
approximately $4.0 million (net of accumulated amortization
of $4.6 million) related to the Peridex® product which
was acquired from The Procter & Gamble Company in
November 1997.

Zila
Nutraceuticals Goodwill
and trademarks totaling approximately $11.4 million (net of
accumulated amortization of $4.0 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.

Significant components of intangible assets at
July 31, 2004 are as follows:

Purchased Technology
Rights In 1996, we
acquired CTM Associates, Inc. (CTM). The purchase of
CTM perfected our interest in the OraTest® technology and
eliminated our obligation to pay royalties to CTM on future
sales of the OraTest® product. The recoverability of the
$3.5 million net purchased technology rights is dependent
upon obtaining FDA approval and generating sufficient revenues
from future sales of the OraTest® products. Fixed assets of
approximately $726,000 (primarily related to our manufacturing
facility), patents and patents pending of $1.4 million and
inventory, drug substance and related components of $552,000 are
also associated with the OraTest® products and are grouped
with the purchased technology rights for the purpose of testing
recoverability. 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.

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. Other intangible assets 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 $5,979,000,
$4,146,000, and $4,748,000 in 2004, 2003 and 2002, respectively.

Stock
Options At July 31,
2004, we had three stock-based employee and directors
compensation plans, which are more fully described in
Note 11. We apply Accounting Principles Board
(APB) Opinion No. 25 and related
interpretations in accounting for our 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, pro forma net income (loss) attributable
to common shareholders and income (loss) per

F-10



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

share attributable to common shareholders for the
fiscal years ended July 31, 2004, 2003 and 2002 would have
been reported as follows (in thousands, except per share
amounts):

|                                                                                         |             |                            |   |        |   |      |   |       |  |  |   |         |  
|---------------------------------------------------------------------------------------- | ----------- | -------------------------- | - | ------ | - | ---- | - | ----- |  |  | - | ------- | -
|                                                                                         |             |                           
|                                                                                         |             | Fiscal Years Ended July 31
|                                                                                         |             |                           
|                                                                                         |             | 2004                       |   | 2003   |   | 2002
|                                                                                         |             |                            |   |        |   |     
|Net income (loss) attributable to common
    shareholders:                               |             |                            |   |        |   |      |   |       |  |  |   |        
|                                                                                         | As reported |                            | $ | (4,376 | ) |      | $ | 7,246 |  |  | $ | (12,069 | )
|                                                                                         | Pro forma   |                            |   | (5,389 | ) |      |   | 6,943 |  |  |   | (12,444 | )
|Net income (loss) attributable to common
    shareholders per basic share outstanding:   |             |                            |   |        |   |      |   |       |  |  |   |        
|                                                                                         | As reported |                            | $ | (0.10  | ) |      | $ | 0.16  |  |  | $ | (0.27   | )
|                                                                                         | Pro forma   |                            | $ | (0.12  | ) |      | $ | 0.15  |  |  | $ | (0.28   | )
|Net income (loss) attributable to common
    shareholders per diluted share outstanding: |             |                            |   |        |   |      |   |       |  |  |   |        
|                                                                                         | As reported |                            | $ | (0.10  | ) |      | $ | 0.16  |  |  | $ | (0.27   | )
|                                                                                         | Pro forma   |                            | $ | (0.12  | ) |      | $ | 0.15  |  |  | $ | (0.28   | )

The weighted-average grant-date fair value of
options granted during the years ended July 31, 2004, 2003
and 2002 was $1,817,000, $583,000 and $375,000, respectively.
The value of options is estimated on the date of grant using the
following weighted average assumptions:

|                                 |                          |                    |  |      |   |      |  |      |   |  |  |      |  
|-------------------------------- | ------------------------ | ------------------ |  | ---- | - | ---- |  | ---- | - |  |  | ---- | -
|                                 |                          |                   
|                                 |                          | Fiscal Years Ended
|                                 |                          | July 31           
|                                 |                          |                   
|                                 |                          | 2004               |  | 2003 |   | 2002
|                                 |                          |                    |  |      |   |     
|Black-Scholes model assumptions: |                          |                    |  |      |   |      |  |      |   |  |  |     
|                                 | Risk-free interest rate  |                    |  | 3.69 | % |      |  | 3.13 | % |  |  | 2.62 | %
|                                 | Expected volatility      |                    |  | 75   | % |      |  | 80   | % |  |  | 72   | %
|                                 | Expected term (in years) |                    |  | 5.73 |   |      |  | 5.56 |   |  |  | 7.10 |  
|                                 | Dividend yield           |                    |  | 0    | % |      |  | 0    | % |  |  | 0    | %

Noncash stock compensation expense related to
deferred stock compensation and stock issuances under our
employee stock purchase plan was $110,000 and $18,000 in fiscal
2004 and 2003, 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 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 year ended July 31, 2004 and
2002, the effect of 874,000 and 335,000 shares,
respectively, of convertible preferred stock, options and
warrants were excluded because their inclusion would have the
effect of decreasing the loss per share.

F-11



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

For the year ended July 31, 2003, the
following is a reconciliation of the numerators and denominators
of basic and diluted per share computations for income from
continuing operations (in thousands, except per share amounts):

|                                                               |                             |   |        |     | 
|-------------------------------------------------------------- | --------------------------- | - | ------ | --- | 
|Income available to common shareholders                        |                             | $ | 7,246  |    
|                                                               |                             |   |        |    
|Average outstanding common shares                              |                             |   | 45,115 |    
|Effect of dilutive securities:                                 |                             |   |        |    
|                                                               | Options                     |   |        | 162 | 
|                                                               | Warrants                    |   |        | 14  | 
|                                                               | Convertible preferred stock |   |        | 100 | 
|                                                               |                             |   |        |    
|Average outstanding and potentially dilutive
    common shares |                             |   | 45,391 |    
|                                                               |                             |   |        |    
|Basic income per share from continuing operations              |                             | $ | 0.16   |    
|Diluted income per share from continuing
    operations        |                             | $ | 0.16   |    

Financial
Instruments The carrying
amounts and estimated fair value of our 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
us to credit risk, consist principally of trade receivables. In
the normal course of business, we provide credit to
pharmaceutical wholesalers and chains, nutraceutical
manufacturers, food wholesalers and chains, rack jobbers,
convenience stores, and dentists. Ongoing credit evaluations are
performed 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 generally accepted accounting principles are excluded from
net income (loss). Such items consist primarily of 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 There were
no new accounting pronouncements that had or would have had a
significant impact on our financial position or results or
operations upon adoption.



|   |                     
|-- | --------------------
|2. | ViziLite®Acquisition

On December 4, 2001, we acquired the world
marketing and distribution rights (excluding the Pacific Rim)
for the FDA cleared 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 certain body cavities using chemiluminescent
light sources.

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 had 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; and (iii) 375,000 of the other
shares delivered to Trylon had an additional contractual

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 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 were 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, the stock in escrow is to be
returned to us and cancelled, subject to certain exceptions.

The 1,625,000 shares of restricted common
stock that were delivered were valued at $2,947,000 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 $621,000 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 510(k) application to the FDA. The $2,474,000 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.

On October 15, 2003, we completed an
agreement that was the result of a mediated settlement with
Trylon. As part of the settlement, we agreed that Trylons
royalty rates for net sales of the ViziLite® product would
be reduced from 10% to 5% for the first five years, and from 5%
to 2.5% for the second five years. Thereafter, the royalty
payments end. As part of the settlement, we agreed to eliminate
the contractual restrictions relating to sales milestones
associated with 500,000 shares of the restricted common
stock and instead tie the removal of contractual restrictions on
these shares to Trylons achievement of the product
development milestones on the ViziLite® line extension and
obtaining the required governmental approvals relating to the
product development milestones.

The October 15, 2003 agreement with Trylon
was further modified by an agreement dated March 26, 2004.
This agreement addressed the timing and requirements for the
removal of contractual restrictions and escrow restrictions on
the 1,250,000 shares of common stock described above,
including the 500,000 restricted shares covered by the
October 15, 2003 agreement. Upon execution of the
March 26, 2004 agreement, we removed the contractual
restrictions on 312,500 of the 1,250,000 shares in
recognition of the achievement of a milestone. On July 31,
2004, we removed the contractual restrictions on another
312,500 shares of stock in exchange for receiving the right
to obtain from Trylon either direct ownership or a royalty-free
license of the ViziLite® product line extension subject to
the 510(k) application pending with the FDA. Trylons
rights to the 375,000 shares held in escrow expired on
June 30, 2004, and the shares were returned to us for
cancellation. Contractual restrictions remain on
250,000 shares that will be removed upon the earlier of
(i) Trylons obtaining the required governmental
approvals relating to the product development milestone by
May 1, 2005 or (ii) December 4, 2011 if the
required governmental approvals are not obtained by May 1,
2005.

As a result of the release of restrictions on
March 26, 2004 we recorded a non-cash charge to research
and development of $72,200 reflecting the estimated difference
in the fair market value of these shares with and without
restrictions. With respect to the acquisition of the technology
rights to the Vizi-Lite® product line extension on
July 31, 2004, we recorded an intangible asset of $63,200.
For the 250,000 shares still subject to contractual
restrictions, we may be required to record additional charges in
fiscal 2005 if the required governmental approvals are obtained.
If Trylon fails to satisfy this timing requirement, then
contractual restrictions remain in place and an additional
charge will be recorded at the end of the holding period in 2011.

F-13



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                     
|-- | --------------------
|3. | Assets Held for Sale

In March 2004, our Board of Directors authorized
the divestiture of the net assets of IST, our plastic molded
products manufacturing subsidiary, in order to focus on our core
business operations. IST is a reporting unit within our
Pharmaceuticals Business Unit. We reclassified all of the assets
and related liabilities to assets held for sale and
liabilities related to assets held for sale,
respectively, and ceased depreciation and amortization of
ISTs assets.

In September 2004, the Board of Directors
reversed the divestiture decision and withdrew IST from the
market. Management determined that IST is the best available
sourcing option for a new product under development and,
therefore, ISTs importance to future operations has
changed. Further, no acceptable purchase offer resulted from the
effort to sell IST. Based on the results of the offer process
and in accordance with the requirements of
SFAS No. 144, we recognized a non-cash impairment
charge of $289,000 in the fourth quarter of fiscal 2004 to give
effect to our revised estimate of the fair value of IST.

Summarized balance sheet information for IST as
of July 31 is set forth below (in thousands):

|                                   |                                                   |          |       |       |  |   |       |       | 
|---------------------------------- | ------------------------------------------------- | -------- | ----- | ----- |  | - | ----- | ----- | 
|                                   |                                                   |         
|                                   |                                                   | July 31,
|                                   |                                                   |         
|                                   |                                                   | 2004     |       | 2003 
|                                   |                                                   |          |       |      
|Current assets                     |                                                   | $        | 250   |       |  | $ | 1,077 |      
|Property, plant and equipment, net |                                                   |          | 1,026 |       |  |   | 1,319 |      
|Patents, net                       |                                                   |          | 217   |       |  |   | 402   |      
|Other                              |                                                   |          | 13    |       |  |   | 46    |      
|                                   |                                                   |          |       |       |  |   |       |      
|                                   | Total assets held for sale                        |          | $     | 1,506 |  |   | $     | 2,844 | 
|                                   |                                                   |          |       |       |  |   |       |      
|Current liabilities                |                                                   |          | 233   |       |  |   | 764   |      
|                                   |                                                   |          |       |       |  |   |       |      
|                                   | Total liabilities related to assets held for sale |          | $     | 233   |  |   | $     | 764   | 
|                                   |                                                   |          |       |       |  |   |       |      

At July 31, 2004, ISTs future minimum
lease payments under a non-cancelable operating lease were
$247,000.

Under the requirements of SFAS No. 144,
as a result of the decision to retain IST, in our quarter ended
October 31, 2004, the assets held for sale and
liabilities related to assets held for sale will be
reclassified to their original financial statement presentation.
If this reclassification were made at July 31, 2004, the
net amounts for property, plant and equipment and patents
($1,243,000) would be presented as long-term assets instead of
current assets.



|   |               
|-- | --------------
|4. | Sale of Assets

On January 30, 2004, as part of our strategy
to employ financial assets in core business competencies, we
completed the sale and a five-year leaseback of our corporate
headquarters for approximately $1.7 million in net cash
proceeds. We realized a pre-tax gain of $1.2 million, of
which we recognized approximately $470,000 in the quarter ended
January 31, 2004. The $470,000 gain represents the excess
of the net proceeds over the net present value of the future
lease payments. The balance of the gain of $765,000 was deferred
and will be amortized on a straight-line basis over the
five-year lease term as a reduction of rent expense in general
and administrative expenses. The leaseback is accounted for as
an operating lease.

On July 30, 2003, we sold our investment in
PracticeWares, Inc. (PracticeWares) for $525,000.
Since no cost basis was assigned to this investment, the entire
cash proceeds from this sale were recorded as a pre-tax gain.

F-14



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                              
|-- | -----------------------------
|5. | Gain from Contract Settlement

On April 14, 2003, we reached agreement in a
dispute with our former contract research organization and
received a $20 million settlement payment on June 30,
2003. As part of the settlement, we incurred approximately
$5.2 million in legal, consulting and other related
obligations, resulting in a net gain of approximately
$14.8 million.



|   |                       
|-- | ----------------------
|6. | Discontinued Operation

In November 2001, we decided to sell the
operations of our 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.

The results of the discontinued ZDS business,
excluding the net gain, are as follows (in thousands):

|                  |  |      |   |      |  |   |        |  
|----------------- |  | ---- | - | ---- |  | - | ------ | -
|                  |  | 2003 |   | 2002
|                  |  |      |   |     
|Net sales         |  | $    |  |      |  | $ | 23,426 |  
|Net income (loss) |  |      |  |      |  |   | (815   | )



|   |            
|-- | -----------
|7. | Inventories

Inventories consist of the following at
July 31 (in thousands):

|                   |  |      |       |      |  |   |       |  
|------------------ |  | ---- | ----- | ---- |  | - | ----- | -
|                   |  | 2004 |       | 2003
|                   |  |      |       |     
|Finished goods     |  | $    | 2,161 |      |  | $ | 2,201 |  
|Work in process    |  |      | 295   |      |  |   | 502   |  
|Raw materials      |  |      | 4,320 |      |  |   | 5,500 |  
|Inventory reserves |  |      | (197  | )    |  |   | (355  | )
|                   |  |      |       |      |  |   |       |  
|Total inventories  |  | $    | 6,579 |      |  | $ | 7,848 |  
|                   |  |      |       |      |  |   |       |  



|   |                       
|-- | ----------------------
|8. | Property and Equipment

Property and equipment consists of the following
at July 31 (in thousands):

|                                               |  |      |        |      |  |   |        |  
|---------------------------------------------- |  | ---- | ------ | ---- |  | - | ------ | -
|                                               |  | 2004 |        | 2003
|                                               |  |      |        |     
|Land                                           |  | $    | 403    |      |  | $ | 620    |  
|Building and improvements                      |  |      | 4,872  |      |  |   | 5,651  |  
|Furniture and equipment                        |  |      | 2,306  |      |  |   | 2,197  |  
|Leasehold improvements and other assets        |  |      | 382    |      |  |   | 368    |  
|Production and warehouse equipment             |  |      | 5,833  |      |  |   | 4,633  |  
|                                               |  |      |        |      |  |   |        |  
|Total property and equipment                   |  |      | 13,796 |      |  |   | 13,469 |  
|Less accumulated depreciation and amortization |  |      | (5,680 | )    |  |   | (5,306 | )
|                                               |  |      |        |      |  |   |        |  
|Property and equipment  net                   |  | $    | 8,116  |      |  | $ | 8,163  |  
|                                               |  |      |        |      |  |   |        |  

As described in Note 3, the table above
excludes property and equipment for IST included in assets held
for sale.

Depreciation expense related to property and
equipment for 2004, 2003 and 2002 was $1,205,000, $1,114,000 and
$1,083,000, respectively. At July 31, 2004, property and
equipment included $232,000 of assets

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

required to be capitalized in accordance with
SFAS No. 13 Accounting for Leases.
Amortization expense related to these capital leased assets is
$28,000.



|   |                  
|-- | -----------------
|9. | Intangible Assets

Intangible assets consist of the following at
July 31 (in thousands):

|                                                 |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |       | 
|------------------------------------------------ | --------------- | -------- | ------ | ------------ |  | -------- | ------ | -------- |  | ------------ | ------ | -------- |  | - | ------ | ------ |  | - | ------ | ----- |  | - | ------ | ----- | 
|                                                 |                 |          |        |             
|                                                 |                 | 2004     |        | 2003        
|                                                 |                 |          |        |             
|                                                 |                 | Gross    |        |              |  | Net      |        | Gross    |  |              |        | Net     
|                                                 |                 | Carrying |        | Accumulated  |  | Carrying |        | Carrying |  | Accumulated  |        | Carrying
|                                                 |                 | Amount   |        | Amortization |  | Amount   |        | Amount   |  | Amortization |        | Amount  
|                                                 |                 |          |        |              |  |          |        |          |  |              |        |         
|Amortizable intangibles:                         |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|Purchased technology rights                      |                 | $        | 7,419  |              |  | $        | 3,909  |          |  | $            | 3,510  |          |  | $ | 7,419  |        |  | $ | 3,430  |       |  | $ | 3,989  |      
|Trademarks and other intangible assets:          |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|                                                 | Trademarks      |          |        | 11,627       |  |          |        | 3,119    |  |              |        | 8,508    |  |   |        | 11,574 |  |   |        | 2,652 |  |   |        | 8,922 | 
|                                                 | Patents         |          |        | 3,189        |  |          |        | 947      |  |              |        | 2,242    |  |   |        | 2,798  |  |   |        | 887   |  |   |        | 1,911 | 
|                                                 | Licensing costs |          |        | 3,100        |  |          |        | 826      |  |              |        | 2,274    |  |   |        | 2,762  |  |   |        | 541   |  |   |        | 2,221 | 
|                                                 |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|Total trademarks and other intangible
    assets |                 |          | 17,916 |              |  |          | 4,892  |          |  |              | 13,024 |          |  |   | 17,134 |        |  |   | 4,080  |       |  |   | 13,054 |      
|                                                 |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|Total amortizable intangible assets              |                 |          | 25,335 |              |  |          | 8,801  |          |  |              | 16,534 |          |  |   | 24,553 |        |  |   | 7,510  |       |  |   | 17,043 |      
|                                                 |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|Unamortizable intangible asset:                  |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|                                                 | Goodwill        |          |        | 12,401       |  |          |        | 5,471    |  |              |        | 6,930    |  |   |        | 12,401 |  |   |        | 5,471 |  |   |        | 6,930 | 
|                                                 |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      
|Total intangible assets                          |                 | $        | 37,736 |              |  | $        | 14,272 |          |  | $            | 23,464 |          |  | $ | 36,954 |        |  | $ | 12,981 |       |  | $ | 23,973 |      
|                                                 |                 |          |        |              |  |          |        |          |  |              |        |          |  |   |        |        |  |   |        |       |  |   |        |      

There were no changes in the carrying amount of
goodwill for the year July 31, 2004.

In accordance with SFAS No. 142, we
discontinued the amortization of goodwill, effective
August 1, 2002. We completed the transitional goodwill
impairment test for our reporting units and recorded a charge of
$4,084,000 as of August 1, 2002 relating to our
Pharmaceutical segment.

Amortization of intangible assets during fiscal
2004, 2003 and 2002 was $1,466,000, $1,302,000 and $2,369,000,
respectively. For fiscal years 2005 through 2009, the
amortization of intangibles is estimated to be approximately
$1,400,000 each year.

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Loss from continuing operations and net income
(loss), as reported and as adjusted with the adoption of
SFAS No. 142, are presented below (in thousands,
except per share amounts).

|                                                                                                           |                                                         |      |         |       |  
|---------------------------------------------------------------------------------------------------------- | ------------------------------------------------------- | ---- | ------- | ----- | -
|                                                                                                           |                                                         | 2002
|                                                                                                           |                                                         |     
|Income (loss) from continuing operations before
    accounting change, as reported                         |                                                         | $    | (11,338 | )    
|Net income (loss) from continuing operations
    before accounting change, excluding goodwill amortization |                                                         |      | (10,158 | )    
|Basic and Diluted:                                                                                         |                                                         |      |         |      
|                                                                                                           | Net loss per common share, as reported                  |      | $       | (0.25 | )
|                                                                                                           | Net loss per share, excluding goodwill
    amortization |      | $       | (0.23 | )



|    |     
|--- | ----
|10. | Debt

On August 27, 2001, we entered into a Loan
and Security Agreement (the Congress Agreement) with
Congress Financial Corporation (Congress). The
Congress Agreement expired on August 17, 2004. Under the
Congress Agreement, Congress provided a $12 million
revolving line of credit to us at an interest rate equal to the
prime rate plus  3/4 percent per annum. The amount of
funds available to us from the line of credit was based upon a
percentage of the value of eligible receivables and inventory
and was $8.7 million at July 31, 2004. There were no
borrowings outstanding under this line of credit at any time
during fiscal 2004. Obligations under the Congress Agreement
were collateralized by various assets, including, but not
limited to our trade accounts receivable, inventories, equipment
and intangible assets of certain of our operating subsidiaries.
Zila and all of its direct and indirect operating subsidiaries
guaranteed the obligations under the Agreement. Under the
Congress Agreement, payment of cash dividends was restricted and
we were also required to comply with a financial covenant based
on an adjusted tangible net worth calculation. At July 31,
2004, our adjusted tangible net worth was, as defined,
$27.0 million compared to a required amount of
$12.0 million.

On February 6, 2004, our subsidiaries, Zila
Nutraceuticals, Inc., Zila Pharmaceuticals, Inc., Zila
Biotechnology, Inc., Zila Swab Technologies, Inc., and Oxycal
Laboratories, Inc., entered into a Credit and Security Agreement
(the Wells Fargo Agreement) with Wells Fargo
Business Credit, Inc. (Wells Fargo) that provides a
$10 million revolving line of credit effective on
August 17, 2004, upon the expiration of the Congress
Agreement and upon the perfection of certain security interests
by Wells Fargo. Borrowings will bear interest equal to the prime
rate. Funds available under the Wells Fargo Agreement are based
upon a percentage of the value of the eligible receivables and
inventory. Obligations under the Agreement are collateralized by
various assets, including, but not limited to trade accounts
receivable, inventories, equipment and intangible assets. The
parent company, Zila, Inc., guarantees the obligations under the
Wells Fargo Agreement.

Under the Wells Fargo Agreement, we are required
to maintain a minimum level of net worth, as defined, and to
limit capital expenditures to $1.7 million in fiscal 2005.
At July 31, 2004, our net worth, as defined, was
$50.2 million compared to the required amount of
$47.0 million. Additionally, payment of dividends is
restricted. The net worth and capital expenditures covenants are
established annually as of August 1. The Wells Fargo Agreement
contains a provision whereby Wells Fargo can call for immediate
repayment of all amounts due under the line upon its sole
determination that a material adverse change has
occurred. As a result of this provision, any borrowings under
the Wells Fargo Agreement will be classified as short-term debt.
There have been no borrowings under the Wells Fargo Agreement.

In December 2002, we entered into an agreement
with PharmaBio Development, Inc. (PharmaBio), the
strategic investment group of Quintiles Transnational Corp, our
contract research organization. Under this agreement, PharmaBio
invested $500,000 in our Company. In return for the investment,
we agreed to pay to PharmaBio an amount equal to 5% of all net
sales of the OraTest® product in the European Union and the

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

United States. The aggregated amount of the
royalty cannot exceed $1.25 million and the royalty is
payable quarterly. The investment was recorded as long-term debt
and will be amortized using the effective interest method.

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 Industrial Development Revenue Bonds (the
Bonds). The proceeds from the Bonds were loaned to
Oxycal for the construction of a new manufacturing and
laboratory facility. The initial offerings of Bonds consist of
$3.9 million Series A and $104,000 Taxable
Series B and mature in 2019. As of July 31, 2004, the
Series B were repaid. The Bonds bear a variable interest
rate that was 1.3% at July 31, 2004. 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. The letter
of credit supporting the Bonds expired on March 15, 2004,
and a replacement letter of credit was obtained on
February 6, 2004 through Wells Fargo in conjunction with
the execution of the Wells Fargo Agreement described above.

Under the terms of the replacement letter of
credit, on February 6, 2004, we placed $517,000 in a cash
collateral account representing the difference between the
letter of credit amount and the maximum commitment amount, as
defined.

We lease facilities and equipment, some of which
are required to be capitalized in accordance with SFAS 13.
SFAS 13 requires the capitalization of leases meeting
certain criteria, with the related asset being recorded in
property and equipment and an offsetting amount recorded as a
liability.

Debt consisted of the following at July 31
(in thousands):

|                                   |                                                                                                           |                                         |   |       |     |  |   |       |     | 
|---------------------------------- | --------------------------------------------------------------------------------------------------------- | --------------------------------------- | - | ----- | --- |  | - | ----- | --- | 
|                                   |                                                                                                           | 2004                                    |   | 2003 
|                                   |                                                                                                           |                                         |   |      
|Short-term borrowings:             |                                                                                                           |                                         |   |       |     |  |   |      
|                                   | Installment note payable on insurance policies                                                            |                                         | $ |      |     |  | $ | 130   |    
|                                   | Note payable for equipment                                                                                |                                         |   |      |     |  |   | 25    |    
|                                   |                                                                                                           |                                         |   |       |     |  |   |      
|                                   |                                                                                                           | Total short-term borrowings             |   | $     |    |  |   | $     | 155 | 
|                                   |                                                                                                           |                                         |   |       |     |  |   |      
|Current portion of long-term debt: |                                                                                                           |                                         |   |       |     |  |   |      
|                                   | IDA bond payable, Series A, current portion                                                               |                                         | $ | 245   |     |  | $ | 426   |    
|                                   | Capital lease obligations, current portion                                                                |                                         |   | 47    |     |  |   |      |    
|                                   | Note payable for equipment                                                                                |                                         |   | 51    |     |  |   | 62    |    
|                                   |                                                                                                           |                                         |   |       |     |  |   |      
|                                   |                                                                                                           | Total current portion of long-term debt |   | $     | 343 |  |   | $     | 488 | 
|                                   |                                                                                                           |                                         |   |       |     |  |   |      
|Long-term debt:                    |                                                                                                           |                                         |   |       |     |  |   |      
|                                   | IDA bond payable, Series A                                                                                |                                         | $ | 3,212 |     |  | $ | 3,578 |    
|                                   | PharmaBio                                                                                                 |                                         |   | 500   |     |  |   | 500   |    
|                                   | Capital lease obligations                                                                                 |                                         |   | 201   |     |  |   |      |    
|                                   | Notes payable for equipment with interest rates
    between 6.34% and 12.25% with maturities through 2006 |                                         |   | 80    |     |  |   | 138   |    
|                                   |                                                                                                           |                                         |   |       |     |  |   |      
|                                   | Total long-term debt                                                                                      |                                         |   | 3,993 |     |  |   | 4,216 |    
|                                   | Less current portion                                                                                      |                                         |   | 343   |     |  |   | 488   |    
|                                   |                                                                                                           |                                         |   |       |     |  |   |      
|                                   | Long-term portion                                                                                         |                                         | $ | 3,650 |     |  | $ | 3,728 |    
|                                   |                                                                                                           |                                         |   |       |     |  |   |      

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Aggregate annual maturities of long-term debt and
minimum payments under capital leases for the fiscal years
ending July 31 are as follows (in thousands):

|                     |  |           |       |         |  |       |     |  |  |   |       | 
|-------------------- |  | --------- | ----- | ------- |  | ----- | --- |  |  | - | ----- | 
|                     |  | Long-term |       | Capital |  | Total
|                     |  | Debt      |       | Leases  |  | Debt 
|                     |  |           |       |         |  |      
|2005                 |  | $         | 296   |         |  | $     | 47  |  |  | $ | 343   | 
|2006                 |  |           | 274   |         |  |       | 48  |  |  |   | 322   | 
|2007                 |  |           | 246   |         |  |       | 50  |  |  |   | 296   | 
|2008                 |  |           | 245   |         |  |       | 44  |  |  |   | 289   | 
|2009                 |  |           | 745   |         |  |       | 12  |  |  |   | 757   | 
|2010 and thereafter  |  |           | 1,986 |         |  |       |    |  |  |   | 1,986 | 
|                     |  |           |       |         |  |       |     |  |  |   |       | 
|Total                |  |           | 3,792 |         |  |       | 201 |  |  |   | 3,993 | 
|Less current portion |  |           | 296   |         |  |       | 47  |  |  |   | 343   | 
|                     |  |           |       |         |  |       |     |  |  |   |       | 
|Long-term portion    |  | $         | 3,496 |         |  | $     | 154 |  |  | $ | 3,650 | 
|                     |  |           |       |         |  |       |     |  |  |   |       | 



|    |                           
|--- | --------------------------
|11. | Stock Options and Warrants

a. Stock Options  We
adopted the Zila, Inc. 1997 Stock Option Award Plan,
effective February 5, 1997, authorizing the Board of
Directors to grant options to employees and certain employee
directors 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 equal to the market
closing price on the date of grant. Options may be exercised up
to ten years from the date of grant. The vesting period is
determined at the time of grant by the Board of Directors and
may vary. In fiscal 2004, 2003 and 2002, we granted options to
purchase 549,000, 445,000 and 513,000 shares of common
stock, respectively, to employees. At July 31, 2004,
1,515,000 shares were available for grant under this plan.

On September 1, 1988, we adopted a Stock
Option Award Plan, authorizing the Board of Directors to grant
options to employees and certain employee-directors 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 were 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, 2004, no shares were available
for grant under this plan.

We adopted a Zila, Inc. Non-Employee Directors
Stock Option Plan, effective October 20, 1989, authorizing
the Board of Directors to grant options of 100,000 shares
to non-employee members of our Board of Directors in increments
of 2,500 shares per director each year. Grants under the
plan are for services provided to us as a director. Amendments
to the plan dated December 8, 1995 and September 26,
2002 increased the authorized number of shares to 200,000 and
700,000, respectively. The September 26, 2002 amendment,
which was approved by the shareholders at the January 14,
2003 annual meeting, also provided for an initial grant of
20,000 options to new directors and an increase in annual
option grants to existing directors from 2,500 stock
options to 20,000 stock options. These stock options vest
quarterly in equal increments. The options are issuable at an
exercise price equal to the market value at the date of grant.
All vested options may be exercised at any time up to five years
from the date of grant. At July 31, 2004,
360,000 shares were available for grant under this plan.

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

A summary of the status of the option plans as of
July 31, 2004, 2003 and 2002 and changes during the years
then ended is presented below:

|                                 |  |        |           |          |  |        |      |          |  |        |            |          |  |   |      |  |  |  |           |   |  |   |      | 
|-------------------------------- |  | ------ | --------- | -------- |  | ------ | ---- | -------- |  | ------ | ---------- | -------- |  | - | ---- |  |  |  | --------- | - |  | - | ---- | 
|                                 |  |        |           |          |  |       
|                                 |  | 2004   |           | 2003     |  | 2002  
|                                 |  |        |           |          |  |       
|                                 |  |        |           | Weighted |  |        |      | Weighted |  |        |            | Weighted
|                                 |  |        |           | Average  |  |        |      | Average  |  |        |            | Average 
|                                 |  |        |           | Exercise |  |        |      | Exercise |  |        |            | Exercise
|                                 |  | Shares |           | Price    |  | Shares |      | Price    |  | Shares |            | Price   
|                                 |  |        |           |          |  |        |      |          |  |        |            |         
|Outstanding at beginning of year |  |        | 1,298,961 |          |  | $      | 2.69 |          |  |        | 2,196,418  |          |  | $ | 4.42 |  |  |  | 2,097,943 |   |  | $ | 5.07 | 
|Granted                          |  |        | 688,617   |          |  |        | 3.93 |          |  |        | 580,000    |          |  |   | 1.59 |  |  |  | 550,500   |   |  |   | 1.71 | 
|Exercised                        |  |        | (206,600  | )        |  |        | 2.13 |          |  |        | (5,000     | )        |  |   | 1.05 |  |  |  |          |   |  |   |      | 
|Forfeited/expired                |  |        | (121,090  | )        |  |        | 1.58 |          |  |        | (1,472,457 | )        |  |   | 4.84 |  |  |  | (452,025  | ) |  |   | 4.38 | 
|                                 |  |        |           |          |  |        |      |          |  |        |            |          |  |   |      |  |  |  |           |   |  |   |      | 
|Outstanding at end of year       |  |        | 1,659,888 |          |  |        | 3.36 |          |  |        | 1,298,961  |          |  |   | 2.69 |  |  |  | 2,196,418 |   |  |   | 4.42 | 
|                                 |  |        |           |          |  |        |      |          |  |        |            |          |  |   |      |  |  |  |           |   |  |   |      | 
|Options exercisable at year-end  |  |        | 974,595   |          |  |        | 3.26 |          |  |        | 759,714    |          |  |   | 3.30 |  |  |  | 1,496,763 |   |  |   | 5.51 | 
|                                 |  |        |           |          |  |        |      |          |  |        |            |          |  |   |      |  |  |  |           |   |  |   |      | 

The following table summarizes information
regarding stock options outstanding as of July 31, 2004:

|                |           |                     |         |                     |  |          |     |             |  |          |      |      |  |  |         |         |  |   |      |      | 
|--------------- | --------- | ------------------- | ------- | ------------------- |  | -------- | --- | ----------- |  | -------- | ---- | ---- |  |  | ------- | ------- |  | - | ---- | ---- | 
|                |           |                     |         |                    
|                |           | Options Outstanding |         | Options Exercisable
|                |           |                     |         |                    
|                |           | Number              |         | Weighted            |  | Weighted |     | Number      |  | Weighted
|                |           | Outstanding         |         | Average             |  | Average  |     | Exercisable |  | Average 
|Range of        |           | At July 31,         |         | Remaining           |  | Exercise |     | at July 31, |  | Exercise
|Exercise Prices |           | 2004                |         | Contractual Life    |  | Price    |     | 2004        |  | Price   
|                |           |                     |         |                     |  |          |     |             |  |         
|$0.76-3.00      |           |                     | 554,834 |                     |  |          | 6.7 |             |  | $        | 1.30 |      |  |  | 450,501 |         |  | $ | 1.28 |     
|                | 3.01-4.50 |                     |         | 694,719             |  |          |     | 6.8         |  |          |      | 3.39 |  |  |         | 296,259 |  |   |      | 3.32 | 
|                | 4.51-6.00 |                     |         | 259,144             |  |          |     | 8.8         |  |          |      | 4.92 |  |  |         | 76,644  |  |   |      | 5.16 | 
|                | 6.01-8.00 |                     |         | 93,191              |  |          |     | 0.8         |  |          |      | 6.99 |  |  |         | 93,191  |  |   |      | 6.99 | 
|                | 8.01-9.92 |                     |         | 58,000              |  |          |     | 3.4         |  |          |      | 9.88 |  |  |         | 58,000  |  |   |      | 9.88 | 
|                |           |                     |         |                     |  |          |     |             |  |          |      |      |  |  |         |         |  |   |      |     
|                | Total     |                     |         | 1,659,888           |  |          |     | 6.6         |  |          |      | 3.36 |  |  |         | 974,595 |  |   |      | 3.26 | 
|                |           |                     |         |                     |  |          |     |             |  |          |      |      |  |  |         |         |  |   |      |     

b. Warrants  We have
issued warrants to various investors, shareholders and other
third parties in connection with services provided. These
warrants were valued using a Black Scholes model and charged to
expense. Warrants issued in exchange for goods are expensed at
the fair value of the consideration received. During the year
ended July 31, 2003 warrants issued for goods or services
were valued at $71,000 and are

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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

included as a component of selling, general and
administrative expenses. Activity related to such warrants,
which expire at various dates through September 2008, is
summarized as follows:

|                           |             |           |         |               |  |   |           |           | 
|-------------------------- | ----------- | --------- | ------- | ------------- |  | - | --------- | --------- | 
|                           |             | Number of |         | Warrant Price
|                           |             | Shares    |         | Per Share    
|                           |             |           |         |              
|Outstanding, July 31, 2001 |             |           | 25,000  |               |  | $ | 4.00-5.00 |          
|                           | No activity |           |         |              |  |   |           |           | 
|                           |             |           |         |               |  |   |           |          
|Outstanding, July 31, 2002 |             |           | 25,000  |               |  |   | 4.00-5.00 |          
|                           | Issued      |           |         | 104,000       |  |   |           | 0.98-4.00 | 
|                           |             |           |         |               |  |   |           |          
|Outstanding, July 31, 2003 |             |           | 129,000 |               |  |   | 0.98-5.00 |          
|                           | Issued      |           |         | 55,000        |  |   |           | 4.00-5.00 | 
|                           |             |           |         |               |  |   |           |          
|Outstanding, July 31, 2004 |             |           | 184,000 |               |  |   | 0.98-5.00 |          
|                           |             |           |         |               |  |   |           |          

c. Stock Purchase Plan 
Under the Zila, Inc. Employee Stock Purchase Plan, we are
authorized, as of July 31, 2001, to issue up to
2,000,000 shares of common stock to our eligible employees,
nearly all of whom are eligible to participate. Eligible
employees may have up to 15% of eligible compensation withheld
and/or they may make a lump sum payment on the last day of the
offering to purchase our common stock. The purchase price for
each share of stock is 85% of the lower of the closing price on
the first or last day of the offering period. A total of 76,800,
143,700 and 12,400 shares were purchased in fiscal 2004,
2003 and 2002, respectively, for aggregate proceeds of $250,000,
$140,000 and $25,000, respectively.



|    |             
|--- | ------------
|12. | Income Taxes

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

|                                                  |         |      |    |      |   |      |      |     |   |   |        |        |  
|------------------------------------------------- | ------- | ---- | -- | ---- | - | ---- | ---- | --- | - | - | ------ | ------ | -
|                                                  |         | 2004 |    | 2003 |   | 2002
|                                                  |         |      |    |      |   |     
|Current:                                          |         |      |    |      |   |      |      |     |   |   |        |       
|                                                  | Federal |      | $  |     |   |      | $    | (95 | ) |   | $      | 280    |  
|                                                  | State   |      |    | (2   | ) |      |      | (93 | ) |   |        | (17    | )
|                                                  |         |      |    |      |   |      |      |     |   |   |        |       
|Total current                                     |         |      | (2 | )    |   |      | (188 | )   |   |   | 263    |       
|                                                  |         |      |    |      |   |      |      |     |   |   |        |       
|Deferred:                                         |         |      |    |      |   |      |      |     |   |   |        |       
|                                                  | Federal |      |    |     |   |      |      |    |   |   |        | (3,648 | )
|                                                  | State   |      |    |     |   |      |      |    |   |   |        | (569   | )
|                                                  |         |      |    |      |   |      |      |     |   |   |        |       
|Total deferred                                    |         |      |   |      |   |      |     |     |   |   | (4,217 | )     
|                                                  |         |      |    |      |   |      |      |     |   |   |        |       
|Total consolidated income tax (benefit) provision |         | $    | (2 | )    |   | $    | (188 | )   |   | $ | (3,954 | )     
|                                                  |         |      |    |      |   |      |      |     |   |   |        |       

F-21



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

|                       |                                                     |      |     |      |   |      |    |     |   |  |     |    |  
|---------------------- | --------------------------------------------------- | ---- | --- | ---- | - | ---- | -- | --- | - |  | --- | -- | -
|                       |                                                     | 2004 |     | 2003 |   | 2002
|                       |                                                     |      |     |      |   |     
|Federal statutory rate |                                                     |      | (35 | )%   |   |      | 35 | %   |   |  | (35 | )%
|Adjustments:           |                                                     |      |     |      |   |      |    |     |   |  |     |   
|                       | State income taxes  net of federal tax
    effects |      |     |     |   |      |    | 5   |   |  |     | (5 | )
|                       | Non-deductible meal and entertainment expenses      |      |     | 1    |   |      |    | 1   |   |  |     | 1  |  
|                       | Non-deductible intangible amortization              |      |     | 4    |   |      |    | 4   |   |  |     | 6  |  
|                       | Increase (decrease) in valuation allowance          |      |     | 30   |   |      |    | (43 | ) |  |     | 87 |  
|                       |                                                     |      |     |      |   |      |    |     |   |  |     |   
|                       | Effective tax rate                                  |      |     | 0    | % |      |    | 2   | % |  |     | 54 | %
|                       |                                                     |      |     |      |   |      |    |     |   |  |     |   

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

|                                      |                                               |      |        |       |   |      |        |       |   |   |        |       | 
|------------------------------------- | --------------------------------------------- | ---- | ------ | ----- | - | ---- | ------ | ----- | - | - | ------ | ----- | 
|                                      |                                               | 2004 |        | 2003  |   | 2002
|                                      |                                               |      |        |       |   |     
|Deferred income tax assets:           |                                               |      |        |       |   |      |        |       |   |   |        |      
|                                      | Net operating loss carry forwards             |      | $      | 4,078 |   |      | $      | 2,480 |   |   | $      | 8,257 | 
|                                      | Capital loss carry forward                    |      |        |      |   |      |        | 185   |   |   |        |      | 
|                                      | Book basis versus tax basis differences       |      |        | 1,416 |   |      |        | 1,964 |   |   |        | 447   | 
|                                      | Alternative minimum tax credit                |      |        | 230   |   |      |        | 249   |   |   |        | 154   | 
|                                      | Miscellaneous reserves and accruals           |      |        | 797   |   |      |        | 425   |   |   |        | 236   | 
|                                      | Other                                         |      |        | 77    |   |      |        | 1     |   |   |        | 8     | 
|                                      |                                               |      |        |       |   |      |        |       |   |   |        |      
|Total deferred income tax assets      |                                               |      | 6,598  |       |   |      | 5,304  |       |   |   | 9,102  |      
|                                      |                                               |      |        |       |   |      |        |       |   |   |        |      
|Deferred income tax liabilities:      |                                               |      |        |       |   |      |        |       |   |   |        |      
|                                      | Depreciation and amortization                 |      |        | (174  | ) |      |        | (25   | ) |   |        |      | 
|                                      | Federal income tax on state NOL carryforwards |      |        | (73   | ) |      |        |      |   |   |        |       | 
|                                      | Other                                         |      |        | (147  | ) |      |        | (20   | ) |   |        |      | 
|                                      |                                               |      |        |       |   |      |        |       |   |   |        |      
|Total deferred income tax liabilities |                                               |      | (394   | )     |   |      | (45    | )     |   |   |       |      
|                                      |                                               |      |        |       |   |      |        |       |   |   |        |      
|Valuation allowance                   |                                               |      | (6,204 | )     |   |      | (5,259 | )     |   |   | (9,102 | )    
|                                      |                                               |      |        |       |   |      |        |       |   |   |        |      
|Net deferred income tax assets        |                                               | $    |       |       |   | $    |       |       |   | $ |       |      
|                                      |                                               |      |        |       |   |      |        |       |   |   |        |      

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

We regularly review our 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 years 2004, 2003 and 2002, after
consideration of available positive and negative evidence, we
determined that it was more likely than not that certain future
tax benefits will not be realized. Accordingly, valuation
allowances were provided that reduced the net deferred tax
assets to $0 as of July 31, 2004, 2003 and 2002. During
fiscal 2002, we 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 carry backs over five years instead of three.

F-22



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

At July 31, 2004, we had federal net
operating loss carry forwards of approximately
$11.4 million which expire in years 2009 through 2024.

The other comprehensive losses in fiscal years
2004 ($2,200), 2003 ($300) and 2002 ($226,000) reflect no income
tax benefit due to the recording of valuation allowances.



|    |                            
|--- | ---------------------------
|13. | Convertible Preferred Stock

On February 1, 2001, we issued
100,000 shares of Series B Convertible Preferred Stock
to National Healthcare Manufacturing Corporation, as part of the
acquisition of IST. 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. We paid dividends of $19,500,
$49,000 and $29,000 during fiscal years 2004, 2003 and 2002,
respectively. At July 31, 2004, accumulated accrued
dividends are $39,000.



|    |               
|--- | --------------
|14. | Treasury Stock

During the quarter ended January 31, 2000,
we began acquiring shares of our common stock under our 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, 2004,
we had purchased 225,100 shares of common stock at an
aggregate cost of $571,000. We have made no purchases of our
common stock under this program in fiscal 2004 and have
suspended purchases under the program.



|    |       
|--- | ------
|15. | Leases

We lease offices, warehouse facilities and
certain equipment, under capital and operating leases, with
terms generally ranging up to 2009 with options to renew for
additional periods.

During fiscal 2004, we entered into new capital
leases totaling $232,200. These capital leases are non-cash
transactions and, accordingly, have been excluded from the
Statements of Consolidated Cash Flows. Interest paid as part of
capital lease obligations was approximately $15,300 in fiscal
2004.

Operating leases are charged to expense as
incurred. Rent expense for fiscal years 2004, 2003 and 2002
totaled $321,400, $469,300 and $407,000, respectively.
Amortization of assets recorded under capital leases was
included in depreciation expense.

As part of our strategy to employ financial
assets in core business competencies, on January 30, 2004,
we completed the sale and a five-year leaseback of our corporate
headquarters for approximately $1.7 million in net cash. We
realized a gain of $1.2 million, of which we recognized
approximately $470,000 in the quarter ended January 31,
2004. The $470,000 gain represents the excess of the net
proceeds over the net present value of the future lease
payments. The balance of the gain of $765,000 was deferred and
amortized on a straight-line basis over the five-year lease term
as a reduction of rent expense in general and administrative
expenses. The leaseback is accounted for as an operating lease
under SFAS 13.

F-23



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Future minimum lease payments for capital and
operating leases follow (in thousands):

|                                                   |  |         |     |           |  |       |       |  |  |   |       | 
|-------------------------------------------------- |  | ------- | --- | --------- |  | ----- | ----- |  |  | - | ----- | 
|                                                   |  | Capital |     | Operating |  |      
|                                                   |  | Leases  |     | Leases    |  | Total
|                                                   |  |         |     |           |  |      
|2005                                               |  | $       | 65  |           |  | $     | 466   |  |  | $ | 531   | 
|2006                                               |  |         | 59  |           |  |       | 244   |  |  |   | 303   | 
|2007                                               |  |         | 58  |           |  |       | 203   |  |  |   | 261   | 
|2008                                               |  |         | 47  |           |  |       | 207   |  |  |   | 254   | 
|2009                                               |  |         | 12  |           |  |       | 88    |  |  |   | 100   | 
|Thereafter                                         |  |         |     |           |  |       |       |  |  |   |       | 
|                                                   |  |         |     |           |  |       |       |  |  |   |       | 
|Total minimum lease payments                       |  | $       | 241 |           |  | $     | 1,208 |  |  | $ | 1,449 | 
|                                                   |  |         |     |           |  |       |       |  |  |   |       | 
|Less: amounts representing interest                |  |         | 40  |           |  |       |       |  |  |   |       | 
|                                                   |  |         |     |           |  |       |       |  |  |   |       | 
|Present value of minimum lease payments            |  |         | 201 |           |  |       |       |  |  |   |       | 
|Less: Current portion of capital lease obligations |  |         | 47  |           |  |       |       |  |  |   |       | 
|                                                   |  |         |     |           |  |       |       |  |  |   |       | 
|Long-term portion of capital lease obligations     |  | $       | 154 |           |  |       |       |  |  |   |       | 
|                                                   |  |         |     |           |  |       |       |  |  |   |       | 



|    |                              
|--- | -----------------------------
|16. | Commitments and Contingencies



| |                                        
| | ---------------------------------------
| | FDA approval of the
    OraTest®product

We are pursuing FDA approval of a New Drug
Application (NDA) for our OraTest® products.
Factors that will affect the cost and timing of completion of
the clinical trials 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.

At July 31, 2004, we had approximately
$552,000 of OraTest® clinical rinse and swab inventory and
ZTCTM drug substance, the active ingredient in the
OraTest® product, and its related components. We intend to
realize the value of this inventory and drug substance during
fiscal 2005 (i) through its consumption during the conduct
of the clinical trials, process development, toxicology studies
and validation testing of our manufacturing process and
(ii) through sales in Europe and Asia. The drug substance
currently has shelf lives with varying expiration dates which
will expire through early 2006. Our periodic testing has
indicated that the drug substance is stable and we anticipate
being able to extend the expiration dates of the entire drug
substance beyond these dates if our plans are delayed. However,
no assurance can be given in this regard.



| |           
| | ----------
| | Litigation

In connection with the acquisition of patent
rights in 1980, we agreed to pay to Dr. James E. Tinnell
(Tinnell), the inventor of one of our treatment
compositions, a royalty of 5% of gross sales of the invention
disclosed in his then pending patent application. In September
2000, we notified Tinnell that we would no longer pay such
royalties since the obligations ceased in August 1998 when the
related product patents expired and we requested reimbursement
of royalties paid since August 1998. We then filed suit in the
Federal District Court requesting a declaratory judgment that we
had no royalty obligations to Tinnell and a judgment for the
overpaid royalties. Tinnell asserted several counterclaims. The
Court has since ruled in our favor stating that we do not owe
royalty obligations to Tinnell and denied several of
Tinnells counterclaims. However, one of Tinnells
counterclaims is still outstanding for breach of contract.
Furthermore, the Court dismissed our request for reimbursement
of overpaid royalties. Tinnell filed a motion asking the trial
court to certify the issue of our royalty obligation for
immediate appeal. In May 2004, we joined the request and also
asked the trial court to certify the issue of our right to
reimbursement of the overpaid royalties. Tinnell also moved under

F-24



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Rule 54(b) for a money judgment in the
amount of royalties due under the original agreement based on
sales in Canada, up to the time the Canadian patent expired,
plus prejudgment interest. We filed an opposition to this motion
on the grounds that the royalty contract was completely
unenforceable and neither party could assert any claims based on
it, neither Tinnell for unpaid royalties nor us for
reimbursement of overpayments. Since the judge previously ruled
that we could not receive reimbursement, it would be an
unenforceable action for any party to be entitled to receive
monies.

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



| |                           
| | --------------------------
| | Daleco Capital Corporation

In June 1992, Daleco Capital Corporation formed a
limited partnership known as Daleco Zila Partners II, L.P.
(the Partnership). We and our officers have no
partnership interest in the Partnership. The purpose of the
Partnership was to provide us 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 our behalf. In 1994, the Partnership agreement
was amended to increase the maximum amount of marketing funds
potentially available to us to be raised to $2,250,000. At
July 31, 2004, approximately $1,820,000 has been spent.

We are committed to pay the Partnership a
commission equal to 5% to 10% of the gross sales of certain of
our products, until such time as up to three times the amount of
funds expended on the marketing program by the Partnership has
been paid to the Partnership. We have paid commissions to the
Partnership of approximately $100, $1,500 and $11,000 for the
years ended July 31, 2004, 2003 and 2002, respectively.



| |                                                 
| | ------------------------------------------------
| | Vital Health Sciences Ltd. License
    Agreement

On October 31, 2003, we entered into a
license agreement with Vital Health that grants us the exclusive
rights in the human dietary supplement market for certain issued
and pending patents, know-how and data pertaining to tocopheryl
phosphates in the United States, Canada and Indonesia. A
subsequent agreement entered into on August 4, 2004,
extends the terms of the original agreement to give us extensive
rights in the animal dietary supplement market in these
countries. The initial term of the license is five years, and we
have the right, unilaterally, to extend the term until the
expiration of the last of the licensed patents. Two of such
patents were issued while other patent applications are still
pending. We also have a right of first refusal for all other
international human dietary supplement markets under the
agreement. Zila Nutraceuticals is currently using Vital
Healths patented tocopheryl phosphate technology to
produce its Ester-E® product tailored for the dietary
supplement market. Under the agreement, starting fiscal 2005, we
are required to make royalty payments based on certain levels of
sales volume. Additionally, we are subject to minimum annual
royalty payment amounts, as defined.



| |                    
| | -------------------
| | Supply Arrangements

Our wholly-owned subsidiary, Zila Nutraceuticals,
Inc., entered into three-year supply agreements with two major
suppliers for the purchase of $26.7 million of ascorbic
acid. Ascorbic acid is the primary ingredient in our
Ester-C® products. Purchases under one of these agreements
commenced in July 2004 and with the other staring in January
2005. The agreements provide a substantial portion of our
anticipated annual requirements for ascorbic acid and will
provide important cost predictability during the terms of the

F-25



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

agreements. Should prices fall sharply, we would
be at risk of being committed to purchase ascorbic acid at
higher than market prices. If our sales should decline
significantly, we could be obligated to purchase supplies in
excess of our needs.



| |                 
| | ----------------
| | Indemnifications

During the normal course of business, we make
certain indemnities, commitments and guarantees under which we
may be required to make payments in relation to certain
transactions. These include: (i) intellectual property
indemnities to customers in connection with the use, sales
and/or license of products and services; (ii) indemnities
to customers in connection with losses incurred while performing
services on their premises; (iii) indemnities to vendors
and service providers pertaining to claims based on negligence
or willful misconduct; and (iv) indemnities involving the
representations and warranties in certain contracts. In
addition, under our by-laws we are committed to our directors
and officers for providing for payments upon the occurrence of
certain prescribed events. The majority of these indemnities,
commitments and guarantees do not provide for any limitation on
the maximum potential for future payments that we could be
obligated to make. To help address these risks, we maintain
general business liability insurance coverage, including
product, commercial, general, fiduciary, employment practices
and directors and officers liability coverages. We
have not recorded a liability for these indemnities, commitments
and other guarantees in the Consolidated Balance Sheets.



| |                    
| | -------------------
| | Contingent Warrants

On March 11, 2004, we entered into an
agreement with a sales representative for our ViziLite®
products. Under the terms of the agreement, on June 17,
2004, we issued a warrant to purchase 25,000 shares of
our common stock for $4.06 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 warrant will
become exercisable on March 31, 2005 if certain defined
sales milestones are met by December 31, 2004. We may be
required to record non-cash charges in the first and second
quarters of fiscal 2005 in connection with the achievement of
these product sales milestones.



|    |                           
|--- | --------------------------
|17. | Related Party Transactions

In fiscal 2004, we paid $6,086 to Hogan and
Hartson, a law firm in which a member of our Board of Directors,
Mr. John Porter, is a partner. The payment was related to
consulting work performed by this firm.

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 at that time,
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 with Douglas dated
March 15, 2001. In addition, Douglas was paid an advisory
retainer of $60,000 during fiscal 2002. The agreements were
terminated in July 2002. Mr. Rocca is no longer a director
of the Company.



|    |                      
|--- | ---------------------
|18. | Employee Benefit Plan

We make available to all eligible employees, the
Zila, Inc. 401(k) Savings and Retirement Plan (the Zila
Plan). We may make matching or profit sharing
contributions to the Zila Plan. Our contributions to the Zila
Plan were $223,000, $191,000 and $154,000 in fiscal 2004, 2003,
and 2002, respectively.



|    |                    
|--- | -------------------
|19. | Segment Information

Our business 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:

F-26



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Nutraceuticals Business Unit, which includes
Oxycal Laboratories, Inc. and its wholly-owned subsidiary, Zila
Nutraceuticals, Inc.: The Pharmaceuticals Business Unit which
includes Zila Pharmaceuticals, Inc. and the Zilactin®
family of over-the-counter products, Peridex® prescription
mouth rinse, the ViziLite® chemiluminescent disposable
light product for the illumination of oral mucosal
abnormalities, and the plastic molded products of Zila Swab
Technologies, Inc., an Arizona corporation dba Innovative
Swab Technologies (IST); and The Zila Biotechnology Business
Unit, which includes Zila Biotechnology Inc., Zila Technology,
Inc. and Zila Limited, and is the research, development and
licensing business specializing in pre-cancer/cancer detection
through its patented Zila® Tolonium Chloride and
OraTest® technologies and now manages the OraTest®
product, an oral cancer diagnostic system, which is currently in
Food and Drug Administration (FDA) phase III
clinical trials.

We evaluate performance and allocate resources to
segments based on operating results. We allocated the net gain
of approximately $14.8 million derived from the settlement
with our former contract research organization based principally
upon the relative contributions of personnel from Corporate and
the Biotechnology segment in helping to achieve such settlement.

Information about our reported segments (with
corporate representing a reconciling item) is set forth below
for each of the three years ended July 31 (in
thousands):

|                                                                                        |      |                |   |                 |  |               |   |           |   |       |   |        |   |  |   |        |   |  |   |        |  
|--------------------------------------------------------------------------------------- | ---- | -------------- | - | --------------- |  | ------------- | - | --------- | - | ----- | - | ------ | - |  | - | ------ | - |  | - | ------ | -
|                                                                                        |      | Nutraceuticals |   | Pharmaceuticals |  | Biotechnology |   | Corporate |   | Total
|                                                                                        |      |                |   |                 |  |               |   |           |   |      
|Net revenues from continuing operations:                                                |      |                |   |                 |  |               |   |           |   |       |   |        |   |  |   |        |   |  |   |       
|                                                                                        | 2004 |                | $ | 32,433          |  |               | $ | 16,993    |   |       | $ | 2      |   |  | $ |       |   |  | $ | 49,428 |  
|                                                                                        | 2003 |                |   | 29,423          |  |               |   | 17,664    |   |       |   | 20     |   |  |   |       |   |  |   | 47,107 |  
|                                                                                        | 2002 |                |   | 19,559          |  |               |   | 15,206    |   |       |   | 107    |   |  |   |       |   |  |   | 34,872 |  
|Income (loss) from continuing operations before
    income taxes and accounting change: |      |                |   |                 |  |               |   |           |   |       |   |        |   |  |   |        |   |  |   |       
|                                                                                        | 2004 |                |   | 8,300           |  |               |   | (728      | ) |       |   | (7,195 | ) |  |   | (4,712 | ) |  |   | (4,335 | )
|                                                                                        | 2003 |                |   | 7,733           |  |               |   | 155       |   |       |   | 3,474  |   |  |   | 186    |   |  |   | 11,548 |  
|                                                                                        | 2002 |                |   | 2,808           |  |               |   | (685      | ) |       |   | (5,287 | ) |  |   | (4,220 | ) |  |   | (7,384 | )
|Identifiable assets from continuing operations:                                         |      |                |   |                 |  |               |   |           |   |       |   |        |   |  |   |        |   |  |   |       
|                                                                                        | 2004 |                |   | 31,469          |  |               |   | 11,499    |   |       |   | 15,583 |   |  |   | 3,558  |   |  |   | 62,108 |  
|                                                                                        | 2003 |                |   | 29,290          |  |               |   | 14,520    |   |       |   | 7,983  |   |  |   | 17,227 |   |  |   | 69,020 |  
|                                                                                        | 2002 |                |   | 28,958          |  |               |   | 17,732    |   |       |   | 7,814  |   |  |   | 2,787  |   |  |   | 57,291 |  
|Capital expenditures:                                                                   |      |                |   |                 |  |               |   |           |   |       |   |        |   |  |   |        |   |  |   |       
|                                                                                        | 2004 |                |   | 759             |  |               |   | 31        |   |       |   | 37     |   |  |   | 450    |   |  |   | 1,277  |  
|                                                                                        | 2003 |                |   | 175             |  |               |   | 153       |   |       |   | 509    |   |  |   | 95     |   |  |   | 932    |  
|                                                                                        | 2002 |                |   | 35              |  |               |   | 64        |   |       |   | 253    |   |  |   | 125    |   |  |   | 477    |  
|Depreciation and amortization:                                                          |      |                |   |                 |  |               |   |           |   |       |   |        |   |  |   |        |   |  |   |       
|                                                                                        | 2004 |                |   | 1,057           |  |               |   | 832       |   |       |   | 683    |   |  |   | 99     |   |  |   | 2,671  |  
|                                                                                        | 2003 |                |   | 986             |  |               |   | 596       |   |       |   | 715    |   |  |   | 120    |   |  |   | 2,417  |  
|                                                                                        | 2002 |                |   | 1,219           |  |               |   | 1,376     |   |       |   | 737    |   |  |   | 120    |   |  |   | 3,452  |  

F-27



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Revenues from customers attributed to all foreign
countries were $5,416,000 $8,948,000 and $6,039,000 in fiscal
years 2004, 2003 and 2002, respectively.



|    |                                     
|--- | ------------------------------------
|20. | Quarterly Financial Data (Unaudited)

Quarterly financial information is presented in
the following summary (in thousands, except per share amounts):

|                                                             |                                                              |               |        |            |   |          |        |         |   |   |        |       |   |   |        |       |  
|------------------------------------------------------------ | ------------------------------------------------------------ | ------------- | ------ | ---------- | - | -------- | ------ | ------- | - | - | ------ | ----- | - | - | ------ | ----- | -
|                                                             |                                                              |              
|                                                             |                                                              | 2004         
|                                                             |                                                              | Quarter Ended
|                                                             |                                                              |              
|                                                             |                                                              | October 31    |        | January 31 |   | April 30 |        | July 31
|                                                             |                                                              |               |        |            |   |          |        |        
|Net revenues                                                 |                                                              | $             | 12,053 |            |   | $        | 13,604 |         |   | $ | 12,650 |       |   | $ | 11,121 |      
|Gross profit                                                 |                                                              |               | 7,060  |            |   |          | 8,012  |         |   |   | 7,925  |       |   |   | 6,995  |      
|Loss from continuing operations before accounting
    change |                                                              |               | (1,568 | )          |   |          | (962   | )       |   |   | (1,567 | )     |   |   | (240   | )    
|Loss before accounting change                                |                                                              |               | (1,568 | )          |   |          | (962   | )       |   |   | (1,567 | )     |   |   | (240   | )    
|Net loss                                                     |                                                              | $             | (1,568 | )          |   | $        | (962   | )       |   | $ | (1,567 | )     |   | $ | (240   | )    
|Basic and diluted net loss per share:                        |                                                              |               |        |            |   |          |        |         |   |   |        |       |   |   |        |      
|                                                             | Loss from continuing operations before accounting
    change |               | $      | (0.04      | ) |          | $      | (0.02   | ) |   | $      | (0.03 | ) |   | $      | (0.01 | )
|                                                             | Net loss                                                     |               | $      | (0.04      | ) |          | $      | (0.02   | ) |   | $      | (0.03 | ) |   | $      | (0.01 | )

|                                                                      |                                                                       |               |        |            |   |          |        |         |   |   |        |       |   |   |        |      | 
|--------------------------------------------------------------------- | --------------------------------------------------------------------- | ------------- | ------ | ---------- | - | -------- | ------ | ------- | - | - | ------ | ----- | - | - | ------ | ---- | 
|                                                                      |                                                                       |              
|                                                                      |                                                                       | 2003         
|                                                                      |                                                                       | Quarter Ended
|                                                                      |                                                                       |              
|                                                                      |                                                                       | October 31    |        | January 31 |   | April 30 |        | July 31
|                                                                      |                                                                       |               |        |            |   |          |        |        
|Net revenues                                                          |                                                                       | $             | 10,734 |            |   | $        | 11,978 |         |   | $ | 12,425 |       |   | $ | 11,970 |     
|Gross profit                                                          |                                                                       |               | 6,565  |            |   |          | 7,147  |         |   |   | 7,352  |       |   |   | 6,147  |     
|Income (loss) from continuing operations before
    accounting change |                                                                       |               | (1,609 | )          |   |          | (876   | )       |   |   | (639   | )     |   |   | 14,483 |     
|Gain from discontinued operations                                     |                                                                       |               |       |            |   |          |       |         |   |   |       |       |   |   | 10     |     
|Income (loss) before accounting change                                |                                                                       |               | (1,609 | )          |   |          | (876   | )       |   |   | (639   | )     |   |   | 14,493 |     
|Cumulative effect of accounting change                                |                                                                       |               | (4,084 | )          |   |          |       |         |   |   |       |       |   |   |       |     
|Net income (loss)                                                     |                                                                       | $             | (5,693 | )          |   | $        | (876   | )       |   | $ | (639   | )     |   | $ | 14,493 |     
|Basic and diluted net loss per share:                                 |                                                                       |               |        |            |   |          |        |         |   |   |        |       |   |   |        |     
|                                                                      | Income (loss) from continuing operations before
    accounting change |               | $      | (0.04      | ) |          | $      | (0.02   | ) |   | $      | (0.01 | ) |   | $      | 0.32 | 
|                                                                      | Accounting change                                                     |               | $      | (0.09      | ) |          | $      |        |   |   | $      |      |   |   | $      |     | 
|                                                                      | Net income (loss)                                                     |               | $      | (0.13      | ) |          | $      | (0.02   | ) |   | $      | (0.01 | ) |   | $      | 0.32 | 

F-28



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##### 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 |   | of Period 
|                                            |               |                |   |            |  |            |   |           
|                                            |               |               
|                                            |               | (In thousands)
|Allowance for doubtful accounts receivable: |               |                |   |            |  |            |   |            |   |  |   |       |  |  |   |      
|                                            | July 31, 2002 |                | $ | 269        |  |            | $ | 59         |   |  | $ | 199   |  |  | $ | 129   | 
|                                            | July 31, 2003 |                |   | 129        |  |            |   | 444        |   |  |   | 273   |  |  |   | 300   | 
|                                            | July 31, 2004 |                |   | 300        |  |            |   | (84        | ) |  |   | 158   |  |  |   | 58    | 
|Allowance for sales returns:                |               |                |   |            |  |            |   |            |   |  |   |       |  |  |   |      
|                                            | July 31, 2002 |                |   | 94         |  |            |   | 159        |   |  |   | 113   |  |  |   | 140   | 
|                                            | July 31, 2003 |                |   | 140        |  |            |   | 196        |   |  |   | 92    |  |  |   | 244   | 
|                                            | July 31, 2004 |                |   | 244        |  |            |   | 174        |   |  |   | 195   |  |  |   | 223   | 
|Inventory reserve:                          |               |                |   |            |  |            |   |            |   |  |   |       |  |  |   |      
|                                            | July 31, 2002 |                |   | 79         |  |            |   | 466        |   |  |   | 252   |  |  |   | 293   | 
|                                            | July 31, 2003 |                |   | 293        |  |            |   | 363        |   |  |   | 301   |  |  |   | 355   | 
|                                            | July 31, 2004 |                |   | 355        |  |            |   | 171        |   |  |   | 329   |  |  |   | 197   | 
|Deferred tax valuation allowance:           |               |                |   |            |  |            |   |            |   |  |   |       |  |  |   |      
|                                            | July 31, 2002 |                |   | 2,370      |  |            |   | 9,247      |   |  |   | 2,515 |  |  |   | 9,102 | 
|                                            | July 31, 2003 |                |   | 9,102      |  |            |   |           |   |  |   | 3,843 |  |  |   | 5,259 | 
|                                            | July 31, 2004 |                |   | 5,259      |  |            |   | 945        |   |  |   |      |  |  |   | 6,204 | 

F-29



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##### Table of Contents



INDEX TO EXHIBITS

|        |     |             |  |                                                                                                                                                                                                                      |  |  |   | 
|------- | --- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | - | 
|Exhibit |     |             |  | Method of                                                                                                                                                                                                           
|Number  |     | Description |  | Filing                                                                                                                                                                                                              
|        |     |             |  |                                                                                                                                                                                                                     
|        | 3-  | A           |  | Certificate of Incorporation, as amended                                                                                                                                                                             |  |  | A | 
|        | 3-  | B           |  | Amended and Restated Bylaws (as amended through
    September 26, 2002)                                                                                                                                              |  |  | O | 
|        | 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)(1)                                                                                                                                                   |  |  | B | 
|        | 10- | C           |  | Non-Employee Directors Stock Option Plan (as
    amended through September 26, 2002)(1)                                                                                                                              |  |  | R | 
|        | 10- | L           |  | Asset Purchase Agreement dated October 28,
    1999 between Zila, Inc., and 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)(1)                                                                                                                                          |  |  | G | 
|        | 10- | V           |  | Employee Stock Purchase Plan(1)                                                                                                                                                                                      |  |  | 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 | 



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##### Table of Contents



|        |      |             |  |                                                                                                                                                                                                                                                                                                                                  |  |  |    | 
|------- | ---- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | -- | 
|Exhibit |      |             |  | Method of                                                                                                                                                                                                                                                                                                                       
|Number  |      | Description |  | Filing                                                                                                                                                                                                                                                                                                                          
|        |      |             |  |                                                                                                                                                                                                                                                                                                                                 
|        | 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  | 
|        | 10-  | Ad          |  | Third Amendment dated December 13, 2002 to
    the 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                                                             |  |  | P  | 
|        | 10-  | Ae          |  | General Services Agreement between Zila, Inc. and
    Quintiles, Inc. dated December 18, 2002 (without exhibits)                                                                                                                                                                                                                 |  |  | Q  | 
|        | 10-  | Af          |  | Investment Agreement between Zila, Inc. and
    PharmaBio Development, Inc. dated December 18, 2002                                                                                                                                                                                                                              |  |  | Q  | 
|        | 10-  | Ag          |  | Offer letter between Zila, Inc. and Lawrence J.
    Batina dated January 27, 2003                                                                                                                                                                                                                                                |  |  | Q  | 
|        | 10-  | Ah          |  | Fourth Amendment dated January 31, 2003 to
    the Loan and Security Agreement dated August 17, 2001 by
    and between Congress Financial Corporation and Zila, Inc., Zila
    Pharmaceuticals, Inc., and Inter-Cal Corporation                                                                                                 |  |  | Q  | 
|        | 10-  | Ai          |  | Credit and Security Agreement between Zila
    Nutraceuticals, Inc., Zila Biotechnology, Inc., Zila
    Pharmaceuticals, Inc., Zila Swab Technologies, Inc., Oxycal
    Laboratories, Incorporated, and Wells Fargo Business Credit,
    Inc., date as of February 6, 2004.                                                      |  |  | S  | 
|        | 10-  | Aj          |  | Reimbursement Agreement between Oxycal
    Laboratories, Incorporated, an Arizona Corporation, and Wells
    Fargo Business Credit, Inc. relating to $3,900,000 
    The Industrial Development Authority Revenue Bonds (Oxycal
    Laboratories, Incorporated Project) Series 1999A, dated as
    of February 6, 2004          |  |  | S  | 
|        | 10-  | Ak          |  | Employment Agreement between Zila, Inc. and
    Douglas D. Burkett, Ph.D., dated as of October 21, 2003                                                                                                                                                                                                                          |  |  | S  | 
|        | 10-  | Al          |  | Purchase Agreement between Zila, Inc. and Gary
    and Janet Hedge, dated as of November 7, 200                                                                                                                                                                                                                                  |  |  | S  | 
|        | 10-  | Am          |  | Lease between Zila, Inc. and Phoenix 7 LLC, dated
    January 30, 2004                                                                                                                                                                                                                                                           |  |  | S  | 
|        | 10-  | An          |  | Offer letter between Zila, Inc. and Andrew A.
    Stevens dated January 15, 2004                                                                                                                                                                                                                                                 |  |  | *  | 
|        | 10-  | Ao          |  | First Amendment dated August 17, 2004 to the
    Credit and Security Agreement dated February 6, 2004 by and
    between Wells Fargo Business Credit, Inc. and Zila
    Nutraceuticals, Inc., Zila Biotechnology, Inc., Zila
    Pharmaceuticals, Inc., Zila Swab Technologies, Inc., and Oxycal
    Laboratories, Incorporated. |  |  | *  | 
|        | 21   |             |  | Subsidiaries of Registrant                                                                                                                                                                                                                                                                                                       |  |  | *  | 
|        | 23   |             |  | Consent of Deloitte & Touche LLP
    (regarding Form S-8 and Form S-3 Registration
    Statements)                                                                                                                                                                                                                               |  |  | *  | 
|        | 24-  | A           |  | Power of Attorney of Douglas D.
    Burkett, Ph.D.                                                                                                                                                                                                                                                                               |  |  | *  | 
|        | 24-  | B           |  | Power of Attorney of Andrew A. Stevens                                                                                                                                                                                                                                                                                           |  |  | *  | 
|        | 24-  | C           |  | Power of Attorney of Morris C. Aaron                                                                                                                                                                                                                                                                                             |  |  | *  | 
|        | 24-  | D           |  | Power of Attorney of Leslie H. Green                                                                                                                                                                                                                                                                                             |  |  | *  | 
|        | 24-  | E           |  | Power of Attorney of Christopher D. Johnson                                                                                                                                                                                                                                                                                      |  |  | *  | 
|        | 24-  | F           |  | Power of Attorney of Michael S. Lesser                                                                                                                                                                                                                                                                                           |  |  | *  | 
|        | 24-  | G           |  | Power of Attorney of John Edward Porter                                                                                                                                                                                                                                                                                          |  |  | *  | 
|        | 24-  | H           |  | Power of Attorney of Timothy Rose                                                                                                                                                                                                                                                                                                |  |  | *  | 
|        | 31.1 |             |  | Sarbanes-Oxley Section 302 Certification of
    the Chief Executive Officer                                                                                                                                                                                                                                                      |  |  | *  | 
|        | 31.2 |             |  | Sarbanes-Oxley Section 302 Certification of
    the Chief Financial Officer                                                                                                                                                                                                                                                      |  |  | *  | 
|        | 32.1 |             |  | Sarbanes-Oxley Section 906 Certification of
    the Chief Executive Officer                                                                                                                                                                                                                                                      |  |  | ** | 
|        | 32.2 |             |  | Sarbanes-Oxley Section 906 Certification of
    the Chief Financial Officer                                                                                                                                                                                                                                                      |  |  | ** | 



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##### Table of Contents





---

|    |  |                                                                                                                                             
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------
|(1) |  | Management contract or compensatory plan or
    arrangement                                                                                 
|*   |  | Filed herewith                                                                                                                              
|**  |  | Furnished 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
    Proxy Statement on Schedule 14A filed November 7, 2000                                       
|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 filed July 6, 2001                                                
|J   |  | Incorporated by reference to the Companys
    Current Report on Form 8-K filed August 10, 2001                                             
|K   |  | Incorporated by reference to the Companys
    Current Report on Form 8-K filed September 4, 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 July 3, 2002                                                
|O   |  | Incorporated by reference to the Companys
    Annual Report on Form 10-K for fiscal year ended
    July 31, 2002                           
|P   |  | Incorporated by reference to the Companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended October 31, 2002            
|Q   |  | Incorporated by reference to the Companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended January 31, 2003            
|R   |  | Incorporated by reference to the Companys
    Proxy Statement on Schedule 14A filed December 12, 2002                                      
|S   |  | Incorporated by reference to the Companys
    Quarterly Report on Form 10-Q for the quarterly period
    ended January 31, 2004