##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2002

OR

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

For the transition period from ...................... to ................................

Commission File Number 1-12607

SUNLINK HEALTH SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

|                                              |  |                    
|--------------------------------------------- |  | -------------------
|Ohio                                          |  | 31-0621189         
|(State or other jurisdiction of incorporation |  | (I.R.S. Employer   
|or organization)                              |  | Identification No.)

900 Circle 75 Parkway, Suite 1300, Atlanta, Georgia 30339(Address of principal executive offices)
(Zip Code)

(770) 933-7000(Registrants telephone number, including area code)

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
filings requirements for the past 90 days.

Yes X No

The number of Common Shares, without par value, outstanding as of May 7,
2002 was 4,997,592.





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##### 



PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)

|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |           |        |        |  | 
|------------------------------------------------ | ----------------------------------------------------------------- | ------------------------------------------------------------------ | ------------------------------------------ | ------------------------------------ | ------ | --------- | ------ | --------- | ------ | ------ |  | 
|                                                 |                                                                   |                                                                    |                                            |                                      |        | March 31, |        | March 31,
|                                                 |                                                                   |                                                                    |                                            |                                      |        | 2002      |        | 2001     
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   |                                                                    |                                            | ASSETS                               |        |           |        |           |        |        |  | 
|Current Assets:                                  |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 | Cash and cash equivalents                                         |                                                                    | $                                          | 6,294                                |        |           | $      | 3,186     |       
|                                                 | Receivables  net                                                 |                                                                    |                                            | 11,197                               |        |           |        | 10,878    |       
|                                                 | Inventories                                                       |                                                                    |                                            | 1,816                                |        |           |        | 1,759     |       
|                                                 | Prepaid expenses and other                                        |                                                                    |                                            | 1,371                                |        |           |        | 1,670     |       
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   | Total Current Assets                                               |                                            |                                      | 20,678 |           |        |           | 17,493 |       
|Property, Plant and Equipment, At Cost           |                                                                   |                                                                    | 28,016                                     |                                      |        |           | 26,917 |          
|                                                 | Less accumulated depreciation and amortization                    |                                                                    |                                            | 1,355                                |        |           |        | 202       |       
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   | Property, Plant and Equipment  Net                                |                                            |                                      | 26,661 |           |        |           | 26,715 |       
|Net Noncurrent Assets of Discontinued Operations |                                                                   |                                                                    |                                           |                                      |        |           | 3,263  |          
|Other Assets                                     |                                                                   |                                                                    | 453                                        |                                      |        |           | 240    |          
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   |                                                                    | Total Assets                               |                                      | $      | 47,792    |        |           | $      | 47,711 | 
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   |                                                                    |                                            | LIABILITIES AND SHAREHOLDERS EQUITY |        |           |        |           |        |        |  | 
|Current Liabilities:                             |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 | Accounts payable                                                  |                                                                    | $                                          | 3,383                                |        |           | $      | 3,947     |       
|                                                 | Third-party payor settlements                                     |                                                                    |                                            | 5,534                                |        |           |        | 6,041     |       
|                                                 | Short-term debt                                                   |                                                                    |                                            | 899                                  |        |           |        | 4,000     |       
|                                                 | Accrued expenses                                                  |                                                                    |                                            | 6,031                                |        |           |        | 5,584     |       
|                                                 | Income taxes payable                                              |                                                                    |                                            | 56                                   |        |           |        | 56        |       
|                                                 | Net current liabilities of discontinued operations                |                                                                    |                                            | 43                                   |        |           |        | 1,109     |       
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   | Total Current Liabilities                                          |                                            |                                      | 15,946 |           |        |           | 20,737 |       
|Long-Term Liabilities:                           |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 | Long-term debt                                                    |                                                                    |                                            | 22,961                               |        |           |        | 15,913    |       
|                                                 | Noncurrent liability for general and professional liability risks |                                                                    |                                            | 1,182                                |        |           |        | 531       |       
|                                                 | Noncurrent liabilities of discontinued operations                 |                                                                    |                                            | 1,714                                |        |           |        | 899       |       
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   | Total Long-term Liabilities                                        |                                            |                                      | 25,857 |           |        |           | 17,343 |       
|Shareholders Equity:                            |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 | Common shares, no par value:                                      |                                                                    |                                            |                                      |        |           |        |           |       
|                                                 |                                                                   | Issued and outstanding, 4,976 at March 31, 2002
and March 31, 2001 |                                            |                                      | 2,488  |           |        |           | 2,488  |       
|                                                 | Additional paid-in capital                                        |                                                                    |                                            | 3,604                                |        |           |        | 3,604     |       
|                                                 | Retained earnings                                                 |                                                                    |                                            | 111                                  |        |           |        | 3,650     |       
|                                                 | Accumulated other comprehensive loss                              |                                                                    |                                            | (214                                 | )      |           |        | (111      | )     
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   | Total Shareholders Equity                                         |                                            |                                      | 5,989  |           |        |           | 9,631  |       
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          
|                                                 |                                                                   |                                                                    | Total Liabilities and Shareholders Equity |                                      | $      | 47,792    |        |           | $      | 47,711 | 
|                                                 |                                                                   |                                                                    |                                            |                                      |        |           |        |          

See notes to condensed consolidated financial statements

2



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##### 



SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(in thousands, except per share amounts)
(unaudited)

|                                                               |                                                                                                                                             |              |        |                    |       |      |        |       |       |  
|-------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------- | ------------ | ------ | ------------------ | ----- | ---- | ------ | ----- | ----- | -
|                                                               |                                                                                                                                             |              |        | THREE MONTHS ENDED
|                                                               |                                                                                                                                             |              |        | March 31,         
|                                                               |                                                                                                                                             |              |        |                   
|                                                               |                                                                                                                                             |              |        | 2002               |       | 2001
|                                                               |                                                                                                                                             |              |        |                    |       |     
|Net Revenues                                                   |                                                                                                                                             | $            | 22,232 |                    |       | $    | 13,639 |      
|Operating Expenses:                                            |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               | Salaries, wages and benefits                                                                                                                |              |        | 10,077             |       |      |        | 6,473 |      
|                                                               | Provision for bad debts                                                                                                                     |              |        | 2,401              |       |      |        | 1,637 |      
|                                                               | Supplies                                                                                                                                    |              |        | 2,559              |       |      |        | 1,584 |      
|                                                               | Purchased services                                                                                                                          |              |        | 1,950              |       |      |        | 1,191 |      
|                                                               | Other operating expenses                                                                                                                    |              |        | 3,354              |       |      |        | 2,033 |      
|                                                               | Rents and leases                                                                                                                            |              |        | 542                |       |      |        | 325   |      
|                                                               | Depreciation and amortization                                                                                                               |              |        | 277                |       |      |        | 186   |      
|                                                               | Gain on sales of property and equipment                                                                                                     |              |        | (10                | )     |      |        |      |      
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|Operating Profit                                               |                                                                                                                                             |              | 1,082  |                    |       |      | 210    |      
|Other Income (Expense):                                        |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               | Interest expense                                                                                                                            |              |        | (750               | )     |      |        | (447  | )    
|                                                               | Interest income                                                                                                                             |              |        | 18                 |       |      |        | 87    |      
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|Earnings (Loss) From Continuing Operations Before Income Taxes |                                                                                                                                             |              | 350    |                    |       |      | (150   | )    
|Income Tax Expense                                             |                                                                                                                                             |              |        |                    |       |      | 275    |      
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|Earnings (Loss) From Continuing Operations                     |                                                                                                                                             |              | 350    |                    |       |      | (425   | )    
|Discontinued Operations:                                       |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               | Loss from operations of Housewares Segment
(net of tax benefit of $0 and $225, respectively)                                                |              |        |                    |       |      |        | (111  | )    
|                                                               | Gain on disposal of Child Safety Segment                                                                                                    |              |        |                    |       |      |        | 2,457 |      
|                                                               | Earnings (Loss) from operations of Life Sciences
and Engineering and Child Safety Segments
(net of tax benefit of $0 and $31, respectively) |              |        | (8                 | )     |      |        | (191  | )    
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|Earnings (Loss) from Discontinued Operations                   |                                                                                                                                             |              | (8     | )                  |       |      | 2,155  |      
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               |                                                                                                                                             | Net Earnings |        | $                  | 342   |      |        | $     | 1,730 |  
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|Earnings (Loss) Per Share:                                     |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               | Continuing Operations:                                                                                                                      |              |        |                    |       |      |        |       |      
|                                                               |                                                                                                                                             | Basic        |        | $                  | 0.07  |      |        | $     | (0.09 | )
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               |                                                                                                                                             | Diluted      |        | $                  | 0.06  |      |        | $     | (0.09 | )
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               | Net Earnings:                                                                                                                               |              |        |                    |       |      |        |       |      
|                                                               |                                                                                                                                             | Basic        |        | $                  | 0.07  |      |        | $     | 0.35  |  
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               |                                                                                                                                             | Diluted      |        | $                  | 0.06  |      |        | $     | 0.35  |  
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|Weighted-Average Common Shares Outstanding:                    |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               |                                                                                                                                             | Basic        |        |                    | 4,976 |      |        |       | 4,976 |  
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      
|                                                               |                                                                                                                                             | Diluted      |        |                    | 5,476 |      |        |       | 4,976 |  
|                                                               |                                                                                                                                             |              |        |                    |       |      |        |      

See notes to condensed consolidated financial statements

3



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##### 



SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(in thousands, except per share amounts)
(unaudited)

|                                                    |                                                                                                                                             |         |        |                   |       |      |        |       |       |  
|--------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------- | ------- | ------ | ----------------- | ----- | ---- | ------ | ----- | ----- | -
|                                                    |                                                                                                                                             |         |        | NINE MONTHS ENDED
|                                                    |                                                                                                                                             |         |        | March 31,        
|                                                    |                                                                                                                                             |         |        |                  
|                                                    |                                                                                                                                             |         |        | 2002              |       | 2001
|                                                    |                                                                                                                                             |         |        |                   |       |     
|Net Revenues                                        |                                                                                                                                             | $       | 65,371 |                   |       | $    | 13,639 |      
|Operating Expenses:                                 |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    | Salaries, wages and benefits                                                                                                                |         |        | 31,459            |       |      |        | 6,810 |      
|                                                    | Provision for bad debts                                                                                                                     |         |        | 7,792             |       |      |        | 1,637 |      
|                                                    | Supplies                                                                                                                                    |         |        | 7,316             |       |      |        | 1,584 |      
|                                                    | Purchased services                                                                                                                          |         |        | 5,596             |       |      |        | 1,191 |      
|                                                    | Other operating expenses                                                                                                                    |         |        | 9,183             |       |      |        | 2,244 |      
|                                                    | Rents and leases                                                                                                                            |         |        | 1,598             |       |      |        | 340   |      
|                                                    | Depreciation and amortization                                                                                                               |         |        | 894               |       |      |        | 189   |      
|                                                    | Gain on sales of property and equipment                                                                                                     |         |        | (339              | )     |      |        |      |      
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Operating Profit (Loss)                             |                                                                                                                                             |         | 1,872  |                   |       |      | (356   | )    
|Other Income (Expense):                             |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    | Interest expense                                                                                                                            |         |        | (2,125            | )     |      |        | (447  | )    
|                                                    | Interest income                                                                                                                             |         |        | 37                |       |      |        | 354   |      
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Loss From Continuing Operations Before Income Taxes |                                                                                                                                             |         | (216   | )                 |       |      | (449   | )    
|Income Tax Expense                                  |                                                                                                                                             |         |       |                   |       |      | 213    |      
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Loss From Continuing Operations                     |                                                                                                                                             |         | (216   | )                 |       |      | (662   | )    
|Discontinued Operations:                            |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    | Loss from operations of Housewares Segment
(net of tax benefit of $0 and $225, respectively)                                                |         |        |                   |       |      |        | (541  | )    
|                                                    | Loss on disposal of Housewares Segment                                                                                                      |         |        | (2,756            | )     |      |        |       |      
|                                                    | Gain on disposal of Child Safety Segment                                                                                                    |         |        |                   |       |      |        | 2,457 |      
|                                                    | Earnings (Loss) from operations of Life Sciences
and Engineering and Child Safety Segments
(net of tax expense of $0 and $62, respectively) |         |        | 823               |       |      |        | (558  | )    
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Earnings (Loss) from Discontinued Operations        |                                                                                                                                             |         | (1,933 | )                 |       |      | 1,358  |      
|Earnings (Loss) before Extraordinary Item           |                                                                                                                                             |         | (2,149 | )                 |       |      | 696    |      
|Extraordinary Item:                                 |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    | Gain on creditor voluntary reorganization of Housewares
Segment                                                                             |         |        | 2,926             |       |      |        |       |      
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Net Earnings                                        |                                                                                                                                             | $       | 777    |                   |       | $    | 696    |      
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Earnings (Loss) Per Share:                          |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    | Continuing Operations:                                                                                                                      |         |        |                   |       |      |        |       |      
|                                                    |                                                                                                                                             | Basic   |        | $                 | (0.04 | )    |        | $     | (0.13 | )
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    |                                                                                                                                             | Diluted |        |                   | (0.04 | )    |        | $     | (0.13 | )
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    | Net Earnings:                                                                                                                               |         |        |                   |       |      |        |       |      
|                                                    |                                                                                                                                             | Basic   |        | $                 | 0.16  |      |        | $     | 0.14  |  
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    |                                                                                                                                             | Diluted |        |                   | 0.16  |      |        | $     | 0.14  |  
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|Weighted-Average Common Shares Outstanding:         |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    |                                                                                                                                             | Basic   |        |                   | 4,976 |      |        |       | 4,976 |  
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      
|                                                    |                                                                                                                                             | Diluted |        |                   | 4,976 |      |        |       | 4,976 |  
|                                                    |                                                                                                                                             |         |        |                   |       |      |        |      

See notes to condensed consolidated financial statements

4



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SUNLINK HEALTH SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

|                                                     |                                                               |          |                                           |        |                   |       |        |         |    |        |  
|---------------------------------------------------- | ------------------------------------------------------------- | -------- | ----------------------------------------- | ------ | ----------------- | ----- | ------ | ------- | -- | ------ | -
|                                                     |                                                               |          |                                           |        | NINE MONTHS ENDED
|                                                     |                                                               |          |                                           |        | March 31,        
|                                                     |                                                               |          |                                           |        |                  
|                                                     |                                                               |          |                                           |        | 2002              |       | 2001  
|                                                     |                                                               |          |                                           |        |                   |       |       
|Net Cash Provided by (Used in) Operating Activities  |                                                               | $        | 1,532                                     |        |                   | $     | (4,698 | )      
|Cash Flows From Investing Activities:                |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Proceeds from sale of property and equipment                  |          |                                           | 1,873  |                   |       |        |         |   
|                                                     | Proceeds from sale of LTS Holdings, Inc. preferred stock      |          |                                           | 850    |                   |       |        |         |   
|                                                     | Cash paid in SunLink acquisition                              |          |                                           |        |                   |       |        | (4,759  | ) 
|                                                     | Cash acquired in SunLink acquisition                          |          |                                           |        |                   |       |        | 232     |   
|                                                     | Proceeds from sale of Klippan                                 |          |                                           |        |                   |       |        | 2,487   |   
|                                                     | Expenditures for property, plant and equipment                |          |                                           | (3,255 | )                 |       |        | (753    | ) 
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|                                                     |                                                               |          | Net Cash Used in Investing Activities     |        |                   | (532  | )      |         |    | (2,793 | )
|Cash Flows From Financing Activities:                |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Proceeds from term loan                                       |          |                                           | 6,000  |                   |       |        |         |   
|                                                     | Payment of term loan                                          |          |                                           | (209   | )                 |       |        |         |   
|                                                     | Proceeds from short-term debt                                 |          |                                           |        |                   |       |        | 4,000   |   
|                                                     | Payment of short-term debt                                    |          |                                           | (4,000 | )                 |       |        |         |   
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|                                                     |                                                               |          | Net Cash Provided by Financing Activities |        |                   | 1,791 |        |         |    | 4,000  |  
|                                                     | Effect of Exchange Rate Changes on Cash                       |          |                                           | 4      |                   |       |        | (57     | ) 
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|Net Increase (Decrease) in Cash and Cash Equivalents |                                                               |          | 2,795                                     |        |                   |       | (3,548 | )      
|Cash and Cash Equivalents at Beginning of Period     |                                                               |          | 3,499                                     |        |                   |       | 6,734  |        
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|Cash and Cash Equivalents at End of Period           |                                                               | $        | 6,294                                     |        |                   | $     | 3,186  |        
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|Supplemental Disclosure of Cash Flow Information:    |                                                               |          |                                           |        |                   |       |        |        
|Cash Paid For:                                       |                                                               |          |                                           |        |                   |       |        |        
|                                                     |                                                               | Interest |                                           | $      | 466               |       |        | $       | 46 |       
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|Noncash Investing and Financing Activities:          |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Long-term debt issued as payment-in-kind for interest payable |          | $                                         | 743    |                   |       |        |         |   
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Capital leases                                                |          | $                                         | 105    |                   |       |        |         |   
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|Effect of acquisition by community hospital segment: |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Fair value of assets acquired                                 |          |                                           |        |                   |       | $      | 39,356  |   
|                                                     | Liabilities assumed and expenses paid                         |          |                                           |        |                   |       |        | (15,000 | ) 
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|                                                     |                                                               |          |                                           |        |                   |       | 24,356 |        
|                                                     | Less debt financing                                           |          |                                           |        |                   |       |        | (19,597 | ) 
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Cash paid                                                     |          |                                           |        |                   |       |        | 4,759   |   
|                                                     | Less cash acquired                                            |          |                                           |        |                   |       |        | (232    | ) 
|                                                     |                                                               |          |                                           |        |                   |       |        |        
|                                                     | Net cash paid for acquisition                                 |          |                                           |        |                   |       | $      | 4,527   |   
|                                                     |                                                               |          |                                           |        |                   |       |        |        

See notes to condensed consolidated financial statements.

5



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##### 



SUNLINK HEALTH SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED MARCH 31, 2002
(dollars in thousands)

Note 1.  Basis of Presentation

The unaudited Condensed Consolidated Financial Statements as of and for
the three and nine months ended March 31, 2002 have been prepared in accordance
with Rule 10-01 of Regulation S-X of the Securities and Exchange Commission
and, as such, do not include all information required by accounting principles
generally accepted in the United States of America. These Condensed
Consolidated Financial Statements should be read in conjunction with the
consolidated financial statements included in the SunLink Health Systems, Inc.
(the Corporation) (formerly known as KRUG International Corp.) Annual Report
on Form 10-K for the fiscal year ended March 31, 2001 filed on June 29, 2001.
In the opinion of management, the Condensed Consolidated Financial Statements,
which are unaudited, include all adjustments, consisting only of normal
recurring adjustments, necessary to present fairly the financial position and
results of operations for the periods indicated. The results of operations for
the three and nine months ended March 31, 2002 are not necessarily indicative
of the results that may be expected for the entire fiscal year or any other
interim period.

Note 2.  Business Operations and Corporate Strategy

The Corporation redirected its business strategy toward the operation of
community hospitals in the United States in fiscal 2001. SunLink Health
Systems, Inc. currently operates six community hospitals and related businesses
which it acquired for approximately $26,500 on February 1, 2001 (the SunLink
Acquisition). The community hospitals are operated through its wholly-owned
subsidiary, SunLink Healthcare Corp. (SunLink). On October 5, 2001, the
Corporation sold all the capital stock of its wholly-owned United Kingdom
(U.K.) housewares subsidiary, Beldray Limited (Beldray), and no longer has
any operating businesses outside the United States. See Note 3   Discontinued
Operations. The Corporation changed its name to SunLink Health Systems, Inc.
and changed its fiscal year end from March 31 to June 30 in August 2001.

Note 3.  Discontinued Operations and Extraordinary Gain

Housewares Segment  Beldray, the Corporations U.K. housewares
subsidiary, was sold on October 5, 2001 for nominal consideration. The sale was
effected in connection with a U.K. court supervised arrangement under which
Beldray refinanced its secured debt, certain unsecured creditors agreed to
forgiveness of 75% of Beldrays current liabilities totaling $2,926, and the
Corporations U.K. subsidiaries were released as guarantors of the secured
debt. This forgiveness of liabilities resulted in a non-cash extraordinary
gain for the nine months ended March 31, 2002 of $2,926. During the nine months
ended March 31, 2002, a loss from discontinued operations of $2,756 related to
the disposal of the housewares segment was reported.

Net current liabilities of discontinued operations of $43 at March 31,
2002 represent remaining estimated costs and expenses relating to the disposal
of the housewares segment. Net Noncurrent Liabilities of Discontinued
Operations at March 31, 2002 include $964 relating to the housewares segment
which represents a reserve for a portion of a guarantee by one of the
Corporations U.K. subsidiaries of Beldrays obligations under a lease covering
a portion of Beldrays manufacturing location. One of the Corporations U.K.
subsidiaries has an option to repurchase the capital stock of Beldray for
nominal consideration if any subsidiary is called upon

6



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##### 



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

to perform under the lease guarantee, or under certain other conditions.
Revenues of Beldray were $6,098 and $21,103 for the nine months ended March 31,
2002 and 2001, respectively, and $7,096 for the three months ended March 31,
2001.

Life Sciences and Engineering Segment  On November 5, 2001, the
Corporation sold its senior preferred stock of LTS Holdings Inc., the parent
company of Wyle Laboratories, Inc. (Wyle), to LTS Holdings Inc. for $850
cash. The Corporation acquired the preferred stock in November 1999 in
connection with the sale of its interest in Wyle to LTS Holdings Inc. The
preferred stock had been recorded by the Corporation at a value of zero due to
the highly leveraged nature of LTS Holdings Inc. Earnings from discontinued
operations of this segment of $823 in the nine months ending March 31, 2002
include the gain on the sale of the shares of $846 and pension expense of $23.

Child Safety Segment  On January 29, 2001, the Corporation sold its
European child safety subsidiary, Klippan Limited (Klippan). A gain of $2,457
was reported on the sale. The results of Klippan for the three and nine months
ended March 31, 2001 are therefore reported in discontinued operations. Revenue
of Klippan was $1,238 and $7,190 for the three and nine months ended March 31,
2001, respectively.

Industrial Segment  In fiscal 1989, the Corporation discontinued the
operations of its industrial segment and subsequently disposed of substantially
all related net assets. However, obligations may remain relating to product
liability claims for products sold prior to the disposal. Net Noncurrent
Liabilities of Discontinued Operations at March 31, 2002 and 2001 were $750 and
$899, respectively relating to the industrial segment.

The Corporation has over the past twelve years discontinued operations
carried on by its former industrial, U.K. leisure marine, life sciences and
engineering and U.K. child safety segments, as well as the U.K. housewares
segment. Reserves relating to discontinued operations of these segments
represent managements best estimate of the Corporations possible liability
for property, product liability and other claims for which it may incur
liability. These estimates are based on managements judgments using currently
available information as well as, in certain instances, consultation with its
insurance carriers and legal counsel. The Corporation historically has
purchased insurance policies to reduce certain of its product liability
exposure and anticipates it will continue to purchase such insurance if
available at commercially reasonable rates. While the Corporation has based its
estimates on its evaluation of available information, it is not possible to
predict with certainty the ultimate outcome of many contingencies relating to
discontinued operations. The Corporation intends to adjust its estimates of the
reserves as additional information is developed and evaluated. However,
management believes that the final resolution of these contingencies will not
have a material adverse impact on the financial position, cash flows, or
results of operations of the Corporation.

Note 4.  Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 141 (SFAS 141), Business
Combinations. SFAS 141 requires the purchase method of accounting for
business combinations initiated after June 30, 2001 and eliminates the
pooling-of-interests method. The Corporation does not believe the adoption of
SFAS 141 will have a material impact on its consolidated financial statements.
In July 2001, the FASB issued Statement of Financial Accounting Standards No.
142 (SFAS 142), Goodwill and Other Intangible Assets, which the Corporation
intends to adopt July 1, 2002.

7



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##### 



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

SFAS 142 requires, among other things, the discontinuance of goodwill
amortization. In addition, the standard includes provisions for the
reclassification of certain existing recognized intangibles, reassessment of
the useful lives of existing recognized intangibles, reclassifications of
certain intangibles out of previously reported goodwill and the identification
of reporting units for purposes of assessing potential future impairment of
goodwill. SFAS 142 also requires the Corporation to complete a transitional
goodwill impairment test six months from the date of adoption. The Corporation
does not believe the adoption of SFAS 142 will have a material impact on its
consolidated financial statements because it recorded no goodwill or other
intangibles in connection with the SunLink Acquisition. In October 2001, the
FASB issued Statement of Financial Accounting Standards No. 144 (SFAS 144),
Accounting for the Impairment or Disposal of Long-Lived Assets. This
Statement establishes a single accounting model for the impairment or disposal
of long-lived assets. As required by SFAS 144, the Corporation will adopt this
new accounting standard on July 1, 2002. The Corporation has not yet evaluated
what the impact of the adoption of SFAS 144 will have on its consolidated
financial statements.

Note 5. Gain on Sales of Property and Equipment

On December 21, 2001, the Corporation sold its 60-bed nursing home in
Jasper, Georgia for $1,550 cash. A gain of $310 on the sale is reported as a
reduction of operating expenses in gain on sales of property and equipment for
the nine months ended March 31, 2001.

Note 6.  Short-Term Debt

In connection with the SunLink Acquisition, the Corporation entered into a
short-term bridge loan with three separate private equity funds in the original
amount of $4,000, which was due February 1, 2002. Prepayments of $1,000 each
were made on the bridge loan in August and December 2001, respectively, with
funds from the sale of excess land, funds generated internally from hospital
operations and from available cash. The proceeds of the Jasper nursing home
sale (see Note 5  Gains on Sale of Property and Equipment) of $1,550 and
existing funds were used to pay off the remaining $2,000 balance of the bridge
loan on December 21, 2001.

Note 7.  Long-Term Debt

|                                                                  |  |           |        |           |  |   |        | 
|----------------------------------------------------------------- |  | --------- | ------ | --------- |  | - | ------ | 
|                                                                  |  | March 31, |        | March 31,
|                                                                  |  | 2002      |        | 2001     
|                                                                  |  |           |        |          
|Senior subordinated note, net of
unamortized discount             |  | $         | 16,356 |           |  | $ | 14,476 | 
|Senior subordinated zero coupon note,
net of unamortized discount |  |           | 1,613  |           |  |   | 1,437  | 
|Term loan                                                         |  |           | 5,791  |           |  |   |        | 
|Capital leases                                                    |  |           | 100    |           |  |   |       | 
|                                                                  |  |           |        |           |  |   |        | 
|                                                                  |  |           | 23,860 |           |  |   | 15,913 | 
|Less contractual current maturities                               |  |           | (899   | )         |  |   |       | 
|                                                                  |  |           |        |           |  |   |        | 
|                                                                  |  | $         | 22,961 |           |  | $ | 15,913 | 
|                                                                  |  |           |        |           |  |   |        | 

In connection with the SunLink Acquisition, SunLink issued an 8.5% senior
subordinated note in the face amount of $17,000 and a senior subordinated zero
coupon note in the face amount of $2,000, both to the seller. The senior
subordinated note is due on January 31, 2006 with interest payable
semi-annually either in cash or additional promissory notes through February 1,
2003

8



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

and in cash thereafter. Additional promissory notes of $1,225 for interest
from February 1, 2001 through November 30, 2001 have been issued and the
accrued interest payable at March 31, 2002 of $516 is included in the senior
subordinated note. Accrued interest of $237 as of March 31, 2001 was included
in the senior subordinated note at that date. The stated interest rate of 8.5%
on the senior subordinated note was considered a below-market interest rate at
the date of issuance; therefore, the note was discounted to estimated market
value at an effective interest rate of 12.3%. The original discount recorded
on the senior subordinated note was $2,809. The unamortized debt discount on
the senior subordinated note was $2,385 and $2,761 at March 31, 2002 and 2001,
respectively.

The purchase agreement for the six hospitals includes a potential
adjustment to the senior subordinated note to the extent working capital at the
purchase date is determined to be greater or lesser than an agreed-upon amount.
The Corporation has submitted to the seller a proposed working capital
adjustment which would reduce the balloon note by $1,200. The seller has
objected to the adjustment and the Corporation and seller currently are seeking
to conclude the working capital settlement under the dispute provisions of the
sale agreement. No adjustment for any working capital settlement has been made
to the balloon note at March 31, 2002.

The senior subordinated zero coupon note is due January 31, 2004. The
interest rate on the senior subordinated zero coupon note was considered less
than the market rate at the date of issuance; therefore, the note was
discounted to an estimated market interest rate of 11.3%. The original issue
discount on the senior subordinated zero coupon note was $594. The unamortized
debt discount on the senior subordinated zero coupon note was $387 and $563 at
March 31, 2002 and 2001, respectively.

The discounts on the long-term debt were determined by the Corporation in
consultation with its financial advisor based on high-yield debt instruments of
similar health care providers and are being amortized over the term of the
specific debt instrument using the effective interest method. For the three
and nine months ended March 31, 2002, the Corporation recognized amortization
expense on the discounts of $144 and $427, respectively. For the three and nine
months ended March 31, 2001, the Corporation recognized amortization expense on
the discounts of $77.

The loan agreement pursuant to which the senior subordinated note and the
senior subordinated zero coupon note were issued requires that SunLink grant to
the lender a security interest in and mortgage on collateral consisting of all
SunLinks and its subsidiaries real and personal property, unless SunLink has
outstanding senior indebtedness that meets certain conditions. The senior
subordinated note and the senior subordinated zero coupon note are not
presently collateralized. Each of the individual hospital subsidiaries of
SunLink is a guarantor of these notes. Further, these notes are subordinate in
payment and collateral to all defined senior indebtedness of SunLink which in
the aggregate does not exceed $15,000, other than debt incurred in connection
with certain future acquisitions.

On January 4, 2002, the Corporation closed a $14,000 credit facility
comprised of a 36-month secured revolving line of credit for up to $8,000 with
interest at prime plus 1.25% and a $6,000 secured term loan repayable over 66
months at an interest rate of 9.78%. The availability of borrowings under the
revolving line of credit is based upon, among other things, a borrowing base
keyed to the level of SunLinks receivables. No amount was outstanding on the
revolving credit facility at March 31, 2002. The Corporation does not expect to
draw on the revolving line of credit until later in its fiscal year ending June
30, 2002. The net proceeds from the term loan of $5,800 are being used for
working capital and to fund a portion of the Corporations hospital capital
projects which include a new replacement hospital in Jasper, Georgia and a new

9



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##### 



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

emergency room at its hospital in Ellijay, Georgia. The term loan is secured by
liens on the real and personal property, except for patient accounts
receivables, as well as the capital stock owned by SunLink or its subsidiaries.
Also, each of the hospital subsidiaries is a guarantor of the loan. The
revolving credit facility is secured by the patient accounts receivable of
SunLink.

Note 9.  Comprehensive Earnings (Loss)

Comprehensive earnings (loss) for the Corporation includes foreign
currency translation and minimum pension liability adjustments. Total
comprehensive loss for the following periods was as follows:

|                       |                    |                          |                  |                         |  |                    |       |           |  |  |     |  
|---------------------- | ------------------ | ------------------------ | ---------------- | ----------------------- |  | ------------------ | ----- | --------- |  |  | --- | -
|                       |                    |                          |                  |                         |  | Three Months Ended
|                       |                    |                          |                  |                         |  |                   
|                       |                    |                          |                  |                         |  | March 31,          |       | March 31,
|                       |                    |                          |                  |                         |  | 2002               |       | 2001     
|                       |                    |                          |                  |                         |  |                    |       |          
|Net earnings:          |                    | $                        | 342              |                         |  | $                  | 1,730 |          
|Other comprehensive    |                    |                          |                  |                         |  |                    |       |          
|                       | Income net of tax: |                          |                  |                         |  |                    |       |           | 
|                       |                    | Change in equity due to: |                  |                         |  |                    |       |           |  | 
|                       |                    |                          | Foreign currency |                         |  |                    |       |           |  |  |    
|                       |                    |                          |                  | Translation adjustments |  |                    | 55    |           |  |  | (87 | )
|                       |                    |                          | Minimum pension  |                         |  |                    |       |           |  |  |    
|                       |                    |                          |                  | liability adjustment    |  |                    |      |           |  |  | (53 | )
|                       |                    |                          |                  |                         |  |                    |       |          
|Comprehensive earnings |                    | $                        | 397              |                         |  | $                  | 1,590 |          
|                       |                    |                          |                  |                         |  |                    |       |          

|                              |                    |                          |                  |                         |  |                   |     |           |  |  |     |  
|----------------------------- | ------------------ | ------------------------ | ---------------- | ----------------------- |  | ----------------- | --- | --------- |  |  | --- | -
|                              |                    |                          |                  |                         |  | Nine Months Ended
|                              |                    |                          |                  |                         |  |                  
|                              |                    |                          |                  |                         |  | March 31,         |     | March 31,
|                              |                    |                          |                  |                         |  | 2002              |     | 2001     
|                              |                    |                          |                  |                         |  |                   |     |          
|Net earnings:                 |                    | $                        | 777              |                         |  | $                 | 696 |          
|Other comprehensive           |                    |                          |                  |                         |  |                   |     |          
|                              | Income net of tax: |                          |                  |                         |  |                   |     |           | 
|                              |                    | Change in equity due to: |                  |                         |  |                   |     |           |  | 
|                              |                    |                          | Foreign currency |                         |  |                   |     |           |  |  |    
|                              |                    |                          |                  | Translation adjustments |  |                   | (95 | )         |  |  | (94 | )
|                              |                    |                          | Minimum pension  |                         |  |                   |     |           |  |  |    
|                              |                    |                          |                  | liability adjustment    |  |                   |    |           |  |  | (60 | )
|                              |                    |                          |                  |                         |  |                   |     |          
|Comprehensive earnings (loss) |                    | $                        | 682              |                         |  | $                 | 542 |          
|                              |                    |                          |                  |                         |  |                   |     |          

Note 10. Contingencies

As a part of a nationwide Medicare audit project regarding hospital
(inpatient) billing practices with respect to the diagnosis of pneumonia, the
federal government (the Government) has reviewed certain medical records of
two of SunLinks hospitals, Chestatee Regional Hospital (Chestatee) and
Mountainside Medical Center (Mountainside) (collectively, the Hospitals)
prior to their purchase by SunLink. The review sought to determine whether
claims were improperly coded for Medicare purposes and whether the Hospitals
submission of those claims violated applicable law, including the False Claims
Act 31 U.S.C. §§ 3729. Based upon its review, the Government has projected
that 103 Medicare claims by Chestatee, and 91 Medicare

10



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

claims by Mountainside were coded improperly. Review and analysis of all
medical records identified by the Government has been substantially completed
and interviews have been conducted by both the U.S. Attorneys Office, Northern
District, Georgia, and the U.S. Department of Health and Human Services, Office
of the Inspector General. Based upon the Governments projections and the
application of the multiple damage provision of the False Claims Act, the
Corporation estimates that, if the Governments projections were
substantiated, the total potential aggregate liability to the Hospitals in this
matter could be as great as $1,500, inclusive of double damages.

The Corporation disputes and intends to vigorously resist all Government
claims of any such improper coding and believes the Governments projections do
not accurately represent the facts. Settlement discussions are underway
between SunLink and the Government. Government representatives informally have
indicated that the Government most likely would not pursue a false claims
charge, require either of the Hospitals to enter into a corporate integrity
agreement, or seek double or triple damages providing a settlement is reached
between the parties. No audit has been conducted by the Government of any
other SunLink hospital in connection with the pneumonia coding investigations.
At March 31, 2002, the Corporation has accrued a liability associated with this
investigation. Management believes the liability is a reasonable estimate of
the future settlement of this investigation based upon recent discussions
between the Corporations legal counsel and the Government. Settlement of these
claims are expected to finalized prior to June 30, 2002, the end of the
Corporations current fiscal year.

As discussed in Note 3  Discontinued Operations and Extraordinary Gain
 , one of the Corporations U.K. subsidiaries remains contingently liable as
guarantor of Beldrays obligations under a lease covering a portion of
Beldrays manufacturing location.

Reserves relating to discontinued operations represent managements best
estimates of the Corporations possible liability for the contingent
liabilities of discontinued operations. While the Corporation has based its
estimates on its evaluation of available information, it is not possible to
predict with certainty the ultimate outcome of many contingencies relating to
discontinued operations. The Corporation intends to adjust its estimates of the
reserves as additional information is developed and evaluated. However,
management believes that the final resolution of these contingencies will not
have a material adverse impact on the financial position, cash flows, or
results of operations of the Corporation.

The Corporation is also subject to various claims and suits arising in the
ordinary course of business, including claims for personal injuries and other
matters. Such pending claims and suits are either insured or, in the opinion
of management, the ultimate resolution of such claims and suits should not have
a material adverse effect on the Corporations results of operations or
financial condition.

11



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|        |                                                             
|------- | ------------------------------------------------------------
|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL           
|        | CONDITION AND RESULTS OF OPERATIONS                         
|        | (dollars in thousands, except per share and admissions data)

Certain Cautionary Statements

In addition to historical information, Items 1 and 2 of this report
contain certain forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995 including, without limitation,
statements regarding the Corporations business strategy, managements outlook
for each of its businesses, and the sufficiency of the Corporations liquidity
and sources of capital. These forward-looking statements are subject to certain
risks, uncertainties and other factors which could cause actual results,
performance and achievements to differ materially from those anticipated,
including, without limitation:



| |  | general economic and business conditions in the U.S. both nationwide and in the states in which the Corporation operates
hospital facilities;                                                                                                        
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | the availability of and the Corporations ability to attract and retain sufficient qualified staff physicians, management
and staff personnel for the Corporations hospital operations;                                                             
| 
| |  | claims under lease and other guarantees relating to discontinued operations and/or former subsidiaries;                                                                                                                                              
| 
| |  | claims for product and environmental liabilities from continuing and discontinued operations;                                                                                                                                                        
| 
| |  | restrictions imposed by debt agreements;                                                                                                                                                                                                             
| 
| |  | the competitive nature of the U.S. community hospital business;                                                                                                                                                                                      
| 
| |  | demographic changes in areas where the Corporation operates hospital facilities;                                                                                                                                                                     
| 
| |  | managements ability to integrate acquired hospitals and implement its business strategy;                                                                                                                                                            
| 
| |  | existing and proposed governmental budgetary constraints:                                                                                                                                                                                            
| 
| |  | the regulatory environment for the Corporations businesses, including state CON laws and regulations, rules and judicial
cases relating there;                                                                                                      
| 
| |  | competition in the market for acquisition of hospitals and healthcare facilities;                                                                                                                                                                    
| 
| |  | the availability of capital to fund working capital, renovations and capital improvements at existing hospital facilities
and for acquisitions and replacement hospital facilities;                                                                  
| 
| |  | possible changes in the levels and terms of government (including Medicare, Medicaid and other programs) and private
reimbursement for the Corporations healthcare services including the payment arrangements and terms of managed care
agreements;
| 
| |  | changes in or failure to comply with Federal, state or local laws and regulations affecting the healthcare industry;                                                                                                                                 
| 
| |  | professional, general, and other claims which may be asserted against the Corporation;                                                                                                                                                               
| 
| |  | the cost and availability of insurance coverage including professional liability (e.g., medical malpractice) and general
liability insurance;                                                                                                        
| 
| |  | the efforts of insurers, healthcare providers and others to contain healthcare costs;                                                                                                                                                                
| 
| |  | the impact on hospital services of the treatment of patients in lower acuity healthcare settings, with drug therapy or via
alternative healthcare services;                                                                                          
| 
| |  | the possible enactment of Federal healthcare reform laws or reform laws in states where the Corporation operates hospital
facilities (including state Medicaid waivers and other reforms);                                                           
| 
| |  | changes in medical and other technology;                                                                                                                                                                                                             
| 
| |  | increases in prices of materials and services utilized in the Corporations hospital operations;                                                                                                                                                     
| 
| |  | changes in exchange rates; and                                                                                                                                                                                                                       
| 
| |  | changes in accounting principles generally accepted in the U.S.                                                                                                                                                                                      

12



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Except as required by law, management undertakes no obligation to publicly
update these forward-looking statements, whether as a result of new
information, future events or otherwise. The foregoing are factors management
thinks could cause actual results to differ materially from expected results.
However, there could be other additional factors besides those listed herein
that also could affect the Corporation in an adverse manner.

Corporate Business Strategy

The Corporation redirected its business strategy in fiscal 2001 toward the
operation of community hospitals in the United States. SunLink Health Systems,
Inc. currently operates six community hospitals and related businesses which it
acquired for approximately $26,500 on February 1, 2001. The community hospitals
are operated by the Corporations wholly-owned subsidiary, SunLink Healthcare
Corp. On October 5, 2001, the Corporation sold all the capital stock of its
wholly-owned United Kingdom housewares subsidiary, Beldray and now no longer
owns any operating businesses outside the United States. In August 2001, the
Corporation changed its name to SunLink Health Systems, Inc. from KRUG
International Corp. and changed its fiscal year end from March 31 to June 30.

Critical Accounting Policies and Estimates

The unaudited Condensed Consolidated Financial Statements herein have been
prepared in accordance with Rule 10-01 of Regulation S-X of the Securities and
Exchange Commission and, as such, do not include all information required by
accounting principles generally accepted in the United States of America. These
Condensed Consolidated Financial Statements should be read in conjunction with
the consolidated financial statements included in the Corporations Annual
Report on Form 10-K for the fiscal year ended March 31, 2001, filed on June 29,
2001. In the opinion of management, the Condensed Consolidated Financial
Statements, which are unaudited, include all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial
position and results of operations for the periods indicated. The results of
operations are not necessarily indicative of the results that may be expected
for the entire fiscal year or any other interim period.

The preparation of these financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results may differ from these estimates
under different assumptions or conditions.

Critical accounting policies are defined as those that are reflective of
significant judgements and uncertainties and potentially result in materially
different results under different assumptions and conditions. Management
believes the following critical accounting policies affect its more significant
judgements and estimates used in the preparation of its Condensed Consolidated
Financial Statements.

Net Patient Service Revenue- The U.S. community hospital segment has
agreements with third-party payors that provide for payments at amounts
different from its established charges. Payment arrangements include
prospectively determined rates per discharge, reimbursed costs, discounted
charges and per diem payments. Net patient service revenue is reported as
services are rendered at the estimated net realizable amounts from patients,
third-party payors, and others for services rendered. Estimated reductions in
revenues to reflect agreements with third-party payors and estimated
retroactive adjustments under such reimbursement agreements are accrued during
the period the related services are rendered and are adjusted in future periods
as final settlements are determined. Significant changes in reimbursement
levels for services under

13



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government and private programs could significantly impact the estimates used
to accrue for revenue reductions.

Allowance for Doubtful Accounts Accounts receivable are reduced by an
allowance for amounts estimated to become uncollectable in the future.
Substantially all receivables are related to providing healthcare services to
hospital facility patients. The Corporations estimate of the allowance for
doubtful accounts is based generally upon its historical collection experience
for each type of payor. The allowance amount is computed by applying estimated
allowance percentages to amounts included in specific payor and aging
categories of patient accounts receivable. Significant changes in reimbursement
levels for services under government and private programs could significantly
impact the estimates used to estimate the allowance for doubtful accounts.

Risk Management- The Corporation is exposed to various risks of loss from
medical malpractice and other torts; theft of, damage to, and destruction of
assets; business interruption; errors and omissions; employee injuries and
illnesses; natural disasters; and employee health, dental, and accident
benefits. Commercial insurance coverage is purchased for a portion of claims
arising from such matters. The Corporation has accrued a liability for
estimated costs and losses under such claims, net of estimated insurance
recoveries, when claims are, in managements judgment, sufficiently
identified.

In connection with the SunLink Acquisition, the Corporation assumed
responsibility for general and professional liability claims reported after
February 1, 2001 (date of acquisition), and the previous owner retained
responsibility for all known and filed claims prior to the acquisition date.
The Corporation has purchased claims-made commercial insurance for coverage
prior to and after the acquisition date. The recorded liability for general and
professional liability risks includes an estimate of the liability for claims
incurred prior to February 1, 2001, but reported after February 1, 2001 and for
claims incurred after February 1, 2001. As a component of the related
liability for general and professional liability risks, the Corporation has
included the premiums related to the estimated cost of insurance for claims
incurred prior to the acquisition date.

The Corporations U.S. community hospital segment is self-insured for
workers compensation and employee health risks. The estimated liability for
workers compensation and employee health risks includes estimates of the
ultimate costs for both reported claims and claims incurred but not reported.
The Corporation accrues an estimate of losses resulting from workers
compensation, employee health and professional liability claims to the extent
they are not covered by insurance. These accruals are estimated quarterly
based upon historical loss patterns.

Income Taxes The Corporation accounts for income taxes in accordance with
Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for
Income Taxes.SFAS No. 109 requires an asset and liability approach and the
recognition of deferred tax assets and liabilities for expected future tax
consequences. SFAS No. 109 generally considers all expected future events
other than proposed enactments of changes in the tax law or rates. The
Corporation has provided a valuation allowance for all tax assets so that the
net tax asset is $0 as it is managements assessment that it is more likely
than not that none of the net deferred tax asset will be realized through
future taxable earnings or implementation of tax planning strategies.
Currently, the most significant tax asset is a U.S. net operating loss
carryforward of approximately $7,000.

14



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Financial Summary

|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|-------------------------------------------------------------- |  | ------------------ | ------ | ----------------- |  | ---- | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                               |  | THREE MONTHS ENDED |        | NINE MONTHS ENDED
|                                                               |  | March 31,          |        | March 31,        
|                                                               |  |                    |        |                  
|                                                               |  | 2002               |        | 2001              |  | 2002 |        | 2001
|                                                               |  |                    |        |                   |  |      |        |     
|NET REVENUES:                                                  |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|Community hospital segment                                     |  | $                  | 22,232 |                   |  | $    | 13,639 |      |  | $ | 65,371 |   |  | $ | 13,639 |  
|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|EARNINGS (LOSS) FROM                                           |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|CONTINUING OPERATIONS                                          |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|BEFORE INCOME TAXES:                                           |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|Community hospital segment                                     |  | $                  | 1,474  |                   |  | $    | 725    |      |  | $ | 3,140  |   |  | $ | 725    |  
|Corporate expenses (U.S. and U.K.)                             |  |                    | (392   | )                 |  |      | (515   | )    |  |   | (1,268 | ) |  |   | (1,081 | )
|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|                                                               |  |                    | 1,082  |                   |  |      | 210    |      |  |   | 1,872  |   |  |   | (356   | )
|Interest expense                                               |  |                    | (750   | )                 |  |      | (447   | )    |  |   | (2,125 | ) |  |   | (447   | )
|Interest income                                                |  |                    | 18     |                   |  |      | 87     |      |  |   | 37     |   |  |   | 354    |  
|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|Earnings (Loss) from Continuing
Operations Before Income Taxes |  | $                  | 350    |                   |  | $    | (150   | )    |  | $ | (216   | ) |  | $ | (449   | )
|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|Adjusted Admissions                                            |  |                    | 4,398  |                   |  |      | 2,733  |      |  |   | 12,392 |   |  |   | 2,733  |  
|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  
|Revenue per Adjusted Admissions                                |  | $                  | 5,055  |                   |  | $    | 4,990  |      |  | $ | 5,275  |   |  | $ | 4,990  |  
|                                                               |  |                    |        |                   |  |      |        |      |  |   |        |   |  |   |        |  

Results of Operations

All of the Corporations net revenues relate to the U.S. community
hospital segment which was acquired February 1, 2001. As such, net revenues
from continuing operations for the three and nine months ended March 31, 2001
represent only the two months subsequent to the acquisition date. The
operations of the Corporations two other business segments which were operated
during that period, U.K. housewares and child safety products, have been
reported in discontinued operations.

The Corporations U.S. community hospital segment reported aggregate net
revenues of $22,232, a total of 4,398 adjusted admissions and revenues per
adjusted admission of $5,055 for the quarter ended March 31, 2002. Community
hospital net revenues for the nine months ended March 31, 2002 were $65,371
with a total of 12,392 adjusted admissions and revenues per adjusted admission
of $5,275. Net revenues increased 3% in the March 31, 2002 quarter compared to
the December 31, 2001 quarter. Adjusted admissions increased approximately 11%
in the March quarter compared to the December quarter reflecting primarily
seasonal volume activity. Revenue per adjusted admission decreased 8% in the
March quarter compared to the December reflecting less intense services. The
Corporation added 13 new doctors at the six facilities during the nine months
ended March 31, 2002. The Corporation seeks to increase adjusted admissions by
attracting additional physicians to its hospitals and upgrading the services
offered by its hospitals.

Operating expenses, including depreciation, were $21,160 and $13,429 for
the quarters ended March 31, 2002 and 2001, respectively. The increase in
operating expenses in the quarter ended March 31, 2002 was due to the inclusion
of the community hospital segment for three full months in the current year
compared to two months in the prior year. Salaries, wages and benefits were
45.3% of net revenues for the current quarter, a decrease from 49.6% from the

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quarter ended December 31, 2001. This percentage decrease resulted in part
due to the 3% increase in net revenue in the March quarter compared to the
December quarter and decreased employee medical insurance costs. The
Corporation has undertaken cost control initiatives in each facility to reduce
labor and other costs. The provision for bad debts was 10.8% of net revenues in
the quarter, a decrease from 11.9% in the quarter ended December 31, 2001 and
13.1% in the quarter ended September 30, 2001. The Corporations level of bad
debts reflects its high level of self-pay patients. The Corporation provides
assistance to the hospitals in implementing additional business office systems
and procedures designed to minimize bad debts. Supplies expense was 11.5% of
net revenues for the quarter, reflecting a lower level and volume of specialty
services performed in the Corporations hospitals. The Corporation expects
supplies expense to increase as additional specialty services are provided by
its hospitals.

Interest expense of $750 and $2,125 for the three and nine months ended
March 31, 2002 resulted from the debt incurred in connection with the
acquisition of the SunLink Acquisition on February 1, 2001 and for the new term
loan of $6,000 closed on January 4, 2002. Cash paid for interest during the
three months ended March 31, 2002 was $134 for the new term loan and cash
interest paid of $466 for the nine months ended March 31, 2002 was for the
short-term bridge loan and the new term loan, respectively.

On December 21, 2001, the Corporation sold its 60-bed nursing home in
Jasper, Georgia for $1,550 cash. A gain of $310 on the sale was reported as a
reduction of operating expenses in the nine months ended March 31, 2002. The
nursing home is on the campus of the existing Jasper hospital which is being
replaced by a new facility approximately five miles away. The Corporation sold
the nursing home to concentrate its management and capital resources on the
Jasper replacement hospital.

No income tax expense was recorded for the three and nine months ended
March 31, 2002 while an income tax expense of $275 and $213, respectively, was
recorded for the three and nine months ended March 31, 2001. The prior year tax
expense was the result of taxable income in the U.K. The Corporation has a net
operating loss carryforward in the U.S. of approximately $7,000 at March 31,
2002. The Corporation has provided a valuation allowance for the entire amount
of the U.S. net operating loss carryforward as it is managements assessment
that it is currently more likely than not that none of the deferred tax asset
generated by this net operating loss carryforward will be realized through
future taxable earnings or implementation of tax planning strategies.

The liability for general and professional liability risks increased
during the quarter ended March 31, 2002 due to, among other things, an increase
in general and professional liability risks retained and increased costs to
insure that portion of such risks not retained. The cost of general and
professional liability insurance (and all insurance in general) has increased
substantially during the year due to changes in the insurance market. The
Corporations general and professional liability insurance has been purchased
through early calendar 2003.

The earnings from continuing operations were $350 ($0.06 per share fully
diluted) in the quarter ended March 31, 2002 compared to a loss from continuing
operations of $425 ($0.09 per fully diluted share) in the comparable quarter
last year. The operating profit of $1,082 for the three months ended March 31,
2002 resulted from operating profit of $1,474 achieved by the community
hospital segment offset by corporate expenses of $392. The prior year
operating profit of $210 resulted from operating profit of $725 achieved by the
community hospital segment offset by corporate expenses of $515. The increased
operating profit of the community hospital segment in the current year results
from three months operating the hospital business compared to two months last
year.

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Liquidity and Capital Resources

The Corporation generated $1,532 of cash from operating activities during
the nine months ended March 31, 2002 compared to a use of $4,698 during the
comparable period last year. The cash generated in the current year resulted
primarily from the operating profit for the nine months of $1,872 plus the
noncash deprecation expense of $894 offset by cash interest paid of $466 and
increased net non-cash current assets. Receivables of the community hospital
segment increased due to the increased net revenues which was offset by
somewhat by increased accounts payable, accrued expenses and third party payor
settlements. The cash used in operating activities in the nine months ended
March 31, 2001 resulted from payment of corporate expenses and the gain on the
sale of Klippan Limited.

On January 4, 2002, the Corporation closed a $14,000 credit facility
comprised of a 36-month secured revolving line of credit for up to $8,000 with
interest at prime plus 1.25% and a $6,000 secured term loan repayable over 66
months at an interest rate of 9.78%. The availability of borrowing under the
revolving line of credit is based upon, among other things, a borrowing base
keyed to the level of SunLinks receivables which, based upon SunLinks
estimates, provides current borrowing capacity of approximately $6,900, at
March 31, 2002.If the amount or quality of receivables is lower than expected,
the Corporations borrowing capacity under the revolving line of credit will
also be lower. If the Corporation experiences a material adverse change in its
businesses, assets, financial condition, management, or operations, or the
value of the collateral securing the credit facility, the Corporation may be
unable to draw on the revolving line of credit. The Corporation does not
expect to draw on the revolving line of credit until later in its fiscal year
ending June 30, 2002. The net proceeds from the term loan of $5,800 will be
used for working capital and to fund a portion of its hospital capital projects
which include a replacement hospital in Jasper, Georgia, and a new emergency
room at its hospital in Ellijay, Georgia. The Corporation disposed of its U.K.
housewares business in October 2001 and received no net proceeds from the
disposal. At March 31, 2002, the term loan balance was $5,791.

The Corporation believes it has adequate financing and liquidity in the
U.S. to support its current level of operations. The principal current sources
of liquidity are the new revolving line of credit, the new term loan facility
and cash generated from operations of the community hospital segment. The
availability under the revolving credit facility is based upon a borrowing base
keyed to the levels of SunLinks receivables. This approximately $6,900
availability could be adversely affected by , among other things, decreases in
receivables due to lower demand for SunLinks services by patients, change in
patient mix and changes in terms and levels of government and private
reimbursement for services. Cash generated from operations could be adversely
affected by, among other things, lower patient demand for SunLinks services,
higher operating costs (including but not limited to salaries, wages and
benefits, provisions for bad debts, general liability and other insurance
costs, cost of pharmaceutical drugs and other operating expenses), or by
changes in terms and levels of government and private reimbursement for
services and the regulatory environment of the community hospital segment.

The Corporation from time to time continues to evaluate potential
acquisitions of rural community hospitals. Financing for any such acquisitions
could come from additional third-party debt, seller-financed debt or the
proceeds from issuance of additional equity. The Corporations current
third-party debt capacity is limited by the Corporations current debt to
equity leverage position.

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The Corporations contractual obligations related to long-term debt,
capital lease obligations and noncancellable operating leases at March 31, 2002
were as follows:

Contractual Obligations

|                  |  |           |        |               |  |           |     |  |  |   |       | 
|----------------- |  | --------- | ------ | ------------- |  | --------- | --- |  |  | - | ----- | 
|Payments          |  | Long-Term |        | Capital Lease |  | Operating
|due in:           |  | Debt      |        | Obligations   |  | Leases   
|                  |  |           |        |               |  |          
|1 year            |  | $         | 888    |               |  | $         | 16  |  |  | $ | 2,402 | 
|2 years           |  |           | 2,591  |               |  |           | 16  |  |  |   | 2,135 | 
|3 years           |  |           | 1,078  |               |  |           | 16  |  |  |   | 880   | 
|4 years           |  |           | 17,544 |               |  |           | 16  |  |  |   | 363   | 
|5 years           |  |           | 1,310  |               |  |           | 16  |  |  |   | 75    | 
|more than 5 years |  |           | 349    |               |  |           | 20  |  |  |   | 36    | 
|                  |  |           |        |               |  |           |     |  |  |   |       | 
|                  |  | $         | 23,760 |               |  | $         | 100 |  |  | $ | 5,892 | 
|                  |  |           |        |               |  |           |     |  |  |   |       | 

The Corporation expended $3,255 for capital improvements at its hospitals
during the nine months ended March 31, 2002. In addition to routine capital
expenditures of $1,975 during the nine months, primarily new and replacement
equipment, the Corporation expended $1,027 for costs related to the replacement
hospital in Jasper, Georgia and $253 for exterior renovations at Chilton
Medical Center in Clanton, Alabama. Management believes an attractive physical
facility assists in recruiting quality staff and physicians as well as
attracting patients. Subject to availability of financing, the Corporation
expects to expend approximately $1,400 for capital expenditures during the
three months ended June 30, 2002, approximately $800 of which will be used for
the replacement hospital in Jasper, Georgia. The total committed cost of the
new Jasper hospital is approximately $11,500, of which $1,800 has been expended
at March 31, 2002. The new hospital is currently contemplated to be funded by
the new term loan and revolving line of credit and cash generated from
operations of the community hospital segment.

At March 31, 2002 the Corporation had outstanding U.S. long-term debt of
$22,860, of which $17,969 was incurred in connection with the February 1, 2001
purchase of the six community hospitals and related businesses, $5,791 was
obtained from the new term loan and $100 related to capital leases. The U.S.
debt includes a seller financed balloon note of $16,356 and a seller financed
zero coupon note of $1,612. The balloon note, due January 31, 2006, has a face
amount of $17,000 and a stated interest rate of 8.5% which, because it was
considered a below market interest rate at the date of issuance, has been
discounted for financial reporting purposes to a market interest rate of 12.3%.
The balloon note has a payment-in-kind (PIK) feature for interest accrued
through January 31, 2003. Interest due and payable through that date may be
paid in additional balloon notes due in 2006 and the Corporation presently
intends to issue PIK notes for interest due through January 31, 2003.
Additional promissory notes have been issued for interest payable from February
1, 2001 to November 30, 2001 totaling $1,225 and the interest accrued through
March 31, 2002 of $516 has been included in the principal amount of the balloon
note at March 31, 2002.

The purchase agreement for the six hospitals provides for an adjustment to
the balloon note to the extent working capital at the purchase date was greater
or less than an agreed upon amount. The Corporation has submitted to the
seller a proposed working capital adjustment which would reduce the balloon
note by $1,300. The seller has objected to the adjustment and the Corporation
and seller currently are seeking to conclude the working capital settlement
under the dispute provisions of the sale agreement. No adjustment for any
working capital settlement has been made to the balloon note at March 31, 2002.

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The zero coupon note is due January 31, 2004, has a face amount of $2,000,
and has been discounted to a market interest rate of 11.3%. The principal
amount of the zero coupon note is subject to reduction for certain indemnified
items pursuant to the purchase agreement.

Contingent obligations remain relating to product liability claims for
products manufactured and sold before the disposal of the Corporations
discontinued industrial segment in fiscal 1989, and for guarantees of certain
obligations of former subsidiaries. The Corporation has provided an accrual at
March 31, 2002 related to a portion of the guarantee by a U.K. subsidiary of a
lease covering a portion of the former housewares segment manufacturing
facility. The Corporation currently is in the process of liquidating three
dormant subsidiaries in Canada, Germany and France. Based upon the
Corporations best estimates, no material amounts are reserved for any
contingencies related to these liquidations.

Related Parties

Two directors of the Corporation are members of two different law firms.
The Corporation has paid $275 for legal services to these law firms in the nine
months ended March 31, 2002.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Corporation is currently exposed to interest rate changes, primarily
as a result of the revolver under the new credit facility. No action has been
taken to cover interest rate market risk, and the Corporation is not a party to
any interest rate market risk management activities.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Federal government (the Government) reviewed certain medical records
of two of the SunLink hospitals, Chestatee Regional Hospital (Chestatee) and
Mountainside Medical Center (Mountainside) (collectively, the Hospitals),
prior to their purchase by SunLink, as a part of a nationwide Medicare audit
project regarding hospital (inpatient) billing practices with respect to the
diagnosis of pneumonia. The review sought to determine whether claims were
improperly coded for Medicare purposes and whether the Hospitals submission of
those claims violated applicable law, including the Federal False Claims Act.
31 U.S.C. §§ 3729 et. seq. Based upon its review, the Government has projected
that 103 Medicare claims were coded improperly by Chestatee and 91 Medicare
claims were coded improperly by Mountainside. SunLink believes the review and
analysis of all medical records identified by the Government has been
substantially completed, and interviews have been conducted by both the U.S.
Attorneys Office for the Northern District of Georgia and the U.S. Department
of Health and Human Services, Office of the Inspector General. Based upon the
Governments projections and the application of the multiple damage provisions
of the Federal False Claims Act, the Corporation estimates that, if the
Governments projections were substantiated, the total potential aggregate
liability of the Hospitals in this matter could be as high as $1,500. The
Corporation disputes and intends to vigorously resist all claims based upon any
such allegedly improper coding and believes the Governments projections do not
accurately represent the facts. Settlement discussions are underway between
SunLink and the Government. Government representatives informally have
indicated that the Government most likely would not pursue a false claims
charge, require either of the Hospitals to enter into a corporate integrity
agreement, or seek double or treble damages if a settlement is reached between
the parties. To managements knowledge, no audit has been conducted by the
Government of any other SunLink facility in connection with the pneumonia
coding investigations. Under the terms of the Stock Purchase Agreement between
SunLink and NetCare Health Systems, Inc. (Seller) for SunLinks purchase of
the six community hospitals, SunLink would be responsible for any settlement
relating to the claims against the Hospitals arising prior to their purchase by
SunLink, but has limited right of indemnification from the Seller for any
future claims which were not disclosed at the date of purchase. At March 31,
2002, the Corporation has accrued a liability associated with this
investigation. Management believes the liability is a reasonable estimate of
the future settlement of this investigation based upon recent discussions
between the Corporations legal counsel and the Government. Settlement of these
claims are expected to finalized prior to June 30, 2002, the end of the
Corporations current fiscal year.

The Corporation is also subject to various claims and suits arising in the
ordinary course of business, including claims for personal injuries and other
matters. Such pending claims and suits are either insured or, in the opinion
of management, the ultimate resolution of such claims and suits should not have
a material adverse effect on the Corporations results of operations or
financial condition.

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | (A) |  | Exhibit 10.1  Master Loan Agreement between DVI Financial
Services, Inc. and SunLink Healthcare Corp., Southern Health
Corporation, Southern Health Corporation of Dahlonega, Inc., Southern
Health Corporation of Ellijay, Inc., Southern Health Corporation of
Jasper, Inc., Southern Health Corporation of Houston, Inc., Clanton
Hospital, Inc. and Dexter Hospital, Inc. dated December, 31, 2001.         
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (B) |  | Exhibit 10.2  Loan and Security Agreement between DVI Business
Credit Corporation and SunLink Healthcare Corp., Southern Health
Corporation, Southern Health Corporation of Dahlonega, Inc., Southern
Health Corporation of Ellijay, Inc., Southern Health Corporation of
Jasper, Inc., Southern Health Corporation of Houston, Inc., Clanton
Hospital, Inc. and Dexter Hospital, Inc. dated December, 31, 2001.
|
| | (C) |  | Reports on Form 8-K  None.                                                                                                                                                                                                                                                                                                                                                                                      

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934,
SunLink Health Systems, Inc. has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.

| |  |                              |  |                                                                         
| |  | ---------------------------- |  | ------------------------------------------------------------------------
| |  | SunLink Health Systems, Inc.
|
| |  | By:                          |  | /s/ Mark J. Stockslager
Mark J. Stockslager
Principal Accounting Officer

Dated: May 8, 2002

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